When sovereigns are no longer a safety net

Australian Financial Review, Smart Money, May 30 2010

It used to be that government bonds were considered the ultimate safe haven investment. What could be safer than a government? If they run out of money they can always get their central bank to print some more. For many years, investors have looked to sovereign debt – bonds issued by governments and states rather than banks or companies – as a safe, steady, secure backstop to their portfolios.

But events in Southern Europe are changing people’s attitudes towards what government debt actually represents. This crisis – and it is a crisis, threatening the euro itself – is not about cash-strapped American homeowners, or weirdly repackaged bundles of indecipherable debt, or the failure of risk-stretched banks. It is about countries themselves – governments that have borrowed too much, can’t pay it back, and are now on the brink of default.

So what does this mean for investors and the way we use government debt in a portfolio?

“If we go back in time to before the global financial crisis, there was very much a view among investors that sovereign debt, if investment grade, was basically generic,” says Clive Smith at Russell Investments. “You could buy sovereign debt and it was set and forget: it didn’t have to be actively managed like corporate credit.” That’s what’s changed. “The events around Greece and other countries have highlighted that you can’t just assume sovereign debt is all the same. These exposures have to be actively managed within portfolios.”

Smith’s is a widely held view, particularly among fund managers who have long considered governments on their own merits just like carmakers or miners. “We’ve long believed there was complacency among global investors about risk,” says John Wilson, CEO of PIMCO Australia, one of the world’s biggest debt investment specialists. “Not every stock is the same and not every government bond is the same. That perception was not universally shared by the investment community, who tend to see assets in blocks.” David Bryant, head of Australian Unity Investments, adds: “The first thing that surprises me is that people are surprised. Greece didn’t wake up to a debt problem today. One problem has been an assumption that sovereign entities can’t fail: we have a history in Asia, Russia, Latin America where that isn’t the case.”

And analysts agree too. “In European nations this concept of risk-free is starting to be challenged by investors,” says Mark Reade, credit analyst at Citigroup. “What it has shown is that government bonds really should be assessed like any corporate bond or other investment opportunity in terms of the risk and the reward.”

It’s hard to put a figure to how much exposure Australians have to sovereign debt around the world. The biggest exposure will be through super funds. Most people go for the balanced option in their fund, in which fixed interest (or fixed income as it is called elsewhere in the world) is typically about 30% of the portfolio. “Depending on the strategy, anywhere up to half that could be in sovereign debt,” says Smith. “It wouldn’t be difficult to imagine an exposure of around 15% for sovereign debt for many super fund type options.” That would suggest at least A$150 billion of Australian assets in sovereign bonds and potentially significantly more.

On top of that there’s managed funds: Morningstar tracks 43 global bond funds with a combined A$7.29 billion under management, in addition to several more “high-octane” funds that invest in higher yielding securities; these 43 don’t invest exclusively in sovereign bonds but will certainly include them. One trend in the last year, when sovereign debt seemed to be one of the best performing asset classes, was to opt for a passive international bond fund such as those offered by Vanguard, in order to capture the performance of the whole market.

That said, most super and managed funds aren’t putting their money anywhere near Greece, or not in significant volumes anyway. Much sovereign debt holding in Australia will be domestic, and Commonwealth bonds are considered among the most secure in the world. Plenty more will be in US treasuries, which, despite the US’s economic woes in recent years, are still considered safe. The broader problem is not so much people having money in Greek bonds – a tiny proportion even of European Union debt, never mind on a global scale – but the knock-on effects of the Southern European problems on sentiment towards sovereign bonds worldwide. “The contagion effect is one of sentiment, not one of substance,” says Bryant.

And this will take a while to resolve. “This is not a two month issue,” Smith says. “How countries deal with debt levels, and the impact for investors on their sovereign debt holdings, is something that is going to be unclear in the near term. They may only realise what the ultimate impact is years down the track.”

But for shrewd bond funds, what’s happening in Europe isn’t all bad news. “In every crisis there is an opportunity,” says Wilson at Pimco. As pricing varies widely on bonds around the world because of uncertainty about Southern Europe, managers are trying to take a view on the investments that have become could value because they’ve been wrongly caught up in the panic. For each possible investment, they will weigh up the risk with the potential reward and make a call. Wilson is not a fan of index funds at a time of crisis, feeling that: “Passive investment is an incredibly dangerous thing” at times like this.

The lesson of the crisis is certainly not to abandon sovereign debt as an asset class – although the surge in the gold price in recent months suggests some investors have been doing exactly that, abandoning treasuries and other government bonds in favour of the precious metal – but to understand its role. “I think there is a lot of merit in investing in fixed income securities, and that very much includes sovereign debt,” says Bryant. “The safest place in fixed income is sovereign debt but there’s good counterparties and not so good.”

Since most Australians don’t buy bonds directly in their own right, the key thing for them to consider is manager selection. When buying an international bond fund, how diversified are they? Look at the most recent portfolio update you can find and see how it is spread across credit rating, type of issuer, and geography. This will give you an indication of the manager’s approach to risk, and how you should fit the product in your portfolio accordingly. There’s nothing wrong with taking a risk to get a return; just be sure you know what level of risk is being taken on your behalf, especially in a product you’re relying on never to lose value.