In the three years since the collapse of Lehman Brothers triggered a global financial crisis, governments struggling to revive their moribund economies have inundated investors with a virtual tidal wave of sovereign debt. This flood of issuance has led many to wonder whether governments will ever be able to repay their debts – and to ask questions about the purchasing power of any repayments they do make. Crucially, it has also highlighted the urgent need for investors to reconsider traditional approaches to allocating their fixed income assets across countries and regions if they wish to avoid the ripple effects of the debt wave.
Drowning in debt
In the summer of 2009, PIMCO highlighted that governments were rapidly expanding their fiscal deficits in an effort to offset a collapse in private demand. Since that time developed country governments have run fiscal deficits unprecedented outside of wartime, and the predictable result is that their debt levels have reached epic heights. U.S. gross federal debt, which stood at 64% of GDP in 2007, exceeded 93% by the end of 2010; and even Germany’s debt-to-GDP ratio increased from 65% to 83% over the same period. Japan, a country that has for many years run one of the highest debt levels in the world, saw its debt balloon to 215% from “only” 179% three years earlier, according to Haver Analytics. While for the U.S. these exploding debt levels – and the lack of any credible plan for dealing with them – have resulted in the loss of its coveted AAA credit rating by S&P, none of the three has been punished by markets for their profligacy (as of yet); interest rates on U.S., German and Japanese government bonds remain at or near all-time lows.
More likely than Brazil to default?
One of the most striking outcomes of the debt build-up over the past several years has been the upending of the traditional relationship between developed and emerging countries. While historically it was the emerging economies that struggled with weak growth and unsustainable levels of debt, today it is mostly their developed counterparts that are drowning in a sea of red ink; emerging countries generally have both lower debt levels and far superior growth profiles. Does this means that emerging sovereigns are now the better credits?
The answer depends on whom you ask. S&P’s downgrade of the U.S. notwithstanding, credit rating agencies continue to rate most developed countries in the double- or triple-A categories. Most emerging countries, on the other hand, are rated single-A or lower, suggesting that in the eyes of the agencies they remain less credit-worthy than developed sovereigns, For example, the agencies presumably see France (AAA*) as less of a default risk than Brazil (BBB*). Investors, by contrast, beg to differ. If the market for sovereign default protection (i.e., credit default swaps) is any indication, they put less faith in rating agencies than they do in fiscal fundamentals: It is now more expensive to buy default protection on France than on far lower-rated, but far less indebted, Brazil. Bem-vindo ao Novo Normal.
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From interest rate risk to credit risk
While some countries have thus far escaped the market’s wrath, others have not been so fortunate. The excessive borrowing of this second group has raised more than simply theoretical questions regarding the possibility of a developed sovereign government defaulting. Investors in Greek debt, for instance, have already been asked to accept a haircut of 50% on their holdings, and other heavily indebted countries are clearly at risk. Portugal and Ireland have lost access to the bond markets and been forced to seek relief from the IMF and their euro zone partners; and even Italy – the world’s third largest borrower – has faced the equivalent of a “run on the bank” that has raised questions about its ability to roll over its considerable stock of maturing obligations. Investors accustomed to considering only the interest rate risk associated with their developed government bond holdings have been shocked to find that credit risk, traditionally a feature confined to the debt of emerging market sovereigns, has become their dominant risk in many cases. Indeed, this shift in the very nature of risk, if the fundamentals of emerging countries with sound balance sheets continue to outshine those of debt-burdened developed sovereigns, is likely to have far-reaching consequences for global investors in the multi-speed world of the next several years.
The “other” risk: financial repression
Though the debt wave of the past few years has thus far produced only isolated examples of outright sovereign default, we would highlight that failure to pay interest or principal in a timely manner is not the only way for a sovereign borrower to stiff its creditors; for investors in government bonds inflation and currency debasement have the potential to be just as costly as outright default. In the Roman Empire, one method used by over-indebted emperors attempting to address their debt burdens was coin clipping – reducing the amount of precious metal contained in each of their coins in order to stealthily debase the currency. In today’s world of fiat currencies, sovereign debtors need not resort to trimming the edges of their notes and coins; they have more elegant methods of financially repressing their creditors. Financial repression, a form of “default by stealth,” is a gentlemanly way for countries with fiat currencies to virtually pick the pockets of bond holders while still paying interest and principal in full. As a way of reducing debt, politicians may find it attractive compared to the alternative of inflicting pain on their constituents through tax hikes or spending cuts. Financial repression may take the form of artificially low – or even negative – real interest rates, unconventional central bank policies or the deliberate weakening of the currency. Although not technically events of default, such repressive policies will just as surely erode investors’ total returns. So while investors should be able to count on most of their sovereign bonds paying par at maturity, they may be disappointed at how little their future dollars, pounds and euros will buy.
Navigating the flood waters
So how can investors protect themselves against sovereign pick-pockets – whether of the conventional or stealthy variety? The key, of course, is to avoid investing in the bonds of those sovereigns whose debt dynamics make them most likely to short-change investors. To do so, we believe investors should start by moving away from traditional “debt-weighted” approaches that tend to focus on the most indebted countries. Just as a banker would consider income to be a good indicator of a borrower’s ability to repay a loan, investors should focus on GDP, or national income, as a measure of a country’s ability to service its debt. Investors may also want to consider broadening their investment universe to include emerging market countries with robust economic fundamentals; this can help them position their portfolios where the opportunities are likely to be rather than where they have been in the past. Ultimately investors need to accept that the rules of the game have changed. In our opinion, adopting a forward-looking, active approach to risk management, rather than one that assumes that past patterns or backward-looking ratings methodologies are a good guide to the future, can help investors better position to manage the heightened risks in a world of increasingly desperate debtors.
Three years ago PIMCO identified many of these pitfalls and suggested that investors could potentially avoid the debt deluge then confronting the world by expanding their horizons beyond traditional developed markets and allocating based on each country’s GDP rather than its stock of accumulated debt. Today, these same strategies should continue to help position investors away from those countries that have become inundated by excessive debt. With outright and stealthy defaults now realities that many investors must confront, we believe a strategy based on sound investing principles and grounded in solid fundamental research is indispensable if they hope to successfully navigate these turbulent waters.