Is canceling the debt an option for future?

Fixed-income executives across the globe are weighing in on a debate over whether governments and central banks should simply cancel the piles of sovereign debt they've accumulated over recent years to prop up developed economies.

The topic is front of mind for some executives because of the huge amount of money being printed by central banks and the trillions of dollars of fiscal spending — major tools used by advanced economies in efforts to curb the economic impacts of the coronavirus pandemic.

The options are clear: Write it off or pay it back. But the path to arriving at one of these conclusions is less obvious, sources said.

Some think canceling debt should be in governments' and central banks' toolkits.

"The reason this matters is because everyone is sitting round today saying, 'Oh my God, we've got a pandemic going on, governments are spending money left, right and center and we're going to be paying the bills of this for years to come'" through higher taxes, for example, said Mark Dowding, London-based CIO at BlueBay Asset Management LLP.

While the need to raise taxes to repay this debt may be the perceived wisdom, "my argument is it doesn't need to be repaid. Intrinsically, central banks have bought that debt and it sits on their balance sheet and could sit there forever. In bond markets, nobody is expecting those central banks to pay back to the market ever, and essentially … it becomes almost like an accounting equation: You owe yourself money. It doesn't really matter. (Governments) could almost afford to forget about that debt or ostensibly cancel that debt," Mr. Dowding said.

The Bank of England, for example, could switch the maturity on all the gilts it owns to 10,000 years and with an interest coupon of zero. "If they wanted to do so, they could do so. The relevance is understanding that when you look at this metric of debt to GDP … you don't need to do anything about it at all. We do not need to condemn our populations to another lost decade of austerity," Mr. Dowding said.

While sources pointed out that moves by central banks and governments were in no way unwarranted, International Monetary Fund figures show how debt-to-GDP ratios have skyrocketed. Gross government debt to gross domestic product in the U.S. hit 131% at the end of 2020, from 95% in 2010. The U.K.'s ratio was 108% to end 2020, up from about 75% in 2010.

Eurozone gross government debt to GDP was almost 90% as of Sept. 30, the most recent data available on the region's Eurostat statistical records. At the end of 2010, the ratio was approaching 80%. Sources estimated that gross eurozone government debt to GDP is currently hovering around 100%.

"We in the U.S. have been dispensing dollars by the trillions, and it's being done in a very casual way," said Tad Rivelle, chief investment officer for fixed income at TCW Group Inc. in Los Angeles, which had $248 billion in assets under management as of Dec. 31. "There has been an utter lack of concern about both the size of the U.S. fiscal deficit as well as the extreme expansion that has taken place at the Fed in terms of its balance sheet."

Some managers, including Vontobel Asset Management AG, think it's just not a realistic scenario to cancel debt for the foreseeable future. Whether to cancel sovereign debt accumulated on central bank balance sheets is "a really interesting argument," said Simon Lue-Fong, London and Zurich-based head of fixed income. "In a way, I understand the arguments for that — why not? No one's a loser from it so to speak. … But the money is still sloshing around there and that brings up all sorts of questions on inflation and crowding out and the whole aspect of central banks being independent," he said.

Mr. Lue-Fong remembers in the 1990s when the Bank of England gained independence from the government and yields "exploded downwards — it was a great thing that your central bank was independent. The market rewarded that."

What's been interesting is that governments' increased interventions in markets and economic policies has not had the opposite impact on yields. "You could say we are in this new world because investors no longer require a risk premia for" central bank independence, Mr. Lue-Fong added.

Another option in reducing or getting rid of accumulated sovereign debt might be to default on it. However, advanced economies do not have the luxury, in some ways, that emerging markets do in terms of resorting to defaulting on their debt.

"As it relates to the notion of an explicit type of sovereign default, I think that's outside the pale in the developed markets," Mr. Rivelle said. "There is no reason or basis to believe anybody is going to seriously contemplate such measures, particularly in the eurozone where it would essentially destroy the banking system." A default would also push up future borrowing costs for a sovereign state.

Fostering inflation is another way of reducing this debt, sources said. It is "like a partial, slow default over time — it's one way to degrade the burden of the obligations," TCW's Mr. Rivelle said.

In fact, inflation is a more "meaningful concern" than whether politicians decide to raise taxes, Mr. Rivelle added. "Capital markets are beginning to price in higher probabilities of higher inflation."

Using Treasury inflation-protected securities as an example, he said the probability the market expects inflation to be 3% or higher in the next couple of years is 20% to 25%.

Canceling the debt could also be inflationary — an issue for all pension funds as they're heavily invested in debt, said Colin Reedie, London-based co-head of global fixed income at Legal & General Investment Management Ltd. "There are so many moving pieces here, it's hard to say with any degree of certainty how this (would) play out. Austerity is arguably easier — growth expectations take a hit, markets would likely correct, but we've seen that before. It's the alternative that's very different," Mr. Reedie said.

Ultimately, the internal debates among money management executives over debt cancellation arrive at a stalemate: Whether it's the right or wrong decision for governments and central banks to make, it likely won't happen anytime soon in advanced economies.

"Frankly I don't think (central banks) will go nuclear and press the button (to cancel the debt), as much as I think it would be entertaining to see the Bank of England pick up all of its gilt certificates and have a big bonfire in Exchange Square" in Central London, BlueBay's Mr. Dowding said. "But I could see a situation where central banks do acknowledge that the expansion in their balance sheet is permanent." However, it is time to have a conversation about government debt levels and understand that elevated debt-to-GDP ratios do not equate to the need for higher taxes, he added.

LGIM's Mr. Reedie agreed that cancellation of debt is unlikely. "Do governments need to pay off their debt? They are so powerful and so strong they can almost do whatever they want. We saw that in all its glory last year and now we're abandoning any pretense that we need to pay it (off)," he said.

Insight Investment executives also do not expect debt to be canceled right now, with central banks continuing with purchases to hold interest rates down, said Gareth Colesmith, head of global rates and macro research, London. "With monetary policy reaching its limits as a policy tool, it is our belief that developed economies have now entered a period we are calling neofiscalism, whereby governments run highly expansive fiscal policies to counter structural disinflationary forces, while central banks enact financial repression to allow this fiscal expansion to remain affordable," he said.

And as Vontobel's Mr. Lue-Fong pointed out, while interest rates are low and look to remain that way for years to come, why risk destroying confidence in what central banks and governments are choosing to do to support their economies?

"I'm not saying it can't work, but I think the path of least resistance is to do nothing — keep on accumulating debt, let levels keep going up and to use that great phrase: Keep calm and carry on," he said.