Sovereign credit risk resurfaced in government bonds last week as the ratings agencies took negative actions on several countries. Fitch Investor Service downgraded Greece to BBB+ from A- a day after S&P put the country on Credit Watch Negative. S&P also placed Portugal’s A+ rating on Credit Watch Negative for a downgrade and placed Spain’s AA+ rating on Outlook Negative (Outlook refers to a longer-term potential ratings direction rather than a pending ratings change). Separately, Moody’s hinted that the AAA rating of U.S. Treasuries and UK Gilts were at risk over coming years. Concern over future ability to service debts was the primary driver of the ratings actions. Emerging market bonds were not spared from the volatility as Moody’s downgraded six Dubai state-owned corporate issues in the wake of the Dubai World debt restructuring.
With Dubai World still fresh on investors’ minds the flurry of negative news sparked risk aversion trades into safer credits. Within Europe, German and French government bonds benefited from flows out of more fiscally challenged European governments from Portugal, Italy, Ireland, Greece, and Spain. U.S. Treasuries strengthened as well early in the week following the news, and among emerging market sovereigns Brazil and select Asian government bonds benefited.
Wider Credit Default Swap Spreads
Concerns over sovereign credit risks were evident in wider Credit Default Swap (CDS) spreads for countries in question. CDS are insurance contracts protecting against default: the wider the spread the greater the price required to pay against default protection and vice versa. For example, 5-year CDS on Greek government bonds closed last week at 2.04% meaning that a holder of $10 million in bonds would have to pay $204,000 annually to be fully insured against default. Although European CDS spreads widened they did not exceed late May levels with the exception of Greece. CDS spreads for what Moody’s described as more “resilient” Germany and France were steady to only marginally higher. Weakness therefore reflected risk aversion into stronger government issues and not a significant increase in default risk. The low level of absolute yields also reflects a very low default risk. If a default were a true risk, Greek government bonds would not peak at a 5.6% yield during the week. If default was viewed as a legitimate risk by the market place Greek bond yields would be in the double-digit range but that is clearly not the case. Furthermore, while yields on peripheral European issues increased relative to German and French yields they remain relatively narrow and, with the exception of Greece, offer little opportunity.
Emerging Market Implications
Among emerging market issuers, Moody’s downgraded six Dubai state owned corporate issuers in the wake of the Dubai World debt restructuring.
The news was not a surprise since the government of Dubai demonstrated it does not guarantee the debts of government-owned corporations. Moody’s cited the lack of government backing as motive for the downgrade. On Monday, December 14, neighboring Abu Dhabi provided $10 billion to help Dubai World meet interest payments and make a principal payment on a maturing bond from one of its subsidiaries. While a market positive, Dubai’s lack of support has caught investors’ attention.
The breaking of the quasi-sovereign relationship, similar to a Fannie Mae/ Freddie Mac relationship here in the U.S., has raised broader questions for
emerging market debt (EMD) investors. The EMD fi xed income landscape has many government-owned issuers. The fear is that other governments may not stand behind state-owned corporations in the event of financial stress. We believe the news will motivate investors to place a premium on the higher quality issuers within the EMD space and not necessarily lead to an exodus from the asset class. Furthermore, breaking the quasi-sovereign relationship for six real estate related issuers is not the same decision process that might be used over commodity or energy related quasi-sovereigns critical to financial well being of certain EMD issuers. We are watching developments closely but currently do not view this recent bout of risk aversion as offsetting favorable fundamentals backing the majority of EMD issuers.
While we believe sovereign default risks are overdone, recent news nonetheless reinforces our view to keep sovereign exposure limited to emerging market sovereign issues and to maintain focus on corporate issues, that demonstrate improving fundamentals. Many sovereigns continue to issue debt (at the expense of rising deficits) for a variety of domestic economic stimulus programs while most corporations have been in cost cutting mode, conserving cash, and de-leveraging. While some EM sovereigns have also produced domestic stimulus they still operate with a surplus and maintain sizeable currency reserves. Looking forward, credit quality metrics for most EMD sovereign issues remain pointed in the right direction in contrast with that of many developed country government bonds Recent events coupled with the low overall level of government bonds have reinforced our bias towards High-Yield Bonds, Emerging Market Debt, and Investment-Grade Corporate Bonds.
- This report was prepared by LPL Financial. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
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