Government debt levels have grown so large that they are beginning to distort how credit markets function, according to new research from the Bank for International Settlements (BIS). In its latest quarterly review, the BIS warns that sovereign debt issuance has reached a scale that is eroding the traditional role of government bonds as the global risk-free benchmark.
As a result, baseline borrowing costs are rising, corporate risk is being mispriced, and household borrowing costs are quietly increasing across advanced economies.
Why the Risk-Free Rate Matters for the Entire Economy
At the center of the BIS warning is the concept of the risk-free rate, a foundational pillar of global credit markets.
In theory, interest rates compensate investors for risk. The greater the chance of default, inflation erosion, or liquidity stress, the higher the return investors demand. Government bonds issued by advanced economies have traditionally been viewed as the least risky assets, since governments control taxation and currency issuance.
Because of this, sovereign bond yields act as the baseline cost of borrowing:
- Highly rated corporations borrow near government yields
- Riskier firms pay wider credit spreads
- Subprime borrowers face the highest borrowing costs
When this benchmark functions properly, markets price risk efficiently. When it becomes distorted, mispricing spreads throughout the financial system.
Excess Government Borrowing Is Pushing Sovereign Yields Higher
The BIS argues that the benchmark itself is now under strain.
Corporate credit spreads remain unusually compressed, which would normally signal a low-risk environment. However, BIS researchers caution that companies have not suddenly become safer. Instead, governments are issuing debt at such a scale that markets are struggling to absorb the supply.
As issuance expands, investors are increasingly demanding compensation to hold sovereign bonds. This dynamic pushes government bond yields higher, raising the baseline cost of borrowing for the entire economy.
The Collapse of the Sovereign “Convenience Yield”
Historically, investors accepted lower yields on government bonds because of their safety, liquidity, and ease of trading. This benefit is known as the convenience yield.
According to the BIS, years of fiscal expansion have flooded markets with sovereign debt, reducing its liquidity advantage. In some cases, the convenience yield has fallen to zero or turned negative.
This means investors are no longer granting governments a borrowing discount. Instead, they are demanding a premium, not because governments are defaulting, but because the market is saturated with issuance.
How Distorted Benchmarks Raise Borrowing Costs
When sovereign yields no longer reflect true risk-free pricing, the consequences extend far beyond government finance.
Because government bond yields anchor credit pricing:
- Fixed-rate mortgages rise as bond yields increase
- Business borrowing becomes more expensive
- Governments spend more servicing debt, reducing fiscal flexibility
In Canada, fixed-rate mortgages are directly tied to government bond yields. As sovereign borrowing costs rise for structural reasons, households face higher mortgage rates even without changes in monetary policy.
Why the BIS Is Concerned About Systemic Risk
The BIS emphasizes that distorted benchmarks can hide underlying vulnerabilities.
Compressed credit spreads can give the appearance of stability while risks quietly accumulate. When markets are mispriced, they become more fragile and prone to sudden corrections rather than gradual adjustments.
If the foundation used to price credit is distorted, every layer of the financial system built on top of it becomes more vulnerable.
The Bottom Line
The BIS is not warning of an imminent crisis. Instead, it is highlighting a structural shift.
Government debt has grown large enough to alter how credit markets price risk, pushing up borrowing costs and weakening the reliability of traditional benchmarks. As 2026 approaches, these distortions may continue to influence mortgage rates, corporate financing, and fiscal sustainability across advanced economies.
References
Bank for International Settlements. (2025). Quarterly Review: Global liquidity, sovereign debt, and credit markets. https://www.bis.org
Better Dwelling. (2025). BIS warns government debt is distorting credit markets. https://betterdwelling.com
Bank of Canada. (2024). Government bond yields and mortgage rate transmission. https://www.bankofcanada.ca
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