The Sovereign Debt Dilemma
June 14, 2010
In the wake of the Greek financial crisis, government bond investors are worried about sovereign risk. These concerns are quite reasonable. But it’s worth remembering that sovereigns have never actually been “risk free.”
There are three broad types of risk attached to all bonds: interest-rate—the risk that rising rates erode capital value; credit—the risk that interest or principal are not paid; and liquidity—the risk of being unable to sell at a reasonable price. Of these, credit risk is the most corrosive as it is the only one that leads to permanent destruction of value.
A government’s credit risk is driven by the willingness and the ability to repay debt. Ability to pay is determined by three things: the amount of debt; the cost of servicing; and the ability to refinance. The amount of debt doesn’t really start to bite until interest costs get too high or a country can no longer refinance its borrowings. Today, for most countries, the cost of debt is still relatively low given current interest rates. And most countries are able to refinance themselves. Even Japan, with a debt-to-GDP ratio of nearly 190%, is still able to finance itself, and at very low yields, largely thanks to huge private sector savings. Other countries have to rely on a combination of domestic and international investors to buy their bonds.
The UK now relies heavily on domestic buyers like pension funds and, more recently, the Bank of England (BoE) to buy its bonds. The challenge is that, as quantitative easing has been phased out, it is up to foreign investors and UK entities like banks to take over the BoE’s buying role. Still, the UK has the benefit of its own currency and the ability to print money. Heavily indebted euro-area countries, like Greece, don’t have this option.
In the euro area, about 18% of the sovereign market consists of the peripheral countries seen most at risk of default—Portugal, Ireland, Greece and Spain. This is an example of where active management comes into its own: by avoiding the peripherals this year, investors would have outperformed a broad euro benchmark significantly. But the time may come when it no longer makes sense to be underweight peripherals and overweight core governments. We expect to see a shifting euro opportunity set this year and, in that environment, active country selection is likely to pay off.
While sovereign risk is an emotive issue at the moment, we would caution against being too hasty in jumping into the next “safe” alternative—for example, avoiding sovereigns altogether and buying high-grade corporate bonds, or focusing only on countries with very low debt. While these are good assets to own, they are not a substitute for a well diversified government portfolio and can expose investors to a new set of risks. For example, corporate bond liquidity can dry up at times of market upheaval and, unlike governments, firms can’t print money or raise taxes to repay their debt. And, while low-debt sovereigns like Norway, Sweden and Australia might have less credit risk, they could carry more interest-rate risk because they are in, or entering, a cycle of rising interest rates. Overall, we think that an actively managed, well diversified portfolio of sovereigns, possibly with an allocation to high quality corporates, should still provide enough safety to meet most investors’ needs.