Are ‘Sovereign Debt Funds’ Wise?

Ashby Monk

Isthimar and its parent Dubai World have been having a rough go of it since September. However, the situation got much worse over the long weekend. I don’t want to spend too much analysing this, as it has been on the front page of every newspaper in the world. However, I do want to think more about ‘sovereign debt funds’–which I would define as an SWF that receives its capital almost exclusively from the issuance of debt. In short, I wonder if it is sound policy for a government to borrow funds (through their wholly owned SWF) for the explicit purpose of investing in riskier assets?

There are clear benefits to such a policy, as the fund is issuing debt at a favorable interest rate thanks to the sovereign backstop, which would seem to suggest that the SWF could return (over the long-term) more than their debt service (i.e. make a profit). But, as we have seen recently, such a policy comes with substantial risks.

This situation reminds me of pension obligation bonds (POBs) in the United States. POBs are general obligation bonds issued by the (state or local) government for which the proceeds are immediately handed over to the public pension fund for investment in riskier assets.  The governments that issue POBs are seeking to fill pension funding gaps in plans by taking advantage of an actuarial arbitrage that assumes pension assets will out pace debt servicing costs. So, in my view, the economic principles that underpin POBs are similar to those that underpin Dubai World. So long as times are good, these instruments / institutions look wise. Once a crisis hits, it’s pure folly.

Indeed, in 2007, governments that issued POBs were probably pretty happy with themselves. And yet, their perception of these instruments today is probably quite different, as the bond proceeds that were invested through the pension fund have been dramatically discounted. This means that the objective of filling the pension gap has not been achieved and, moreover, the governments still have to pay off the debt. Significantly, it’ll be the citizens / taxpayers who pay in the long-term.

It is for this reason that former New Jersey Governor Jon Corzine called POBs “The dumbest idea I ever heard…It’s speculating the way I would have speculated in my bond position at Goldman Sachs.” In the future, will we say the same thing about sovereign debt funds I wonder? Time will tell…

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This website is a project of Professor Gordon L. Clark and Dr. Ashby Monk of the School of Geography and the Environment at the University of Oxford. Their research on sovereign wealth funds is funded by the Leverhulme Trust and The Rotman International Centre for Pension Management.

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