BIS Warns Government Debt Is So Large It’s Distorting Credit Markets

Research from the central bank for central banks shows government debt is pushing its limits. The Bank for International Settlements (BIS) latest quarterly review reveals sovereign debt is now so abundant that it’s eroding the discount they once enjoyed. The scale is so large it’s distorting credit markets and mispricing corporate risks while quietly inflating household borrowing costs.

The Risk-Free Rate and Why It Matters

Credit markets are competitive, and the risk-free rate sets the pace of the game. Interest rates rise and fall for a lot of reasons, like monetary policy or inflation, but at a high level it’s all about risk. Whether it’s non-payment or inflation, investors demand compensation for the risks they assume. The risk-free rate is the benchmark set by the least risky yields: sovereign bonds. 

Makes sense, right? The party in charge of the printing press is least likely to default on its obligations. Their yield is the risk-free rate, setting a baseline cost for all borrowing. Everyone else is riskier, so they add a spread to compete. The riskier the borrower, the larger the required spread, and the more they pay. Companies like Apple borrow near the benchmark, while subprime lenders pay a lot more. 

In theory, yields should represent relative market risks. However, baseline distortions can make the whole market underassess market issues. That’s what the BIS is pondering, as a broken benchmark means the whole system is mispriced. 

Excess Government Debt Distorts Markets, Drives Yields Higher

Corporate credit spreads are unusually small, which can suggest a low-risk environment. BIS researchers argue that isn’t the case, as companies aren’t suddenly safer. The problem is the benchmark used to measure the risk that’s now distorted. Governments are borrowing at such as scale it’s becoming difficult to absorb. Investors are now asking for a premium to absorb the bonds, distorting the entire market.  

It’s attributed to a falling “convenience yield,” the premium investors place on holding sovereign bonds. Since they’re supposed to be safe and liquid, investors typically accept lower yields. However, a lack of fiscal constraint in recent years has resulted in expanding debt issuance and excess supply. Sovereign yields are climbing, driving the benchmark cost of borrowing higher. 

The researchers note the convenience yield has turned negative, in some cases. Investors now demand a premium, rather than granting a discount to hold sovereign bonds. After flooding the market, sovereign issuance no longer provides investors with better liquidity. The cost of sovereign borrowing isn’t rising due to credit rating downgrades or missed payments, but the market simply isn’t large enough to absorb it.

This seems like an issue for the monocle-wearing crowd, but it has very real consequences. If sovereign yields no longer reflect risk-free pricing, the entire credit market is mispricing risk. That’s a problem that impacts the whole economy. 

Distorted Benchmarks Misprice Risk, Inflates Borrowing Costs

A distorted benchmark means credit risk is underpriced, and quietly inflates borrowing costs. Since sovereign yields act as the benchmark for other loans, the impact spreads through the economy. For example, Canadian fixed-rate mortgages are directly based on government bond yields. At the same time, governments themselves pay more to borrow as the convenience yield erodes. The public ends up spending more on debt servicing, leaving less for services and infrastructure.

The biggest issue is systemic mispricing. Compressed spreads can mask underlying risks, giving the illusion of economic strength. That makes markets more fragile, as they’re more vulnerable to sudden repricing when reality catches up. If the benchmark is a broken foundation, it presents a risk to everything built on it.