Investing in Fixed Income - April 2012
While many assets have some attributes of safety, the global universe of what most investors view as potentially safe assets is dominated by sovereign debt, according to the IMF’s latest Global Financial Stability Report.
As at the end of 2011, AAA-rated and AA-rated OECD government securities accounted for $33trn (£20.7trn) – 45 per cent – of the total supply of potentially safe assets. Relative safety explains why investors have substituted riskier asset classes with the debt of stronger governments in the last year, including German bunds, Japanese government bonds and US treasuries – in spite of Standard & Poor’s downgrade of the US’s credit rating last year.
This flight to quality has accounted for an increasing differentiation between sovereign debt, according to the report. However, yields on some government bonds that ceased to be perceived as safe have spiked in the aftermath of the crisis, while yields on bonds viewed as safe havens irrespective of credit rating, such as those of the US, Japan, and Germany, for example, have declined to historic lows.
The current degree of differentiation across sovereigns in the OECD is more pronounced than in previous periods, with historically low ratings in southern Europe, Iceland and Ireland, and downgrades in countries that had maintained AAA ratings since S&P reinstated sovereign ratings in the mid-1970s – Austria, France, and the United States.
Nick Hayes, manager of Axa Sterling Strategic Bond fund, says: “The argument for gilts and bunds is that the world will be volatile for a number of years. We’re in a low growth, low yield environment. When equities are doing badly and peripheral bonds are doing badly and credit spreads are going wider, then you all want to be in safe haven government bonds, even if they do yield 2 per cent.”
As the IMF points out, some advanced economies’ central banks have also influenced the markets for safe assets via massive purchases of government securities.
The US Federal Reserve and the Bank of England have purchased such assets to boost liquidity in the financial system and stimulate economic activity by lowering long-term interest rates – the process known as quantitative easing. These policies have contributed to a substantial decline in long-term yields on government securities.
These large-scale purchase programs have turned the Federal Reserve and the Bank of England into large holders of long-term government securities, with some risks for safe asset markets. The longer-term purchases have resulted in a marked increase in the maturities of both central banks’ government securities holdings.
At the end of January 2012, roughly 40 per cent of the Bank of England’s holdings consisted of securities with remaining maturities of 10-25 years, according to IMF data.
Philip Laing, investment director for government bonds at Standard Life Investments (SLI), says: “Bonds are being held because [investors] want to get their money back. It’s not about getting returns – it’s about the certainty of getting your money back. It’s return of capital – not return on capital.”
And in an uncertain world, no matter how bad inflation gets, investors are sometimes happy to settle for just that.
Jenny Lowe is features editor at Investment Adviser