The global pool of AAA-rated government bonds, as rated by the three main ratings agencies, has fallen 6 per cent in the past year and 60 per cent since 2007, according to analysis by the Financial Times.
This has meant the amount of AA-rated sovereign debt now exceeds the AAA pool, with implications for fund managers and clients alike.
Joshua McCallum, UBS Global Asset Management’s senior fixed income economist, says: “[The decline] has less to do with governments globally and much more to do with the ratings.
“The simplest thing the ratings agencies could have done was to have introduced a new rating of quadruple A for places like Norway, Switzerland and Australia, rather than downgrading everyone else.
“If you are a country that issues debt in a currency that you can print, the idea of default risk is essentially negligible. The shift from AAA to AA is not something that tells me anything truly amazing.”
He says the credit default swap (CDS) market is a much better indication of country risk and that downgrades matter principally where there are investment guidelines and benchmarks in place.
“Most UBS clients were willing to write in an exception for the US,” he said.
“They did not really see the kind of risk that was there [applying to] the US and perhaps they had been demanding too much in insisting on AAA.”
So AA has effectively become the new AAA, at least for UBS clients.
But will government debt ever be upgraded to AAA, and if so, when is it likely to happen?
Darren Ruane, Investec Wealth & Investment’s head of fixed interest, says that with the global economy showing recovery across all regions, including Europe, the sharp reductions in country credit ratings may have come to an end.
But Stewart Cowley, Old Mutual Global Investors’ investment director for fixed income and macro, finds it difficult to envisage a major reversal of government credit ratings any time soon.
Mr McCallum, however, is sanguine about the US going into technical default. “The only thing that would worry me would be the market reaction,” he says.
“The US government would compensate investors for any losses because reputationally they could never afford it.”
He says the lack of triple A sovereign debt is only a problem if investment guidelines do not take into account the new reality and the importance of liquidity.
“If investors holding ultra-safe Norwegian bonds thought the central bank was going to raise interest rates, there would be a rush to sell,” he explains.
“They might not have any doubt about the credit quality, but they might all rush for the exit at the same time because of a lack of liquidity.”
So how are managers allocating to sovereign debt at present? When government bond yields in the core countries fell below 1.5 per cent in 2012, many bond managers reduced duration – their exposure to interest rate rises – and sought returns from higher yielding assets, including peripheral European sovereign bonds.
Bernhard Urech, Swiss & Global Asset Management’s head of fixed income interest rates, says investors had two options when reacting to downgrades – adjusting their minimum quality requirements or eliminating the downgraded countries.
Mr Ruane thinks that with the back-up in yields, particularly US yields, in 2013, there is now more value in the core government bond markets of the US and UK.
But Mr Cowley says there is a lack of conviction that we are through the other side of the great recession, even though evidence is mounting in the US and UK.
UBS has reacted by creating a new benchmark called “G5+AAA (US, UK, Japan, Germany and France), the five big, liquid bond markets, plus an allocation to the smaller AAA-rated economies to combine credit quality with liquidity.
But Mr McCallum says economists are paying less attention to ratings, and that as long as investors are sensible and treat the new AA as AAA, it is a legacy issue.
Mr Cowley believes ratings downgrades have had little effect on government bond yields, mainly because quantitative easing has artificially suppressed yields.
Ian Fishwick, Fidelity portfolio manager for institutional fixed income, says: “Nobody is willing to take the rating agencies as gospel truth, although there will still be a few funds restricted to triple A.”
This loss of faith in the rating agencies has precipitated a step change in the quality and quantity of research by investment houses, he says.
“Before the financial crisis, emerging market debt investors concentrated on credit risk, while most developed market investors focused on interest rate risk. This has now changed.”
Fidelity has built a team of sovereign analysts, largely aimed at emerging economies, but who apply some of the same techniques in developed markets.
UBS has a dedicated head of sovereign debt research in its fixed income team which looks at real returns, the probability that a country moves over one of the key thresholds, and the risk that a country prints [inflates] its way out of its troubles.
McCallum says: “Moving from AAA to AA is more important than going from AA to A, while going from investment grade to junk is the single most important rating move. Even the IMF and the rating agencies have changed their methodologies.”
