Sovereign bond investors should target quality, says Dexia

The debt crisis has left investors in government bonds thoroughly shaken and faced with the reality that their investments are not risk-free, contrary to previously accepted wisdom.

The knee-jerk reaction of many investors was to transfer their affections to traditional flight-to-quality assets such as US and Japanese govies and Bunds. However, the long-term value of such a strategy is questionable.

Japan and the United States are sustaining a mountain of debt of, respectively, 200% and 100% of their GDP. Additionally, the US has, for more than three years now, had a government deficit of more than 8% of GDP. Germany, which is in a better position in terms of tax ratios, is another favourite of bond investors; however, the country is not immune to the debt crisis especially as a result of contingent liabilities linked to the European solidarity.

Moreover, in the coming decades, it will be faced with growing ageing population charges. The conclusion is that the traditional “quality” investments have been wrongly attributed this status at a time when, paradoxically, the interest rate on these bonds is at an all-time low.

Most investors are still managing their portfolio in the same old way, placing their faith in the easiest and most indisputable tool up until now: the benchmark. But the most recent crisis has taught us that blindly following benchmarks is not advisable for a number of reasons.

International bond benchmarks currently comprise mainly US and Japanese debt because of their market capitalisation. Consequently, benchmarked investors loan not to the wealthy, but to already heavily indebted issuers (see graph 1). This is at odds with the flight to safety – the main driver of investments in government bonds.

A second drawback of traditional benchmarks is the average maturity of the bonds, which is determined by the debtor and is thus not necessarily the optimal solution for investors.

The third risk for an international bond portfolio is currency risk. International benchmarks have almost 70% exposure to the dollar and the yen due to the size of their public debt. Both of these currencies have fragile fundamentals and possible high levels of correlation.

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