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A new map of risk

There has been a remarkable turn-round in sovereign debt, with emerging nations safer than some developed countries

Geoff Hitchin
Geoff Hitchin

Protestors have taken to the streets in Greece, Italy, Spain and Portugal to fight government austerity measures and expectations are growing of a sovereign default in the eurozone.

For bond investors the global risk map for govern-ment debt has been redrawn. A number of developed nations that would once have been marked green, as in go ahead and buy, are now very definitely coloured red, as in do not touch, certainly at current yields.

While the warning lights are flashing brightly on the PIIGS – Portugal, Italy, Ireland, Greece and Spain, it is also worth noting that debt burdens as a percentage of GDP are looking uncomfortably high in the UK, France, Japan and even the US.

During the financial crisis, the governments of developed nations piled up debt in the form of budget deficits equiv-alent to 9-10 per cent of GDP.
By the end of 2010, it is likely that taken as an average government debt in OECD countries will have risen to 71 per cent of GDP, compared with 44 per cent in 2006.

Compare this with emerging market nations, where average public debt as a percentage of GDP is calculated to be around 37 per cent and forecasters are predicting a modest fall over the next five years.

Consider also that the prospects for growth among these emerging economies are far stronger simply because they are at an earlier stage of the development process.

Small wonder then that investors have been reassess-ing their calculations of where quality now lies and increas-ingly looking towards the government bonds of emerging economies.

Conventional wisdom has been turned on its head and this has been reflected in the markets. In recent weeks the yield on a November 2017-dated euro-denominated bond issued by the Brazilian government was 4.38 per cent. Compare that with bonds dated June 2020 issued by the Portuguese and Greek governments, offering yields of 5.33 per cent and 8.33 per cent respectively.

The bond markets recognise that even if a country such as Greece is able to persuade its population to accept an aust-erity programme it may not be possible to escape a debt crisis by tackling the deficit.

Tough government budgets mean job losses, spending cuts and pay reductions. That forces down consumption and investment, which can result in a higher deficit to GDP ratio.

Against that backdrop, the appeal of emerging market debt is obvious but it is worth sounding a note of caution.
The road to growth for the emerging market nations will not be an entirely smooth one. Inevitably, there will be major jolts along the way that will have serious implications for the unwary investor.

Debt and anaemic growth among the developed econ-omies that provide markets for their exports will act as a drag on growth, until the transition is made to greater domestic consumption. These expand-ing nations also face their own homegrown challenges – the risk of asset bubbles in China, for example. A successful investment strategy will take a global view in the search for value and diversification. It is important to recognise the opportunities offered by developed nations where recovery is robust. Countries such as Australia, Canada and Norway are all strongly positioned for recovery and their bonds, and forward purchases of their currencies, deserve consideration in a balanced fixed interest portfolio.
The sensible investor will recognise that the risk landscape has changed and sovereign debt in developed countries can no longer be viewed as 100 per cent safe.

That is not, however, the signal for a headlong dash into emerging market bonds. They have their place, of course, but maintaining a global perspective has never been more important.

Geoff Hitchin is manager of the Marlborough global bond fund

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