Europe's debtor paradise will end in tears

Quantitative easing in the eurozone is different. Its hallmark is the advance of negative interest rates and negative bond yields across the continent.

That did not happen in the US and the UK because these countries had large fiscal deficits when the Federal Reserve and the Bank of England began their respective bond buying programmes. There was more than enough bond issuance back then to keep bond yields positive. In the eurozone, by contrast, extreme monetary loosening confronts fiscal orthodoxy. Result: eurozone bonds are so scarce that investors end up paying for the privilege of lending to governments.

With an estimated €1.5tn eurozone bonds now showing negative yields, the eurozone looks increasingly like a debtors' paradise. Ratios of debt to gross domestic product look manageable even in the most heavily indebted countries. The definition of solvency is up in the air as debt burdens are refinanced at ever longer maturities. Creditors are the losers, though with at least one big exception: members of defined benefit pension schemes.

Pension fund liabilities are, in effect, long term loans by employees to the sponsoring company, secured on the assets of the fund. As long as the company remains solvent it matters not a jot to the employees what happens to investment returns. The return on their loans is insulated from market fluctuations because it is defined in relation to salaries. The trend towards liability matching is helpful to them because a portfolio of government bonds with matching duration and stable returns guarantees prompt payment of benefits when they fall due, regardless of what happens to bond yields.

For the sponsoring company and its shareholders it is another matter. Negative bond yields cause the value of liabilities to balloon and the adverse impact on the pension fund's solvency will tend to outweigh any benefit from QE on the value of the assets. In crude terms, if the assets produce a negative income, the fund will need more of them to match a given liability. That can be a very expensive proposition for the sponsor.

This reflects interestingly on the fashion for liability driven investment. Part of the logic was that shareholders should not be exposed to the risk of allocating pension plan assets to equities, which are more risky than bonds. If the company wanted to take equity-type risks this could be done more efficiently on its own balance sheet. What that means in today's negative yield environment is that companies and shareholders are exposed to an unprecedentedly high cost of supposedly risk free bonds. The resulting prospect of widening pension fund deficits could lead to greater risk aversion in corporate investment.

For big companies with access to the corporate bond market there can be an offset while borrowing costs remain absurdly cheap. Yet if they do choose to invest, there is a question of how QE affects capital allocation. The risk is that cheap borrowing will finance suboptimal investments, whether in fixed assets or expensive share buybacks in a frothy equity market. At the same time the debtors' paradise keeps zombie banks afloat and allows them to roll over the debts of zombie companies. That in turn holds back productivity growth.

From the perspective of investors there is a growing question about the quality of earnings, which are flattered by the decline in interest rates and, in the eurozone, by the benefit of devaluation where companies choose to preserve profit margins rather than expand market share.

The big question concerns the endgame. In the eurozone sovereign debt market siren voices are declaring that limits on public debt need rethinking given that debt servicing costs are manageable and nobody is worrying about default risk except in the case of Greece. The ease of debt servicing also takes the pressure off governments to reform. Even those of us who do not share the German penchant for fiscal austerity have to ask where it all ends.

That question hinges partly on whether negative yields reflect secular stagnation or a global savings glut. Either way, there is the further question of whether markets have lost their capacity for mean reversion.

It will take quite a while for the negative yield phenomenon to go away, but go away it will. And when it does, those who thought it a good idea to rethink conventional definitions of solvency may have a nasty surprise.

The writer is an FT columnist

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