Investors may find fixed income less secure as bond benchmarks are pushed into riskier assets. Traditionally, bond indices have to allocate weightings based on the volume of debt issued rather than the ability of the issuer to repay. While this may not have seemed problematic when some parts of the fixed-income market were considered risk-free, the current investment climate has challenged that complacency.
In recent months, concerns have been particularly focused on the eurozone, with difficulties faced by southern European countries still far from resolved. While negotiations are ongoing, however, countries within the monetary union still need to tap debt markets to meet current spending obligations. HSBC estimates that Italy’s gross debt issuance in 2012, for example, will be £206bn of a total £702bn issued by eurozone countries. Meanwhile, France, which saw its AAA sovereign debt rating cut by Standard & Poor’s last month, is expected to issue £164bn-worth of sovereign bonds this year or a net £80bn of additional debt.
This has implications for investors whether investing through passive index tracker funds or in active funds bench-marked against a bond index. As Reuters reported last week, Citi’s Euro Government Bond index, for example, allocates a quarter of its weight to Italy, rated BBB- by Poors, but just 21 per cent to Germany, 6 per cent to the Netherlands and 1 per cent to Finland – three of the remaining AAA nations in the monetary union.
As this illustrates, the problem with volume-based indices is that at times of market stress, they become weighted towards countries with the biggest public debt burdens.
AFH Independent Financial Services head of research and FE Adviser Fund Index panellist Graham Toone says: “There is not a central exchange for the bond market like there is for equity markets but it does raise questions about the current valuation of bonds. I do not think that the 2 per cent ’risk-free’ return from government debt reflects the reality at the moment.”
Without a risk-free rate, investors and IFAs are in a bind. Although it has long been said that all investments are subject to a degree of risk, it has nevertheless been the case that a number of models relied upon historical norms that may no longer be the case.
Vanguard chief investment officer Jeff Molitor says: “The whole question of a risk-free rate of return is really just a theoretical one.
There are a number of investors who are always looking to find remedies for situations they wish they had dealt with years earlier.”
All active investment decisions come with a risk and Molitor says the cap-weighted model makes sense as long as investors understand the product.
He says: “We believe there is a place for cap-weighted indices. Some of our portfolios are constructed so that if the bonds fall below AA, they are removed from the index. The rules depend on the individual portfolio.”
However, investors must strike between the desire for protection against a credit event and the cost of achieving it. Few currently believe that an economy the size of Italy will default on its debt repayments but the sovereign debt difficulties facing southern Europe are far from resolved.
Toone says: “Things remain uncertain and people are modelling portfolios on historic equity returns rather than on sovereign debt markets. At some stage, there will hopefully be a return to normality.”
Data supplied by FE