Covid-19 and the ‘safe asset trap’

Pandemic policy response could end safe asset shortage

‘Safe assets’ are a pillar of an ordered financial system. They are a store of value for institutions including pension funds and insurance companies, as they allow them to match long-term assets to long-term liabilities. They are also structural elements of commercial bank balance sheets.

More generally, they are used by financial institutions to meet regulatory requirements and provide collateral to borrow additional funds. These stores of value come in many forms: cash, bank deposits, US Treasury bills or European government bonds. They can include high-rating corporate bonds, stocks and real assets such as real estate, infrastructure and gold.

In recent decades the supply of safe assets has not kept pace with global demand. The collective growth rate of the advanced economies that produce these assets has lagged the global growth rate. Tight fiscal policies in advanced economies reduced the supply of safe assets, and central and commercial banks have absorbed much of the high-quality sovereign bond stock.

In theory, since the price of government bonds is determined by the interaction between supply and demand in the market, a supply shortage produces lower yields, as happened after the 2008 financial crisis. When bond yields in many economies approached zero, a huge gap in the supply of safe assets was created. Economists developed the concept of a ‘safe asset trap’ to describe the phenomenon.

Owing to strong volatility, there has been a flight to safety and liquidity among investors, and government bond yields in core European nations and the US have fallen sharply. As a consequence of central banks easing policy, rates in several advanced economies fell close to zero, and government bond yields are expected to stay low for even longer. The stock of government bonds with yields of less than 1% doubled to around 80% in March from around 40% outstanding at end-2019.

Covid-19 may help capital markets overcome the ‘safe asset trap’. Rising national public debts among European Union member states, as well as new virus-related instruments, may create large amounts of sovereign and EU bonds. The vast sums of money that public funds are putting into the recapitalisation of stressed enterprises may provide higher-quality stocks while raising the calibre of corporate bonds issued. The US has committed to raise its debt by $3.7tn through September to cover increases in spending and the decline in revenues.

Sovereign funds are becoming increasingly important issuers in global capital markets, adding to the stock of quasi-governmental debt. Some issue to reach their target portfolio size. Many do so for leverage, others to spur the development of local capital markets. Some funds have tapped capital markets to bolster their response to the pandemic.

Cassa Depositi e Prestiti’s Covid-19 social response bond is one example. Greater issuance of debt by sovereign funds in highly rated jurisdictions helps promote good macroeconomic policy-making by adding to the stock of available safe assets.

The question is, are the yields of these new safe assets going to be high enough to maintain the long-term value of assets managed globally by pension funds, insurance companies, endowment funds and the like? If the economy recovers and demand for safe assets surpasses supply, then institutional investors may escape the safe asset trap and enjoy the long-term higher yields they require.

Edoardo Reviglio is Head of International and European Projects at Cassa Depositi e Prestiti. This article was originally published in Global Public Investor 2020.

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