Should investors only allocate to AAA-rated economies?

The risk of finding yourself insufficiently diversified across markets has instigated a clear trend among advisers away from investing in country-specific equity funds towards funds with broader geographical diversification and funds of funds. Additionally, even the managers of the more broadly-based funds pay limited attention to rating agency opinions.

Sub-investment grade countries that Templeton has invested in include Kenya and Ghana, both of which Fitch Ratings rates B+, and Nigeria, Egypt and Sri Lanka – rated respectively by Fitch as BB-, B and BB-. But neither these ratings nor those of Standard & Poor’s (S&P) or Moody’s have played much part in stock selection.

Mark Mobius, executive chairman of the Templeton Emerging Markets Group, says: “Our fixed income analysts and managers certainly do look at these ratings but on the equity side we don’t find them of much use since individual companies in markets that have even very poor ratings can do quite well. We therefore can’t use the agency ratings as a guide for equity investment. The exception, of course, is if there are going to be currency controls and nationalisation or confiscation of assets.”

Perhaps the biggest limiting factor is that equity fund managers tend to invest in companies rather than countries and, with so many companies now being internationally focused, where they actually do businesses is far more important than where they are listed.

Lee Freeman-Shor, fund manager, alpha funds at Old Mutual Global Investors, has found himself frequently having to answer questions about why he invests in ‘Piigs’ countries (Portugal, Ireland, Italy, Greece and Spain). But he has pointed out that the stocks concerned are not exposed to local markets.

For example, his European Equity fund has a holding of supermarket cash and carry chain Jeronimo Martins which, although listed in Portugal, derives 60 per cent of its sales from Poland and has appreciated in value by more than 30 per cent in the past two years.

There is also a commonly expressed feeling that the sovereign ratings of emerging markets can be ‘out of sync’ with those of developed ones.

Mark Parry, senior investment manager, multi-asset at Aberdeen Asset Management, says: “A fast growing country may have a lower rating than a more developed one with lower growth and bigger budget challenges because of bigger fiscal deficits, but this will only be taken into account up to a point in the ratings. Ultimately we are trying to access growth to our investors and credit ratings alone may not get us there.”

When it comes to investing in government bonds, sovereign ratings have inevitably increased in importance as investors seeking returns capable of beating inflation have increasingly had to look towards riskier markets.

Richard Carter, senior fixed interest specialist at Quilter, says: “Most highly rated countries, like the US, UK and Germany, have low yields at the moment and while these will usually have a role to play in investors’ portfolios, it is hard to argue that they are particularly good value.

“Lower-rated countries are certainly worth considering and the debt fundamentals of many emerging markets are actually improving. But it is important to be aware of currency risk because the exchange rates are usually much more volatile than the underlying bonds.”

Most experts stress that sovereign ratings are only one part of the picture that government bond investors need to consider, and that the growth and inflation rates of the underlying economy, the outlook for interest rates and the policies of the central bank are just as important. Some also feel that rating agencies can be slow to react to changing debt dynamics.

Jack Kelly, investment director, global government bonds at Standard Life Investments, says: “The sovereign debt in Spain continued to be highly rated through the first few years of the crisis, even as spreads widened sharply versus Germany. As investors look to build a sovereign portfolio, they should take into account changing dynamics, even when the change takes place with the sovereign bonds coming from a fairly low ebb.”

Additionally, sovereign ratings can be of great relevance to corporate bond investors if the country is on the cusp of investment grade.

Chris Higham, manager of Aviva Investors’ Corporate Bond and Strategic Bond funds, says: “If the sovereign rating goes below investment grade it can be significant for certain mandates and result in a much higher cost of borrowing. The lower a sovereign goes, the harder it is for a corporate to maintain investment grade, so whether Spain goes below investment grade is one of the big uncertainties of this year.”

Edmund Tirbutt is a freelance journalist