The persistence of low interest rates considered by Deloitte’s Ian Stewart

Ian Stewart, Deloitte’s chief economist in the UK, has drawn up a list of cautionary points for bond investors to consider amidst ongoing demand for certain debt instruments.

One of the striking features of the financial scene today has been the extraordinary low level of interest rates on the bonds of major industrialised nations.

Interest rates – or yields – on ten year bonds issued by the UK government are at the lowest level since 1703. Over the summer yields on German and Swiss two year bonds turned negative, creating the remarkable situation in which investors are paying for the privilege of lending money to governments.

Not everyone has benefitted from this process. Despite last week’s announcement by the European Central Bank of unlimited bond buying, the cost of borrowing for ten years for the Greece government is more than ten times what Germany pays.

Yet for the countries in the northern part of the euro area, and pretty much all industrialised countries elsewhere, the cost of borrowing for the government is exceptionally low.

For these countries high levels of government borrowing haven’t deterred investors from buying government debt. Indeed, US ten-year bonds have risen in value by 11% since Standard Poor’s downgraded America’s debt rating citing concerns about the ability of the government to control the deficit.
Four factors seem to be at work.

Demand for safe assets has risen as the uncertainties confronting the world economy have risen. Investors are willing to pay a premium to insure against the risk of big declines in the value of their capital. So in the UK investors have kept buying government bonds despite the fact that interest rates on bonds have failed to keep up with inflation for four years.

Declining growth expectations in the industrialised world point to lower returns on risky assets such as equities. This process has supported demand for government bonds and, in turn, reduced yields. (The interest rate on bonds declines with rising bond prices).

Government bonds offer protection against the risk of deflation. At the end of its term investors are assured of getting their money back.

Meanwhile, the financial crisis has created powerful new sources of demand for government bonds. To counter the risk of deflation central banks have embarked upon Quantitative Easing – buying government bonds on a huge scale. In addition to that, regulation designed to strengthen the financial sector has led banks to increase their holdings of government bonds.

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