Sovereign debt haunts Europe

Dominic McCormick argues that the sovereign debt problems experienced by some European countries could continue to ripple through the global economy.

A recent article in the Weekend Australian Finance Review (January 29/30) titled “The bonds baby boomers need” discussed the need for more bonds in investment portfolios — particularly those of retirees.

Several other financial services groups, typically fixed interest focused fund managers or brokers, have also been promoting the case for more bonds.

While I do agree with one aspect of their argument — that retail portfolios are typically too exposed to equity risk and need more diversification — the idea of adding more bonds, especially certain government bonds, strikes me as a rather dangerous strategy in the current environment.

A crisis in major sovereign bond markets resulting in significantly higher yields, losses on many bond/fixed interest funds and significant implications for other asset classes is one of the major risks for the next few years.

We have already seen a preview of what the early stages of such crises may look like given the experience of the European ‘PIIGS’ (Portugal, Ireland, Italy, Greece and Spain).

But to date the broader market impact of these events has been minimal or brief. In fact, most major developed bond markets rallied (rates fell) in response to these concerns in 2010, even though some of these countries may ultimately face similar issues.

While a broader based sovereign bond market crisis is no certainty, building portfolios without being cognisant of the developing risks is dangerous. Complacency is rampant and growing risks are being ignored largely because of the positive experience of most bond market investors over recent decades.

Depending on the country, government or sovereign bonds have been in a major bull market with gradually declining interest rates for most of the last 20-30 years. In a number of cases, bonds have outperformed equities over these long-term periods, challenging traditional finance theory.

There have been a few bumps along the way — in 1994 Australian 10-year bond rates, for example, moving from just over 6 per cent to over 10 per cent — but mostly it has been relatively smooth sailing. And everyone knows that government bonds were one of the few assets that made money in 2008.

The general perception remains that sovereign bonds of developed countries are among the safest investments around. The long-term bond rate is often referred to as the ‘risk-free’ rate.

The last defaults of any ‘rich’ countries were in the middle of the 20th century, and the sovereign debt of most developed countries is still highly rated by the rating agencies.

Surely, then, these high ratings and excellent track records confirm that developed country government bonds are a solid returning, low-risk, diversifying asset, fully deserving a prominent role in virtually all, and particularly conservative, portfolios today.

However, what this view lacks is a perspective on value, on current fundamentals of sovereign issuers and on likely scenarios for the global economic/investment environment over the next few years.

The full story

Much of bond markets’ good performance in recent decades has come significantly from the capital gain resulting from them being initially priced at very high yields in the early 80s and 90s — on fears of ever increasing inflation — and moving to very low yields in recent years.

However, once this move has occurred it cannot be a future source of further strong returns. With starting yields of 3 per cent or 4 per cent today, it is foolhardy to extrapolate the much higher historical returns into the future.

From a credit/fundamental perspective many government bonds have become much more risky in recent years as fiscal deficits have grown and public debt levels ballooned. In the rest of the world the global financial crisis (GFC) is called the ‘credit crisis’, and it is governments that have effectively taken on much of the problematic debt from the private/financial sector.

Poor fiscal policy in the last decade and the recent recessions have also contributed.

A risky corporate or individual borrower in bad financial shape with excessive debt would already be paying a much higher interest rate.

However, the government bond market’s reputation as a safe haven coupled with widespread deflationary fears has meant markets have been slow to apply similar conditions on more vulnerable sovereign bonds.

Only the last year’s problem in peripheral Europe is beginning to change this attitude.

Investing in a number of sovereign bond markets now is like backing an ageing athlete based on how he or she used to perform in their 20s — rather than on the flabby, unfit, injury prone, ‘post athlete’ they have become in their 40s.

The crowd is still cheering that bonds are a good investment (and keeping yields close to record lows) but the underlying fundamentals have rapidly deteriorated in recent years and could deteriorate further in coming years.

It is not just peripheral Europe that is vulnerable to dramatic reassessment. Japan’s public debt is over 200 per cent of gross domestic product (GDP).

The UK is also struggling with high deficits and debt. The US is forecast to have a deficit in 2011 of $1.5 trillion (or around 13 per cent of GDP) and with the ratio of public debt to GDP likely to surpass 100 per cent later in the decade.

These deteriorating fundamentals are occurring with interest rates at near record low levels — if a crisis does begin to develop, then the rising cost of servicing excessive debts as rates rise could create a vicious feedback loop that exacerbates the problem.

Debt servicing will also become harder for most developed nations in the future with an ageing workforce and a reduced income tax base.

Last year’s European bailouts of Greece and Ireland (with more likely to come) may just be holding off the true day of reckoning by delaying needed restructuring or default. It’s like delaying a hangover by plying a drunken person with more alcohol. It may work for a while but the eventual hangover will be much worse in the end.

Some investors are still most worried about deflation and want to hold bonds, because a deflationary environment is the one setting in which bonds are seen to do very well.

But even this outcome depends on the simplistic view that the level of inflation/deflation is always the most important driver of bond interest rates. While this is the case in normal circumstances, when default, restructuring or debasement risk comes into the equation this view is simply wrong.

For example, both Greece and Ireland are facing significant deflationary pressures yet their bonds have been very poor investments in recent times

Of course, deflation without default or restructuring could make some bonds good investments even from current low yields, and one should not totally write off deflation as a scenario.

Further, I am not suggesting that investors avoid all sovereign bonds.

However, while the outlook for inflation is uncertain, it is noteworthy that some of the more vulnerable countries, such as the US and UK, are pursuing policies specifically designed to increase inflation (ie, designed to give you, the investor, a lower real return).

Part of this inflation risk may be the result of imported inflation from commodity prices and/or currency weakness (the latter is also often the result of specific government policies to devalue the currency to remain competitive).

An investor in US treasuries today is buying into an investment at a starting interest rate not far from 50-year lows, issued by a government that some believe will be insolvent within a decade unless fiscal policies are dramatically changed and whose monetary authorities are pursuing policies to undermine your real yield by specifically trying to create inflation.

And these policies are also debasing the very currency in which these securities are issued. Of course with the benefit of the world’s reserve currency, debasement via inflation and currency depreciation rather than some form of default or restructuring may be a preferred path for the US.

If US treasuries turn out to be a good investment in coming years it will be in spite of the authorities’ concerted efforts to make them a poor one.

We cannot rely on the rating agencies to warn us of upcoming problems. The GFC showed that they make major mistakes, are often conflicted and tend to move slowly.

However, the fact that we have recently seen both Moody’s and Standard & Poor’s (S&P) express concern about debt levels in the US, and S&P downgrade Japan’s long-term debt rating from AA to AA-, should be causing alarm.

The International Monetary Fund has also recently expressed concerns on the debt levels of major economies.

Meanwhile there seems to be enormous complacency among many institutional and retail investors that hold large and often increasing amounts of bonds.

Many were burnt in 2008 and feel more in bonds are necessary.

In 2009 and 2010 retail money was pouring into US bond funds. Banks’ liquidity rules and risk aversion are leading them to hold large exposures to highly rated sovereign debt (the GFC arose largely from financial institutions gorging themselves on highly rated mortgage-backed securities).

China and emerging markets have ended up with large holdings in US treasuries in their reserves as a result of large trade surpluses, partly to restrain the appreciation of their currencies against the sagging US dollar. From a contrary investor perspective these are all worrying signs.

Forget gold, commodities or emerging markets. The biggest long-term bubble today is arguably the government bonds of some major countries — including the US, UK and Japan.

Answering the critics

Critics of this view would highlight that those betting against the US or other bond markets have been wrong for years.

Why is now any different? 2009 changed the playing field in that we saw the beginning of moves towards sovereign bond defaults/restructurings in several developed countries (eg, Ireland, Greece) for the first time in over 60 years — and this is being reflected in market pricing.

Why else would the yields on Irish and Greek bonds be at 9.5 per cent and 11.5 per cent respectively when yields on German bonds (all denominated in Euro) are just over 3 per cent?

The dam has cracked, and the bonds of many heavily indebted developed countries are beginning to be priced with more emphasis on their risk of default/debasement rather than as a safe haven asset with a small premium over historically stable inflation rates.

A common view in the US, even among those who fully understand that the debt situation is unsustainable, is that this won’t become a real problem for a number of years yet.

When the consensus is that the market may crash but not for a while yet, you can be almost certain that consensus is totally wrong in one of two ways.

Either the crash never happens, or it happens much earlier than people expect. Either way market prices of most bonds do not really reflect the risk of a crisis occurring, which is why it will be so devastating if it occurs.

Of course, some countries are in much better shape from both a valuation and fundamental perspective, and fortunately Australia is one of those with absolute yield levels at 5-6 per cent (well above most developed countries) and low public debt levels at around 22 per cent of GDP.

While having an excessive home bias towards Australian equities could be a poor strategy in the future, a significant skew to Australian bonds in the fixed interest component — including inflation-linked bonds — could make sense.

Having said this it would be hard to see Australia being immune from dramatically rising bond rates globally, especially in the US.

Further, the universe of available investment grade securities covers more than government bonds, and arguably some corporate borrowers are in better shape financially than many governments (although they are still hostage to what government fiscal and monetary policies can do to the currency in which their debt securities are issued).

Good active fixed interest managers are in a position to avoid the more vulnerable areas.

The problem is that most global bond/ fixed interest funds are benchmarked against indices that are dominated by government debt and by the countries that arguably are most vulnerable to crisis.

The Barclays Global Aggregate Bond Index consists of 57 per cent government debt and the vast majority of this is Japanese, European, UK or US debt. Even if they have a negative view ‘tracking error’, focused managers will end up with this sovereign risk as the dominant risk in their portfolios.

There also seem to be many local investors who see the ‘currency pick up’ currently available from hedged foreign bonds because of the Australian/overseas interest rate differential as an easy and semi-permanent ‘free lunch’.

The irony is the lower the overseas interest rate — and probably the more overvalued their bonds — the bigger this currency pick up component of total return is.

But this is hiding the pure risk involved in investing at low yields and the risk of sharp rises as markets normalise and inflation fears emerge or as some of these default issues become more prominent.

The image of picking up pennies in front of the steamroller comes to mind.

What to do?

If one takes these risks seriously, what should investors do with respect to their fixed interest exposures? My suggestions are:

• Don’t overload on bonds just because they did well in 2008 and over recent decades — look forwards, not backwards;
• Look for fixed income exposures that are less vulnerable to a crisis (eg, less indebted countries, better corporate debt, floating rate, and selected inflation linked bonds). Or use non-benchmarked active managers with total flexibility to invest in these areas;
• Consider ways to specifically hedge against sovereign debt crises. Unfortunately this is not easy to implement as it may involve direct derivatives strategies or specialist offshore funds;
• Consider some exposure to assets that could do well if certain governments attempt to reduce the impact of their debt levels by implementing policies that create inflation (eg, gold, commodities, agricultural land et cetera); and
• Think about the currency implications of such moves and the overall currency exposures across portfolios. Look to avoid or limit currency exposure to those countries most vulnerable to a sovereign debt crisis and/or pursuing policies likely to debase their currency.

If a broad-based bond market crisis does develop it will also have significant global economic and investment implications and could affect almost all other asset classes.

Some countries could see much higher inflation or even hyperinflation, while higher bond rates could ultimately bring about severe recession or depression.

The higher cost of capital and a ‘risk-free’ rate would see a de-rating of equity markets and lower price/equity ratios, although the effect across different markets and sectors could vary.

In some countries the shift out of poorly performing bonds could actually be a positive for equities — although it may be important to be currency hedged.

Robust businesses with well-diversified earnings that can still rise with inflation could also still do relatively well.

On the other hand, periods of debt crisis and associated extreme currency volatility have historically inspired trade wars and geopolitical instability. This has certainly not been a positive for equity valuations in the past.

Even if you believe this scenario only has a very small probability of occurring, it is worth considering because of its significant implications.

Too often, investors focus on fighting the last war. Sovereign bonds were good to own in 2008. Next time though, some sovereign bond markets could actually be the cause of a new crisis requiring a very different approach.

Dominic McCormick is the chief investment officer at Select Asset Management.