Over the past few months, the short term outlook for the global economy has become far more uncertain. One thing that history has taught us is that the markets do not like uncertainty. When there is uncertainty, money usually flows away from risky assets and into safer assets. Generally in this scenario, stock prices will go down and highly rated securities such as stable government bond prices will go up.
We are in a unique situation where debt concerns in Europe mean there is more uncertainty about investing in some of the European Sovereign bonds due to their low Standard & Poor’s and other rating agency’s status. This could become much like investing in financial corporation bonds during the economic crisis in 2008-2009. During this period, some financial short term bonds were yielding in excess of 25 per cent due to the chance the bonds would default. Currently, a similar instance has developed for some of the European sovereign debt. For example as of 5 August, 2011, the Irish, Portuguese and Greek two year bonds were providing extraordinary yields at 12.13 per cent, 11.95 per cent, and 31.50 per cent respectively. While the two year European bonds that are considered safe such as French and German bonds are yielding 1.182 per cent and .841 per cent respectively. Even with S&P lowering the long-term credit rating of the United States to ‘AA’ from ‘AAA’ yields on US securities are close to record lows because investors consider the debt safe.
What makes some government bonds riskier than others?
There are usually a couple of situations that make sovereign debt more or less risky. One is the willingness to pay and the second is the ability to pay the debt. The issue with Portugal, Greece and Ireland is their perceived ability to pay current and future debt.
If the country’s cash flow is negative, it can become impossible to pay off their existing debt unless they either start making more money, start spending far less or their debt is restructured. Restructuring debt consists of changing the terms of the loan such as an increased duration to pay the loan, reducing the interest rate on the loan and reducing the principal amount owed.
Government debt co-signers wanted
When a person who does not have either a good credit background or a decent credit score needs to borrow money for a large purchase, the lender typically demands a co-signer on the loan before they will loan the money to such person. This is the same scenario occurring with countries such as Ireland and Greece. The potential fear is that yields on Portugal, Greek and Irish debt are so high that the only way they can get short term refinancing is if other nations either loan them money or guarantee to make their debt payments for them. The problem with this guarantee by other nations is that it will change the credit profile of the country or countries providing that support. If Portugal, Greece and Ireland default, it could create an even bigger problem for the stable countries that provided the guarantee.
Where to go?
As a bond investor, there are certain borrowers that look more attractive than others even though the countries debt ratings are the same. There are many factors that need to be looked at, but reviewing the gross domestic product to surplus or deficit ratio will help illustrate which countries are more attractive on a budgetary basis. The preference is to loan money to governments, agencies or corporations that are backed by the full faith and credit of a country or countries that have better long and short term outlooks based on a surplus or a slightly negative deficit to GDP, as opposed to countries that are running large deficits. One such example is the Kingdom of Denmark, which appears very stable even while currently running a small deficit.
Another security that is attractive is Kommunalbanken AS, which is AAA rated and offers local government funding services. This company acts as a state instrumentality for the Norwegian central government by providing low cost loans to the Norwegian local government sector. The bonds are backed by the government of Norway, which runs one of the highest budget surpluses of any country in the world. In addition, the bonds are issued in various currencies, which means that you can obtain a similar yield that you would on US or UK sovereign debt but with a different country as the backer.
In short, there are still some good places to loan money that are relatively safe, but they have become increasingly harder to find and it takes a bit more homework.
Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.