The real cost of intervention by governments across the world hit home in December when Greece was downgraded by the three major credit rating agencies. With many other governments struggling to balance the books, sovereign risk looks set to be a major concern for investors in 2010. When the Panhellenic Socialist Movement, more commonly known as Pasok, swept to power in Greece in October 2009 following an early general election, the party was aware the country’s finances were in a bad state. But shortly after assuming control, Pasok revealed just how dire the situation was: rather than a budget deficit for 2009 estimated earlier in the year at 6% of GDP, the figure was revised to 12.7%. In November, meanwhile, the European Union predicted Greece’s government debt as a percentage of GDP would hit 112.6% by the end of 2009, 125.7% in 2010 and 135.4% in 2011. With such a gloomy near-term outlook, it hardly came as a shock when Fitch Ratings and Standard & Poor’s both downgraded Greece to BBB+ from A-, while Moody’s lowered its sovereign rating to A2 from A1. Ten-year Greek government bonds, which carried a spread of 108 basis points over the equivalent German Bund early in August, ballooned to 277bp on December 21 before narrowing to 239bp by the end of the year. Such volatility over a short period of time is not characteristic of a ‘risk-free’ asset, although in reality Greek government bonds have never attained the safe-haven status afforded to US Treasuries and UK gilts, for example. Increasingly, however, investors and analysts are looking closely at the unprecedented amounts of debt being issued by the US and UK governments to fund bank rescue schemes and stimulus programmes. In his pre-budget speech in December, UK Chancellor of the Exchequer Alistair Darling said public sector net borrowing in the UK would reach £178 billion for the 2009/10 fiscal year. Meanwhile, the US government issued more than $2 trillion of Treasury bonds in 2009, bringing the total outstanding gross public debt figure to $12.9 trillion, or 90.4% of GDP. By 2011, that number is forecast to reach $15.7 trillion, or 101% of GDP. Although it might be an exaggeration to say Treasuries and gilts are in danger of losing their risk-free status any time soon, buyers of sovereign bonds could begin to look more actively at alternatives in the coming year. And they are not short of choices. “2009 was a spectacular year for supply across a whole range of countries,” says Brian Coulton, managing director and head of Europe, the Middle East and Africa sovereign ratings at Fitch Ratings. “But in some ways the past year was also a sweet spot for demand because of the huge flight to quality and liquidity. There was also a rebalancing of economies going on as the private sector repaid debt and the public sector became the borrower of last resort.” Gilting the lily That was certainly true in the UK, where the Labour government’s response to the financial crisis was to tap into a market for gilts that is both deep and wide. The principal buyer was the Bank of England. Of the bank’s outstanding stock holdings totalling £188.4 billion (as of December 10, 2009), £186.4 billion was accounted for by holdings of gilts, wherein lies the big issue for 2010. December’s pre-budget report made reference to £178 billion of additional supply in the pipeline and, as Richard Batty, global investment strategist at Standard Life Investments, points out, this will have implications for sovereign bond fund managers. “There is expected to be a budget deficit of around 12% of GDP, which is likely to continue for a number of years. What is worrying is the extent to which domestic and overseas investors will take up that supply. This is in light of the absence of any real change in fiscal policy by the current government: investors have to wait for the next budget, perhaps before an election in March or, more probably, after an election in June. “This creates a lot of uncertainty in the minds of investors. Already the gilt/Bund spread, which had been in the 20bp–40bp range, is now wider than 60bp. So the market is starting to price in some of these concerns.” So uncertain is the outlook, there have been mutterings of the UK’s triple-A rating coming under threat. Some analysts refute there is a pressing risk, as the UK’s debt profile compared with other triple-A rated sovereigns is unusually long. But if the recent crisis emphasised one thing, it was how the effect of negative speculation can be multiplied many times over in terms of investor sentiment. Colin Finlayson, an investment manager in the fixed income team at Aegon Asset Management, believes the perception of increased default risk is out of touch with reality. “There is a low probability we will actually see any meaningful default among the larger issuers of government bonds,” he says. “But the perceived risk of it could be enough to cause quite a lot of dislocation within the markets. The market is looking now at the countries with the most onerous deficits relative to GDP, and speculating on the countries that will have most difficulty in funding those deficits through the bond market.” Finlayson points to Greece and its position at the riskier end of the scale, highlighting the “complication” caused by it being a euro currency. This, he says, imposes constraints on the one hand but also might offer de facto support from the Eurozone community. Nevertheless, he regards this as cold comfort for those fund managers nursing mark-to-market losses, with many investors preferring not to hold Greek paper. Over the next year he sees investors becoming more discerning in their appetite for sovereign paper, with a greater emphasis on analysis and closer scrutiny of issuers’ fiscal positions. As a result, the manager adds, investors may well punish those countries whose numbers do not stack up. Zeina Bignier, head of sovereign, supranational and public sector bonds at Société Générale, agrees. She expects 2010 to be another “difficult year” in which investors are likely to diversify their holdings, relying less on rating agency opinions and more on their own analysis. Bignier adds that investors, rather than speaking in terms of “core Eurozone or non-core sovereigns”, will instead look at best yields and credit strength across the spectrum. However, such an approach may not be open to all. Royal London’s Craig Inches, who manages the firm’s fixed income sovereign debt fund, works to benchmarks that do not include some of the peripheral European sovereigns. He, along with a number of other fund managers Credit spoke with for the purposes of this article, says some of the longer-dated paper issued by core European sovereigns such as France and Germany look attractive. Aegon’s Finlayson also has a preference for core Europeans and an overweight position his firm will likely maintain in 2010, and possibly longer – at least until there is greater clarity on the finances of some of the smaller European economies. Eurozone peripherals At the close of 2009, there was plenty of attention on PIGS – an unflattering reference to Portugal, Ireland, Greece and Spain. All of these demonstrated sovereign stress to a greater or lesser degree. The Greek downgrade made the most headlines, while S&P reduced Portugal’s credit rating outlook from stable to negative. Ireland took the bull by the horns and received plaudits for the committed way in which it was prepared to tackle its fiscal needs. Spain wobbled in the markets for a couple of days but later regained its popularity. While the mainstream media tends to lump all the PIGS economies together, investors are taking a more considered view. “It’s not a question of defaults or otherwise,” says Geoff Lunt, a fund manager of a UK and global fixed income portfolio at HSBC Global Asset Management. “The market has become more discriminating about the credit risk of different sovereigns. Ever since the rally in the credit markets started in March 2009, the Eurozone peripherals in particular were seen as a high-beta play. In other words, the better risk assets performed, the better the peripheral Eurozone countries would do. But subsequently, as it has emerged that specific sovereigns are facing country-specific issues, the price of government bonds from those countries has changed to reflect fundamentals. That is the right way for the market to react. Formerly, sovereign risk was seen more of a spread play and a low risk, but now we are moving into a world where investors are more discriminating.” SG’s Bignier says the ongoing saga in Greece proves there is a distinct variation in investor attitudes for government debt in Europe. “Belgian spreads, for example, remained stable and even narrowed at the very long end. Italy was stable, narrowing all along the curve. Spain, due to its negative outlook, widened and then recovered. This shows investors will examine each country on its merits.” Investors are taking an equally discriminating view when it comes to emerging market sovereigns. Although the recent Dubai crisis was triggered by the potential default of a private company, the term ‘quasi-sovereign’ attached to that entity gained great currency. Many investors mistakenly viewed Dubai World as a government-guaranteed credit. And although neighbouring emirate Abu Dhabi ultimately intervened to prevent a default, the Dubai government’s stance on the affair – where it was either unwilling or simply unable to provide financial support – was seen in a negative light by many investors, which could impede its own bond issuance plans. No domino effect Perhaps the only bright spot to emerge from the situation in Dubai was that it did not trigger a complete reversal of sentiment towards emerging market credit, which has happened in the past. Instead, fund managers speak positively about investing in emerging markets in 2010. SG’s Bignier notes a preference among investors for oil-producing countries such as Brazil and Russia. She also highlights Turkey, for which there is strong support from local investors following its upgrade by Fitch to one notch below investment grade in early December. Perhaps unsurprisingly given the firm’s presence in the emerging markets, HSBC Global Asset Management’s Lunt is bullish. “The success of emerging market debt becomes self-fulfilling. The government’s financial position improves, yields go down, the debt gets smaller to service and it becomes a virtuous circle. In the context of a global recovery and the continuation of globalisation, I can’t think of many reasons not to feel cautiously positive on emerging markets debt.” At Investec Asset Management, fixed income portfolio manager Michail Diamantopoulos believes the emerging world is in a stronger fiscal position than the developed world. “This you can easily see from the trajectory of their fiscal balances and their debt-to-GDP ratios. One of the big themes next year could be a compression in spreads between the emerging and developed markets. “We like countries such as Turkey, Brazil, Mexico and Hungary because they provide high yields and their credit fundamentals are improving. We are not very bullish on duration, directionally, but we like these sovereigns on a spread basis against the developed world.” Mike Amey, executive vice-president and a portfolio manager at Pimco, says his firm is taking an alternative route to gaining emerging market exposure. “Our preference in the emerging markets is for currencies rather than bonds at the moment. We think there is a clearer, cleaner play from currency exposure than what is currently available from the bond markets. We do still see some value in the Brazilian bond market, however, where the currency looks likely to continue strengthening.” Aegon’s Finlayson says the firm has attempted to diversify away from its core sectors to fiscally strong governments. So its play for a slice of the Asia-Pacific growth story is to invest in Australian bonds. Australia, while by no means an emerging market, benefits from its exports of raw minerals to Asia, particularly China. In addition, Australia emerged from the downturn relatively unscathed and on a surer footing than other countries, and was the first developed country to start hiking interest rates in October. The Reserve Bank of Australia raised rates by 0.75% between October and December last year, with the key policy rate now at 3.75%. Standard Life’s Richard Batty says that at the short end of the curve, Australian rates offer an attractive alternative to other developed sovereign bonds. That said, he adds that swap rates indicate the market is pricing in quite a rapid rise in interest rates in the next few years and it remains to be seen whether this will prove accurate. Despite the US government’s mammoth issuance of $2.1 trillion of Treasuries in 2009, investor sentiment remains broadly positive with the US economy seemingly in recovery mode. The effect of various stimulus programmes still has some way to develop, however, so in 2010 the outlook will be driven in part by the government’s success in tightening the fiscal screw without hindering the recovery. In that respect the US is saddled with the same problems as the rest of the post-recessionary sovereign debtor community, only it is bigger and probably a few months ahead of the pack....
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