Definition: “In economics, crowding out is any reduction in private consumption or investment that occurs because of an increase in government spending” (source: Wikipedia). The government spends more, financed by raising taxes (reduces consumer demand) or increased government borrowing (reduces capital available to other asset classes). Global governments (excluding China) have high single digit deficits for 2010 (US is around 10%, Spain is around 9%). They will need to, and have indicated they will, increase taxes AND issue more government debt. Macroeconomic schools of thought are varied on the effect on consumer consumption and the effect on financial markets when a government issues more debt than historically seen.
Analysts have calculated that around $9 to $14 trillion of government debt will need to be issued in 2010 (US around $1.5 trillion) to finance their deficits. If governments print money (US 2009 occurrence) this will eventually lead to inflation. If governments issue more debt than the markets deem prudent, this will eventually lead to a Greece-type of problem. However, there is a knock-on effect to corporate bond spreads (difference between the yield on US Treasury bond with comparable maturity and the yield on a corporate bond). The global government bond market is changing from viewing government bonds as a rate product (based on inflation differentials) to a credit product (based on credit quality of underlying issuer). For example, an emerging market bond fund will now view corporate bonds and government bonds in the same sphere. Corporate bonds will also have a “push” factor incorporated into their attractiveness, based on increased tax rates and reduced consumption leading to lower overall net profit margins, thus affecting their attractiveness (this is more of an emerging market story than a developed market story). If the yields on government debt increase and the corporate/government debt spread decreases, this will make it difficult for corporations to issue the debt needed (especially relevant in the US and UK for CMBS and RMBS re-financing in 2010 - 2012).
After the dramatic spread compression from fall 2008 highs to current spreads, corporates have an added uncertainty with regard to spread increases, not because of credit quality challenges but because of global government debt issuance. Markets are already pricing in this uncertainty. The relationship between government and corporate issuance should be discussed with your bond manager who invests in taxable bonds.
Bottom line: Investing in bonds carries different types of risks than investing in stocks. Bond investors need to understand those risks and plan for the needs they expect their bond investments to meet. Investing in bonds is neither good nor bad. It depends on the goals you expect the bonds to help achieve.
Always Asking, Never Assuming™
Christopher Holtby