With Greece poised on the Acropolis of default, risky sovereigns have rattled not just the banks who bought their debt, but pension funds and other institutional investors who have been told for years to diversify their fixed income holdings by investing globally, instead of sticking to home government bond and corporate credit markets.
But really, suggests one investment manager, there was nothing that could have been done. The reason, says Stéphane Monier, global head of fixed income and currencies for Lombard Odier Investment Managers, an arm of the Swiss Lombard Odier Darier Hentsch & Cie private bank is that sovereigns were safe bets from the early 1990s onwards.
“What is very striking is that for a very long period of time, interest rates had been going down in the world and also there have been few crises during that period..When we had crises, basically the bond investors were bailed out, whether by the government or by the financial authorities.”
Thus, from 1990 to 2008, bond investors saw one long bull market, and for bond managers, it didn’t matter if you were first-quartile or third-quartile, falling interest rates made for capital gains, and governments offered a “put.” In other words, they took the losses, in the hope that, through a long work-out process, there was still something to recover from junk debt.
Things are looking a little differently today, as Greece thinks of default and critics ask why the bondholders aren’t taking a haircut – absorbing some of the losses from monetary authority interventions. The uncertainty certainly puts pressure on sovereign credits which, in Europe, were once top-rated.
That is something new, and perhaps calls for a new way of looking at how diversified bond portfolios approach global bonds.
“I think the crisis of 2008 has completely changed this picture,” says Monier. “First, as we know after that period, there are only two possibilities whether interest rates will remain stable for a long period of time or whether they will go back up.” That’s something investors really haven’t had to face during the long bond bull. More significantly, “The second fact is that the authorities allowed Lehman Brothers to go bankrupt.”
Those factors are not reflected in bond indexes for sovereigns, which by and large follow market capitalization – how much debt issuance is outstanding, rather than the creditworthiness of the issuer — or its contribution to global GDP. How dangerous is that?
“If I take one of the most dramatic examples, which is Greece, you can see that Greece only represented 2.6% of the Euro market cap index in 2001. While the Greek government was leveraging up through that period, for 10 years, the weight of Greece increased to 5%.”
So Greek sovereigns took up a significant share of Euro bond indexes, simply based on issuance.
To put market-weighting of sovereign debt in profile, Monier points out “most European investors had more exposure to Greece than to all of the emerging markets, despite the fact that all the rest of the emerging markets were 50% of the global economy.”
Emerging market debt is underrepresented in bond indexes, despite the notable strides made by emerging market economies. In developed economies, “debt is coming in in excess of 100% of GDP while the emerging economy fundamentals are much stronger, with a debt to GDP ratio of around 35% and still improving.”
As it turns out, many emerging market governments have a better prospect of paying back their debts than do European economies, whose government debt has been given a free ride by the debt-rating agencies.
Lombard Odier proposes an index that shifts away from the market cap of issuance and more towards economic fundamentals, classed along three scales: macro-economic factors; socio-economic factors; and forward-looking obligations.
In the macro-economic category, GDP and its rate of growth counts as a measure of a country’s ability to repay its debts. Socio-economic factors concern how a country manages its budgets, exports and worker productivity. Forward-looking obligations involve the composition of workforce: retirees to the working-age population as well as pension obligations.
These factors don’t easily reduce to an index. And, while Monier argues that Lombard Odier’s index is not simply the result of lots of back-testing, he does note that, from 1999 to 2008, there would have been little difference in the returns produced by the Lombard Odier’s index and a market-cap-weighted index. The year 2008 provides the breaking point.
That said, a market-cap index will outperform during a credit bubble – which is perhaps what income investors fear most. That’s when the ratings agencies are not notably quick off the mark.
So what would a fundamental index have looked like? Lots of Germany, Austria, Netherlands and Nordic countries, and much less Italy, France, Greece and other high debt-to-GDP suspects.
Applied worldwide, it would mean much less U.S. and Japan, and much more emerging economies, especially China and India, despite their capital controls.