Sovereign Debt: Not all Nations are Created Equal

Within the sovereign debt market, each country, large or small, faces unique as well as common challenges. From quantitative easing to austerity programs, the credit crisis and global economic decline have sharply outlined the different approaches sovereign nations have used to manage their obligations.

There are many reasons sovereign debt appeals to institutional investors. For some, it is principal preservation, asset-liability matching or yield. Others participate in this market to gain exposure to a particular currency or simply for speculation. And some investors, including banks, insurance companies and pension funds, are mandated to own it either by their regulators, their shareholders or by market realities.

“There will always be large and varied constituencies for which sovereign debt makes perfect sense and this is unlikely to change any time soon,” says Marcelo D. Pesci, sovereign analyst, global fixed income at Northern Trust, London.

Still, while government bonds continue to play a prominent role in a diversified portfolio, for the global investor venturing into foreign local markets the question remains: Will the proceeds from their local currency investments be readily convertible and transferable if risk levels increase and/or large numbers of international investors decide to head for the exits?

Risk and Reward

Sovereign debt issuers fall all along the risk-reward spectrum. Emerging markets often offer more attractive yields than more established economies. But, attractive yields are often a signal from the market of potentially higher risks, as highlighted by recent instability in Northern Africa and fears of contagion in the Middle East.

“Emerging markets’ yields offer extra returns for a reason, but investors often underestimate the extra risk,” says David Blake, director of global fixed income at Northern Trust, London.

In contrast, U.S. Treasuries often offer relative safety if less attractive yields. Even in light of its recent economic woes, the United States remains a powerhouse in the government bond marketplace. It is the world’s single-largest economy and military power, and one of the most developed, stable and long-standing democracies in the world.

In February 2011, despite mounting concerns over the country’s ratio of debt to gross domestic product, ratings agency Moody’s Investors Service maintained its AAA rating on U.S. government debt. Among the reasons cited by the agency were the country’s overall stable outlook and the U.S. dollar’s position as the world’s reserve currency, meaning investors can move in and out of the dollar at will.

There may be criticism over the U.S. dollar’s status as reserve currency, but many believe this is unlikely to change any time soon. “The world cannot easily turn its back on the dollar as a reserve currency for the simple fact that so many countries worldwide own trillions of dollars in reserves,” Pesci states. “There are few, if any, non-self-destructing ways of exiting those positions in the short to medium term.”

On the other hand, Europe continues to feel the effects of the economic turmoil inside some of its member countries. Bond yields in debt-riddled Greece, Ireland, Italy, Portugal and Spain tend to spike higher when investors become concerned. Some analysts remain fearful the European sovereign debt crisis will dampen the value of the euro in the long term. There has even been widespread speculation that the euro could be abandoned as the common currency.

Blake does not think this is likely, but there is recurrent speculation that one or more of the weaker countries may leave the single currency. “This would almost certainly be followed by a default and restructuring of the country involved and would likely be followed by similar moves by other weak economies,” he says. Blake notes a more dramatic scenario would be abandonment of the euro by the so called “core countries,” like France or Germany, but this is highly unlikely.

Pesci says Europe in general, and peripheral European countries in particular (with the notable exception of Ireland), have the disadvantage of low economic growth due to internal rigidities, most notably in their labor markets, so they are expected to lag behind others despite their potential. Still, there are pockets of highly desirable, export-oriented or geographically diverse companies within these countries. At the same time the case for improved flexibility becomes stronger by the day, as acknowledged by the recent reforms in the Spanish labor legislation.

“We expect Europe to emerge battered but alive after the ‘extend and pretend’ periods draw to a close and we move to more realistic, or rather more sustainable, permanent solutions,” Pesci says, referring to the European Financial Stability Facility, the fund launched last year as a temporary measure to address the sovereign debt crises. The idea behind the fund is to support new loans, at less expensive rates, until an economic rebound, or improved tax collection combined with lower levels of government spending, enable struggling countries to meet their debt obligations in a sustainable manner.

The Asian Situation

Emerging Asia and the developed world are highly interconnected by trade and investment, but some parts of Asia are suffering from woes similar to the U.S. and Western Europe.

Asian countries with large, young populations are happy to produce goods or to provide services to more advanced economies, often at a fraction of the cost. These countries encourage trade by ensuring that their exchange rates remain competitive, making investing locally more appealing.

They also encourage foreigners to invest in production capacity (outsourcing) and export back to their own countries, explains Bert Rebelo, senior investment specialist at Northern Trust, Hong Kong.

He adds, however, that there is the risk of having too much of a good thing. “These Asian economies are in danger of becoming overheated just as the rest of the world is starting to pull itself out of recession.” In addition, further real growth could be impeded by their less advanced levels of social protection. Rebelo notes, for example, if the need for cooling down the economy arose, the authorities would have limited means as a result of restrictive credit conditions to ensure those affected by unemployment were properly protected. This could prove a source of instability, potentially deterring decisive action by the monetary authorities.

Japan faces a particular set of challenges within the Asian context. Japan is a developed country with a mature population, similar to the “baby boom generation” in the United States. Older populations have specific needs in terms of health care and other forms of support. Therefore the younger generations will be expected not only to shoulder the burden of the retiring generation, but also to ensure the existing national debt — already high by any standard — is duly serviced.

“This is a challenge for policymakers,” Rebelo says. “If Japan’s example is anything to go by, then longer working lives, lower salaries and lower standards of living than those of the previous generations is what awaits most developed countries.” He adds that this would be the case even without the substantial debt burden left by the previous generations.

Even before the March earthquake and tsunami raised further questions about Japan’s financial situation, Standard & Poor’s downgraded the country’s sovereign debt rating to AA- from AA, citing political instability and expectations for the country’s fiscal deficits to remain high during the next few years. If Japan’s government fails to reassure the rating agencies of the sustainability of its public finances, further downgrades remain a real possibility.

Europe continues to feel the effects of the economic turmoil inside some of its member countries. Bond yields in debt-riddled Greece, Ireland, Italy, Portugal and Spain tend to spike higher when investors become concerned

Commodities Conundrum

Commodities have a double role to play in sovereign debt markets. Rising commodities prices spark fears of inflation in consumer nations (and increased outlays), leading to negative pressure on bond prices. Conversely, producing nations benefit from higher prices, which help to reduce debt levels while improving living standards and their overall international standing. Generally speaking, the fear of inflation creates positive momentum for commodities markets.

The emergence of Brazil, Russia, India, China and other nations’ burgeoning middle classes as consumers has “shifted the demand curve to the right, which in plain English means that there will be more demand for most commodities regardless of price,” Pesci says.

Supply problems with grains also have contributed to dramatic increases in food prices leading to instability, particularly in lower income countries where the proportion of disposable income devoted to foodstuffs is greater than in wealthier nations. This in turn can encourage policymakers in emerging markets to “sacrifice” foreign currency reserves in buying extra food supplies to be sold at a discount in the local markets. Such moves — distortive as they are likely to be — will be welcomed by the local populations but may exert pressure on the external position of the countries involved in such practices.

Grain supply has been restricted further by mandatory use of corn-based ethanol, particularly in the United States, which consumes an ever increasing proportion of U.S. corn production, as well as bad weather in key producing parts of the globe. In addition, oil prices topped $100 per barrel again earlier this year and are expected to remain high due to physical and investment demand, as well as instability in Northern Africa and potentially the Middle East.

The Money Supply

As the credit crisis unfolded, central banks worldwide made fresh funds available to avert a breakdown of their banking and payments systems.

“Over time all this extra liquidity comes with a hefty price tag, namely a lot more cash chasing broadly the same amount of goods and services,” Pesci notes. “That invariably pushes prices up over the medium term.”

Cash injections by the United States and other nations will be hard to withdraw without risking the fragile recovery, keeping commodities at relatively high levels for the foreseeable future, he adds.

Convertibility and Transferability

Investors interested in local sovereign debt markets have other considerations to weigh, such as whether a hedging strategy should be used and what their exit strategy should be once investment objectives have been achieved or the risk/reward profile no longer meets investment guidelines.

Investors considering the quickly industrializing parts of the globe also should be aware of the problems of transferability and convertibility.

An abundance of cash, thanks to the accommodative U.S. monetary policy, has made many investors forget that getting your money back into hard currency is always an issue in times of distress. “There is a risk of overbuying certain stories,” Pesci warns, “but the vast reserves of dollars held by many emerging market central banks make a run for the exit pretty unlikely in the foreseeable future.”

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