01 August 2015

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Bond market risks in light of recent downgrades

15/02/2012

The eurozone crisis has prompted a radical shake-up in the global bond market. Traditionally, bond portfolios have been constructed on the assumption that developed market government bonds are lowest-risk, with risk increasing through higher grade corporate bonds and then again through emerging market bonds and higher yielding corporate bonds.

 

However, there has been a shift in investors’ thinking in areas such as the credit default swap market where, for example, higher-grade companies such as Coca-Cola and Nestlé are in some instances now considered lower-risk than major sovereign borrowers, such as the US or Switzerland.

In many cases the rating agencies agree. The downgrades of the US, France and other eurozone nations may not have had the immediate impact on government borrowing costs that many expected, but they also reflect the idea some higher-quality corporates are now a better credit risk than some governments. A similar adjustment is going on in the appraisal of emerging market versus developed market government debt. In 1994 just 2% of the bonds in the leading JP Morgan Emerging Markets Bonds Global Diversified index were considered ‘investment grade’. Today, that figure has now moved up to 56% with major economies such Brazil now considered investment grade.

In many ways, this is a rational reappraisal of the new environment. Global corporations require people to buy soap, pet food or pharmaceuticals, say, and this will happen through most economic environments. However, governments need to raise revenue through taxes or through higher growth rates, both of which are difficult in the current environment. Company balance sheets are, in general, in better shape than those of most governments.

Equally, the balance sheets of many emerging market governments now look better than those of developed markets. Many have fiscal and budget surpluses. They experienced some acute pain in the early 1990s and have learned their lessons about the perils of high debt.

What should this mean for investor portfolios? The environment is unusual but there is a shift taking place in the relative risk of global bonds. It is no longer sufficient to assume developed market government bonds are ‘risk-free’ or other types of bonds are necessarily ‘risky’. Investors are slowly shifting to reflect the new environment, with significant flows into emerging market bonds and out of eurozone bonds, and higher weightings in corporate rather than sovereign bonds. Bond market risk parameters have changed and investors should adjust their thinking accordingly. 

 

Paul Dixon
Chartered Financial Planner

 

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