A deepening crisis of confidence in sovereign debt within the euro zone is prompting institutional and retail investors to rethink their fixed-income allocation strategies.
There was temporary relief in the last few days of April, after the International Monetary Fund and the European Central Bank announced a $146 billion rescue package for Greece to prevent a default and restore confidence in the euro. Market turbulence resumed late last week amid violent protests in Greece, which raised serious doubts about the Greek government's willingness and ability to implement tough fiscal measures required under the terms of the aid package. Gloom turned to panic on May 6, as stock markets around the world plummeted. Equities sold off further on May 7.
The metric the market is using to gauge sovereign risk is the spreads on credit default swaps, which represent the number of basis points an investor must be willing to pay to protect bonds with a face value of $1 million against default. A basis point is 0.01 percentage point.
A resorting of sovereign risk spreads has been taking place within the euro zone, says Jim Carlen, who manages the RiverSource Emerging Markets Bond Fund (REBAX), which is now part of Columbia Management and which had $259 million in assets as of Mar. 31. Although each of the 16 countries in the European Union issues euro-denominated bonds, the risk varies by issuer. "There's a flight to quality, to the most creditworthy issuers in the euro zone, and that's Germany and France. So spreads on those have been stable, and spreads on the weakest members have been widening."
On May 6, the spread on 5-year credit default swaps for Greek debt spiked to 941, from 838 basis points the prior day. The spread for Portugal went to 461, from 422; for Spain to 275, from 227; for Ireland to 272, from 238; and for Italy to 232, from 187. In contrast, the spread on German bonds went up just 5 basis points, to 60, according to Bloomberg data.
avoid all euro zone debt?
Greece's five-year CDS spreads had narrowed to 400 basis points after the rescue package was announced late in April, but the spread widened again early last week as concerns about contagion to other debt markets escalated, says Carlen. He worries that the greater probability that Greece will default on its debt or have to restructure it may have a major averse impact on the overall appetite for risk, which could prompt a big drop in liquidity in all asset classes.
Questions about the ability of the European Central Bank and the International Monetary Fund to guarantee not only Greece's debt but also that of other heavily indebted countries such as Portugal and Spain have put the euro under extraordinary pressure in the last few weeks. That's good reason to stay away from all euro zone sovereign debt for now, says Mark Beischel, co-manager of Waddell & Reed's Ivy Global Bond Fund (IVSAX), which has $160 million in assets.
"Right now, there's absolutely no support for the euro. I don't think [ECB Chairman Jean-Claude] Trichet has any concern about the euro," he says. "We think Trichet and the ECB have been consistently behind the curve in their policies."
Genworth Financial Asset Management (GNW) in Encino, Calif., has shunned government and corporate debt in Europe for many months because of balance sheet and foreign exchange concerns, Tim Knepp, the firm's chief investment officer, said in an e-mail message. Selected European corporate bonds may pose better credit risks than government debt, but bank exposure to the current problem remains an open question, as does the broader "contagion" issue, he said. Genworth assets continue to be allocated to Asian corporate and government bonds, excluding Japan, because household and sovereign debt levels there are more conservative than in Europe and "the prospects for [gross domestic product] growth across Asia are also more supportive of regional financial stability," he wrote. Knepp relies on the Aberdeen Asia Bond Institutional Single Bond Fund (CSABX) for that exposure.
greater volatility: new opportunities
In the past, fixed-income risk was associated more with corporate credit, while government bonds were considered extremely safe. But now that much of the risk on corporate balance sheets has moved to government balance sheets, that's no longer the case, says Jonathan Beinner, chief investment officer of global fixed-income at Goldman Sachs Asset Management (GS).
With sovereign debt levels within individual countries higher than where they have been historically—and moving in the wrong direction—sovereign risk will be a primary source of volatility and something that debt investors will need to research carefully, Beinner says.
"You can't just assume that government bonds are risk-free any more and that won't go away for many years," he says. This creates new opportunities because debt volatility will be higher than before, but it also highlights the need for more bottom-up assessment of a country's economic growth opportunities, currency risk, demographic profile, inflation risk, trade imbalances, and whether more capital is flowing into or out of a country—all of which determine the level of risk of a default or restructuring of debt at some point in the future, he adds.
Beinner believes Asian government bonds have benefited from rising concerns about European sovereign debt, although it's difficult for investors to buy Chinese government debt right now and yields on Japanese debt are too low to attract much interest. Indonesian bonds are a good bet and a prime example of an emerging market whose circumstances have changed materially for the better over the past 13 years, he says.
As with the reversal that's occurred between sovereign and corporate debt, there has also been an upending of assumptions about the debt of developed countries vs. emerging markets, says Beinner at Goldman Sachs. Historically, emerging markets were regarded as highly indebted and lacking credible monetary and fiscal policies for dealing with debt crises.
emerging market debt: relatively low
"That's changed materially. The emerging markets have become the developed markets of the past, and vice-versa," Beinner says. "Emerging markets were the first to bounce back after the financial crisis because of the better structure in their financial systems, [with] sustainably lower debt levels as a percentage of GDP."
While the developed world is heading toward debt levels of 100 percent of GDP—Greece is already above that—most emerging markets have debt levels closer to 40 percent of GDP, says Beinner.
If the euro market selloff proves to have been an overreaction, the safe way for investors to get back into the market is through sovereign debt, says Bill Larkin, a portfolio manager for fixed income at Cabot Money Management in Salem, Mass. His favorite closed-end fund is the Templeton Global Income Fund (GIM), 79 percent of whose holdings are in sovereign debt, mostly with maturities of five-to-seven years. Its top holdings are bonds from South Korea, Indonesia, Poland, Australia, and Brazil—all emerging markets.
The fund is down about 10.3 percent since May 3, with a yield currently at 5.28 percent. "For something that's 80 percent government bonds, that's not bad," says Larkin.
A higher-grade choice would be the SPDR Barclays Capital International Treasury Bond ETF (BWX), which tracks the Barclays Capital Global Treasury Ex-US Capped index and prefers bonds of developed economies. "If there's normalization [of the euro zone situation], you'll get [currency] appreciation of 5 percent, plus income on a diversified basket of country debt. I would think it's pretty safe," he says.
Looking at Argentine sovereign debt
The Ivy Global Bond Fund is currently geared more to corporate than government bonds. The managers say they prefer to try to get a handle on company risk rather than on the direction of either interest rates or currencies. "We can get the same yield on a two-year corporate that you might be able to get on a four- or five-year sovereign," says Waddell & Reed's Beischel.
Argentina is one of the few countries whose debt interests Beischel and co-manager Dan Vrabac because the country seems to have resolved its legal problems and is regaining access to global capital markets. They're also considering such Argentine corporate debt as issues of electric-transmission and -distribution companies.
Beischel and Vrabac are steering clear of financial companies, as well as Chinese property companies. They like Mexican homebuilders, which seem to be lagging and misunderstood, with investors not taking enough notice of the government's extensive support for the industry or the mismatch between housing supply and demand. They also like commodity infrastructure plays such as Noble Group Limited in Singapore, which ships agricultural and industrial commodities to growing populations in various parts of the world.
Key Private Bank (KEY) in Cleveland would ordinarily be looking at how to diversify away from U.S. Treasury bonds, but it's postponed any reallocation moves until there's more certainty about the outcome in Europe, says Bruce McCain, the firm's chief investment strategist.
"There's no obvious mechanism in the euro zone area that's big enough and has the firepower to guarantee what's going on in Greece," he says. "So you have potential for this to go a lot further in terms of a selloff of sovereign debt if investors truly begin to panic."