Paradigm lost

The assumption that developed market sovereign bonds do not have default risk is now dead. In this frightening new world investors are radically reassessing the notion of debt sustainability, writes Andrew Capon.

  • 13 Dec 2011
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If the philosopher of science Thomas Kuhn were alive today he would rightly be appalled by the serial abuse of his term "paradigm shift". A new product or service is not a paradigm shift. By definition a paradigm shift is in no way incremental. It represents profound change, such as the adoption of Copernican astronomy in place of Ptolemaic. Competing paradigms are incommensurable; they cannot be reconciled.

To say a paradigm shift has occurred in government bond markets is therefore a bold statement. But for bond investors it is also the reality that they now confront. For years the lexicology of government bond markets has been all about spread — the additional yield an investor expected to be paid for owning the debt of one country versus a 100% risk-free sovereign issuer in a reserve currency (the US globally and Germany in the Eurozone).

Prices would ebb and flow as traders and investors looked into the history of those yields to decide whether a bond was relatively cheap or expensive. Credit risk was not part of the assessment. That has changed.

A eureka moment

Jerome Booth, head of research at Ashmore, an emerging market debt specialist with $65bn in assets, calls this a eureka moment. He believes it explains the extreme volatility seen in fixed income markets in 2011. "Once you accept there is the risk of default, however small, it changes everything. There is no going back. Your entire valuation system goes out of the window. You have to go back to square one and consider how to value a bond if there is default risk. Markets are moving so fast because a lot of people are having that eureka moment."

The catalyst for this profound change in the psychology of markets is Greece. The crisis in the Eurozone turned from bad to ugly when the possibility of a Greek restructuring began to be mooted in late 2010, says Myles Bradshaw, senior vice president and pan-European strategist at $1.35tr in assets Pimco in London. "The assumption was there would be cross-country support first of all and then that the European Central Bank would act. When neither of these things happened investors began to price sovereign bonds according to credit risk. That has been the transmission mechanism for contagion."

Most problematic of all, investors do not see any way that the genie of developed market sovereign credit risk can be put back in the bottle. If sovereign debt is no longer regarded as free of credit risk its utility falls. It can no longer be regarded as near-money, nor can it easily be used to create money cheaply via repurchase agreements. The expected Greek PSI (private sector initiative) has made matters worse, according to Ewen Cameron Watt, managing director and chief investment officer of the BlackRock Investment Institute.

That is because the PSI will not trigger sovereign credit default swaps. "If CDS does not protect against a restructuring it is not an effective hedging tool," he says. "If that is the case, sovereign bonds are tricky to hedge in a portfolio. What do you do with credits you can’t hedge if they start to look risky? You sell them because every credit manager learns on day one it is the assets that default that kill portfolio performance." Of BlackRock’s $3.3tr in assets under management, more than $1tr is invested in fixed income.

Another consequence of the Greek PSI is that asset managers have been turned into second-class citizens.

The European Stability Mechanism is effectively treated as a preferred creditor, subordinating other debtholders. Harvinder Sian, rates strategist at RBS Global Banking & Markets, says this seemingly technical point is hugely significant.

"It is highly destructive," he says. "If you hold debt of any sovereign that may have to tap the ESM you should be asking, ‘what is my recovery rate?’ If I am an investor asking for my money back because I hold a bond that is supposed to be a lien on the resources of a country and the Federal Republic of Germany is in the room before me, I’m not going to be the loudest voice or the one that is listened to."

Investors who have been wrong-footed by the Eurozone crisis will not want to be burnt twice. Pimco’s Bradshaw can see rising yields, increased volatility and distressed sellers forcing prices down further being repeated in country after country. "Why not?" he asks. "The ECB seems to be treating Eurozone countries as the US Federal Reserve would treat municipalities. The Fed wouldn’t rescue a city that got into trouble and the markets would never allow a city to run the sort of deficits compared to revenues that every Eurozone country, including Germany, has."

Quantitative dissonance

In this bond market dystopia investors are being forced to consider sovereign risk and its corollary, debt sustainability. The best guide may be the experience of emerging markets where defaults have long been a fact of life. The starting point for many is quantitative measures such as the debt-to-GDP ratio. This figure is attractive because it is readily available, comparable across markets and time and intuitively sensible. It measures the debt burden of a country in relation to its annual income.

However, in their study of financial and economic crises This Time Is Different, Carmen Reinhart and Kenneth Rogoff show that the notion of debt sustainability is extremely slippery. In 30 emerging market defaults since 1970, the average external debt to GDP ratio when trouble struck has been 69%. However, problems can occur at much lower levels. Argentina defaulted with a level of debt below 50%.

Among the Eurozone periphery, Greece is an extreme outlier with a debt-to-GDP ratio of around 200% (pre-haircut). But Spain, with a debt-to-GDP ratio of just 68%, has lower debt levels than Germany, though the Federal Republic runs a primary budget surplus. Japan has had no problem selling JGBs, in spite of a debt-to-GDP ratio stuck at over 200% for close to a decade. After the Napoleonic Wars the UK had a debt-to-GDP ratio of around 240%, did not collect income tax, and still paid back its creditors.

The only thing that can be said with certainty is that the less debt a country has, the less likely it is to default, an observation that can be filed under the heading of obvious but not helpful.

Reinhart and Rogoff do, however, demonstrate one interesting statistical relationship. Growth in countries where the debt-to-GDP ratio is above 90% is lower, which in turn impacts the ability of a country to service its debt. Italy, with its debt-to-GDP ratio of 120% and parlous growth record, has become the European poster child of this unfortunate phenomenon.

Safe and stable assets

The debt-to-GDP ratio can be overlaid with other quantitative measures, such as the primary budget balance. Italy does well on this score and the UK poorly. But the two factors that investors are currently focused on are directly related to financial markets rather than good fiscal governance. The first is interest rate volatility.

"When a pension fund or an insurance company buys a government bond it is looking for a safe and stable asset to match liabilities," says Pimco’s Bradshaw. "When volatility soars that asset no longer has that profile. For any given level of interest rates there is less demand for the bonds. A volatility crisis turns into a liquidity crisis and as yields go up, this can quickly become a solvency crisis."

That process — a liquidity crisis morphing into a solvency crisis — can be accelerated by the structure of the outstanding debt. The second quantitative factor that investors are therefore watching closely is the average maturity of the debt stock. Due to the endeavours of the Debt Management Office, the average maturity of the UK Gilt market is now 14 years. Italy’s average maturity, though better than that of Greece, is half of the UK’s and it needs to roll debt equivalent to 43% of GDP in the next two years.

BlackRock’s Cameron Watt calls this "the proximity to distress" and it is a vital component of a sovereign risk index that the BlackRock Institute has developed. "I would characterise the Eurozone crisis as principally about supply and demand," says Cameron Watt. "It is as much about flow as it is stock. The UK Gilt yield is so low because of the longer term structure of the debt and because pension funds are relatively price-insensitive buyers. Gilts appear to be a safe haven because of the duration and flow dynamics. The stock situation, the amount of debt, remains very bad."

The German yoke

Ulrik Ross, global head of public sector, global markets at HSBC, sees this concern among investors as yet another vector of contagion from the financial crisis. In 2007 and 2008 the markets fretted about short term funding needs and asset liability mismatches in the banking sector. That has now infected sovereigns. He has some straightforward advice. "In times of crisis with historically low risk-free yields, it makes sense to fund at the longest duration possible. Credit premium is high which is holding back many issuers, however we still advise our clients to be conservative and take long term financing."

The spectre of default and sovereign risk was supposed to be an emerging markets phenomenon. Emerging markets tend to have less diverse economies. They may be dependent on prices for commodities they have little influence over. But the biggest problem of all is that to make their debt attractive to international investors, emerging markets must issue in foreign currencies. If their own currency depreciates, the cost of the debt service goes up.

The external finance position of a country is a measurable factor that has long been a critical determinant of debt sustainability among emerging markets. It has become significant in developed markets largely because of the creation of the Eurozone. RBS’s Sian says: "The Eurozone sovereigns, with the exception of Germany, are issuing in a foreign currency."

The Eurozone crisis has highlighted two critical structural considerations regarding debt sustainability. The first is what erstwhile French leader Charles de Gaulle called the "exorbitant privilege". The role of the US dollar as a reserve currency means it can fund in its own currency in almost limitless amounts and never be subject to a balance of payments crisis. It is a debt sustainability advantage that the credit rating agencies explicitly acknowledge.

"The reserve status of a currency is very important," says Alexandra Dimitrijevic, managing director and criteria officer for sovereign ratings at Standard & Poor’s in Paris. "It provides stability because there are not many alternatives where central banks are comfortable putting their reserves. Small countries who are not able to issue on their own currency are much more susceptible to sudden changes in investor sentiment."

The creation of the euro was supposed to confer de facto reserve currency status on all its members, something that would have delighted the French general had he lived to see it. The current crisis has exposed this as a fallacy. Political failure is largely to blame. But there were always structural weaknesses at the heart of the euro project. "Sovereign risk is much more of an issue in the Eurozone simply because these economies have given up the ability to print their own money," says Pimco’s Bradshaw. "That makes the co-ordination of fiscal and monetary policy much more difficult."

In a debt crisis there are only four policy options. A country can grow rapidly to generate wealth to pay back the debt, a trick the UK managed during the industrial revolution following the Napoleonic Wars.

It can indulge in massive monetary easing, devaluing its currency and inflating the debt away.

It can default, the favoured option of Greece for 50% of years since independence in 1832.

Or, it can indulge in financial repression, a combination of negative real interest rates, modest inflation and quasi-forced purchases of government bonds, a policy prescription that worked remarkably well in the UK and US in the aftermath of World War II.

If a country does not have control over its central bank and printing presses, inflation and financial repression are much more difficult to achieve. Growth is proving elusive in the developed world, partly because of high levels of debt. Default causes massive collateral damage, particularly to the financial system (see box). No wonder then that S&P has punished the Eurozone periphery in its latest methodological review of sovereign ratings.

"In the assessment of monetary flexibility we have introduced a two step analysis," says S&P’s Dimitrijevich. "A country in a monetary union benefits from a institutionally significant central bank and the tools it has at its disposal. However, it may be that a country within a union has a problem that cannot be addressed by monetary policy. For countries with problems that differ materially from the core of the monetary union, which cannot be addressed solely by monetary policy, we give them a lower monetary flexibility score."

Fund managers who are keen to find new ways of assessing debt sustainability and new benchmarks to manage their funds against, have adopted this quantitative approach to debt sustainability. It is a curious quirk of market capitalisation weighted indices that in equity markets they reward success, the companies that perform best see their weight in an index increase. In sovereign bond markets it is those countries that have to issue most that receive a higher weighting.

In normal market conditions, this largely reflects the size of a given economy and is intellectually justifiable. That justification becomes harder in times of stress, when big issuance and a high weighting in an index looks more like a reward for failure. It is this anomaly that the BlackRock sovereign risk index is partly designed to address. It gives a 40% weight to fiscal measures of sustainability, 20% to the external finance position, 10% to the health of the financial sector and 30% to a country’s willingness to pay.

This approach prompted BlackRock to focus on the risk of Italy in its June introductory publication, highlighting its relatively low average debt maturity as placing it in close "proximity to distress" while a poor demographic and growth profile lengthens what BlackRock terms the "distance from stability". Cameron Watt says that compared to either CDS spreads or credit rating agency actions, the index flags up problems faster.

BlackRock is not alone in devising new methodologies for assessing sovereign risk. Barclays Capital has introduced GDP-weighted indices and fiscal-strength weighted indices. Credit Suisse developed a scorecard approach in 2010, which James Sweeney, director of global strategy research in New York, says has been adopted by dozens of institutional clients. It is not intended to be used as an index. A third of the factors are subjective and it is up to users to make their own assessments in these categories.

Different strokes

Ultimately idiosyncratic factors may outweigh what is measurable. That is the belief of Ashmore’s Booth. "An index is a false hope," he says. "It is a collection of things that may be important. The same is true of the methodologies of the credit rating agencies. Assuming the same weights for factors in different countries is an immediate dumbing down. You have to understand at a granular level what decisions might be made in different scenarios in the future and apply a probability to them, country by country."

For Booth there are several key drivers that are difficult to capture systematically. The most important are the incentives of the debt issuer and the debt holder and their alignment. For example, official institutions, the Federal Reserve itself and other central banks (mostly Asian creditors) now own more US government debt than at any time since the collapse of the Bretton Woods exchange rate system in the early 1970s.

Credit Suisse’s Sweeney says that these buyers have very different motivations to fund managers. "It may be a strength or a weakness, it depends on the circumstances, but these holders are going to think long and hard about the geopolitical impact of dumping Treasuries in a way a fund manager seeking the best returns for his portfolio would not," says Sweeney.

As Cameron Watt at BlackRock points out, the large pensions sector in the UK is a big prop for Gilts prices. Financial repression also enables governments to rig markets in their favour, something that holders of nominal bonds should be acutely aware of.

For example, pension fund accounting rules mean that liabilities are priced off the long dated (15 years plus) Gilts curve, meaning there is a natural bid for these assets, something that has certainly helped the DMO extend the maturity profile of government debt.

Capital gains on Gilt holdings by individuals are free of tax, but the same is not true of investment in equities. Banks, as they are finding to their cost, are compelled by Basel III and liquidity requirement rules to hold government debt.

Insurers face similar strictures under Solvency II. Booth believes it is unlikely any G10 sovereign will ever default, but he does not rule out "default by other means". Keeping real interest rates strongly negative, as they are currently in the UK and US, will help inflate away debt stock.

Ultimately, however, debt sustainability is about the willingness to pay as much as the ability to do so. That depends on a subjective assessment of a country’s culture and politics, believes Booth. During the Asian financial crisis in 1998, South Korean women queued up at banks to hand over their gold rings to ease the country’s lack of reserves.

The dictator Nicolai Ceausescu exported Romania’s agricultural output and let his citizenry suffer through long winters with minimal food, electricity or heating, to pay the country’s foreign debts. He may have earned the gratitude of bondholders, but he ended up in front of a firing squad. Hardly a fate many politicians would opt for.

The end of the beginning

Regardless of what now happens in the Eurozone, sovereign risk is now firmly on the agenda of investors. Rogoff shows that the direct effect of a banking crisis is an on average an 86% increase in government debt three years later and that lulls in defaults, such as in the Gold Standard era after World War I, are generally followed by a wave of sovereign crises.

What started in Greece will not end there. But even that chapter has still to draw to a close. In a restructuring, the primary incentive of a sovereign is to get debt down to a level at which it can access capital markets in the future.

Pimco’s Bradshaw says the 50% haircut is not sufficient. By his calculations this would still leave Greece with a debt-to-GDP ratio of 120%. "That is based on growth assumptions that are wildly optimistic and no fund manager would buy Greek debt at those levels in any case," he says.

In a typical International Monetary Fund-sponsored bail-out of an indebted emerging market country, it would fix the fiscal position and devalue the currency to recover competitiveness and export markets. Increasingly this looks like the best option for Greece. RBS’s Sian is minded that way, so are Pimco’s Bradshaw and Ashmore’s Booth.

Booth thinks an orderly restructuring with a 75% haircut and an eventual exit from the euro is the likely outcome. That is not a prospect that will calm markets. However, this experienced emerging markets hand reminds developed market bond investors waking up to the realities of default risk that the alternatives can be far worse. A disorderly default, a refusal to pay anything in the manner of Argentina, is possible.

If that happened Greek bonds might trade at less than 10 cents. Booth recalls a time when defaulted Ivorian debt was priced at 0.625 of one cent on the dollar. Even Thomas Kuhn would not dispute that this would represent a paradigm shift for a developed market sovereign bond issuer.


Banking on equity, shrinkage and the ECB

  In its latest methodological review of sovereign government ratings in June, Standard & Poor’s made two significant changes in the light of the recession and financial crisis. It placed greater emphasis on the potential effect of financial sector problems on governments’ fiscal profiles and introduced specific considerations on how to perform credit analysis on sovereigns in a monetary union

BlackRock’s new sovereign risk index ascribes a 10% weighting to the strength of the financial system. It considers the threat the financial sector poses to the creditworthiness of a country if it were to be nationalised in its entirety and assesses the likelihood of this outcome. This is not a fanciful exercise given the experience of Iceland, Ireland and the UK. Nor are European sovereign exposures any less significant. The assets of France’s five largest banks amount to three times its GDP.

The run on Northern Rock in September 2007 and its nationalisation the following year demonstrated right at the outset of the financial crisis the close interconnection between risk in the banking system and sovereign risk. This coupling has been exacerbated by regulatory capital rules, which force banks to hold government bonds as a "risk-free" asset on their balance sheet.

In normal market conditions that might be thought of as reasonable. Unfortunately, banks are now suffering collateral damage from the Eurozone crisis. In October the European Banking Authority announced that banks must reach 9% core tier one by June 2012 and include notional losses on Eurozone sovereigns. The EBA calculates this will mean €106bn in new equity capital.

The danger is that there will be no investor demand. As well as issuing new equity, European banks need to refinance €1.7tr of debt over the next three years. At HSBC, Ulrik Ross, global head of public sector, global markets thinks bank equity and debt will prove attractive. But there is one big caveat. "Confidence needs to be restored in the Eurozone," he says. "The structural issues need to be addressed. If that happened, I think private capital could be attracted into the market."

If it is not, further state bail-ins cannot be ruled out, in spite of the already high level of sovereign indebtedness. Breaking the sovereign-bank link in Europe would then become even more intractable. That is not something the banks want and part of the solution lies in their hands. Morgan Stanley’s bank analysts’ believe that the actual amount of equity raised will be between €50bn and €70bn. Banks will instead opt to delever, shrink their balance sheets and shuffle risk-weighted assets.

That prospect, however, has economic costs. Cash-strapped banks will mean credit conditions remain poor and that is likely to dampen growth, which will make sovereign debt sustainability more difficult. That in turn impairs the sovereign assets on the balance sheets of banks. The vicious circle turns once more. Reversing it will not be easy. For Pimco’s Bradshaw the first step is for the authorities to acknowledge there is problem.

In Europe, this means that the European Central Bank must put out the volatility firestorm by flooding the market with money and buying government debt. "I fail to see how the ECB can claim to act as a guardian of financial stability when it refuses to guarantee and stand behind the most levered asset on banks’ balance sheets. Banks do not have to put capital aside to hold these bonds. If you cannot guarantee the security of that asset, you cannot safeguard the financial system," says Bradshaw.

The alternative is genuinely frightening. If Spanish bank debt is priced off the government bond curve and sovereign bonds are now viewed as a credit, the economic implications are enormous. In a recession government debt yields should fall as investors seek safety. The government can then fund its debt more cheaply as can many other well rated economic actors, speeding the recovery.

If investors think there is credit risk, this virtuous circle turns vicious. A recession means that sovereign debt sustainability becomes more difficult and investors push yields up. The effect of fiscal policy is neutered. The costs to the banking system also rise, so credit conditions worsen. In a monetary union a country does not have the flexibility to devalue. The main levers of macroeconomic control are lost and the cost of finance across the entire economy increases markedly.

The notion of sovereignty itself is questionable in that situation. But banks might also be part of the solution. At Pimco, Bradshaw thinks one way to ameliorate the Eurozone crisis would be to have a Europe-wide bank deposit scheme. "That would both create European-wide institutions and lessen the likelihood of bank runs." But it is also an institutional reform that must wait for others.    
  • 13 Dec 2011

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4 DBS 191.19 2 9.03%