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Saints and sinners

Sovereign debt and shifts in global economic power have further complicated the bond market

The financial crisis cost millions of jobs, destroyed an investment bank and caused investors to question their faith in efficient markets. It divided banks, companies – even countries – into winners and losers.

In the former camp, equity-market investors might put gold miners, discount supermarkets (such as Aldi and Lidl) and McDonald’s (whose dollar menu offers comfort food to cash-strapped consumers).

In the latter camp dwell a motley assortment of losers, including US car manufacturers, Spanish cajas (building societies) and Irish banks.

A similar process of discrimination, sifting the prudent wheat from profligate chaff, is taking place in government bond markets.

As the dramatic widening in the gap between the borrowing costs of financially strong countries (such as Germany) and those with weaker fiscal positions (such as Ireland) suggests, investors are taking an increasingly binary view of sovereign debt.

Which countries will be the winners? To help quantify the risks facing sovereign borrowers and provide a roadmap for investing, we developed a proprietary system that ranks the major economies based on a combination of measures of their fiscal health, vulnerability to external shocks and prospects for economic growth.

At its simplest level, the financial crisis accelerated a long-term structural shift in the balance of global economic power away from the developed world and towards emerging markets. Most developed economies have emerged from the financial crisis burdened by significantly higher levels of public and private sector debt than their emerging market peers.

Deleveraging is likely to weigh on economic growth for years to come. Unfavourable demographic trends are further hampering the capacity of these economies to deli-ver growth. With weak growth and a heavy fiscal burden, the risks associated with lending to some developed economies will continue to rise.

In contrast, many emerging economies used the boom to strengthen their sovereign credit profiles by, for example, reducing public debt levels, taming inflation and accumulating foreign exchange reserves.

Today, many developing economies are the envy of Western policymakers, with healthy public sector balance sheets and the potential for domestic demand to drive long-term growth.

The story, however, is not as simple as a binary split between developed and emerging markets. Some developed economies have emerged from the financial crisis with their creditworthiness enhanced. Australia, Norway and Switzerland have all benefited either from close ties to rapidly growing parts of the world (China is Australia’s biggest export partner) or from extremely healthy balance sheets (witness Norway’s $50 bn sovereign-wealth fund). Despite being lumped in with other emerging markets, many Eastern European economies face significant challenges.

Rules of thumb, then, do not work. The most highly rated borrowers on our ranking are much more than a basket of emerging economies – our quantitative assessment of the world’s strongest sovereign borrowers highlights the attractions of a number of first-world countries such as Switzerland and Norway. We also favour sovereign bonds issued by countries such as Chile, Russia, Taiwan and Malaysia.

In contrast, our analysis suggests that the long-term prospects for debt issued by the US, the UK, Japan and some eurozone borrowers are far less promising.

How can investors profit from the bond market’s increasing willingness to discriminate between issuers?

Exotic instruments such as foreign exchange forwards and credit default swaps are out of the range of most investors and many investment funds. Perhaps the best option for most investors is to buy short-dated government bonds in highly ranked countries and reduce holdings in those economies that score poorly on our rankings.

Sounds straightforward? Perhaps not.

Separating the saints of the government bond world from its sinners, selecting the right instruments and mastering challenges such as inflation and interest rate risk – takes specialist expertise. That is one thing that the financial crisis has not changed.

Sebastian Mackay is investment director, fixed income at Swip


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