Fixed Income  

Government bonds – which country is safest?

This article is part of
Fixed Income - February 2014

Once seen as the natural safe haven for investors in times of volatility, government bonds have suffered in recent years as low yields combined with ratings downgrades has made some investors wary.

There are currently just 10 countries who have a AAA rating across all three major credit rating agencies – Standard & Poor’s, Moody’s and Fitch – with Germany the one major influential economy in Europe and among the developed markets still with the top rating.

But with the US still rated AAA by Moody’s and Fitch, and even the UK holding the top rating from S&P, does this notion of ratings really matter if yields are improving? The 10-year spread on a UK government bond was approximately 2.78 per cent on January 24, and 2.74 per cent on a US Treasury, this compares with 2 per cent on a UK 10-year government bond and 1.84 per cent on a US Treasury a year earlier.

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David Tan, head of global rates, international fixed income, JP Morgan Asset Management, says: “We do not believe it matters that there are only 10 countries rated AAA by all three big rating agencies.

“Firstly, US Treasuries remain the ultimate flight-to-safety asset and in most ‘risk-off’ scenarios (including US government shutdown or debt ceiling showdown) investors will still buy US Treasuries to protect their portfolios.

“Secondly, many of these AAA governments do not have deep, liquid markets to accommodate large cross-border capital flows. Thirdly, many investors including ourselves prefer to do our own research and make our own judgments on sovereign creditworthiness.”

In addition, Mr Tan points out that AA is still a very high credit rating and clients accept the reality of a shrinking cohort of AAA sovereigns.

Nick Hayes, manager of the Axa WF Global Strategic Bonds fund, agrees that it is not the absolute rating that matters it is the relative rating.

He explains: “We’ve seen a migration south in terms of ratings, including the UK and the US, but does it matter? We all used to think AAA was absolutely sacrosanct and really important, and we thought that if you ever had the big countries losing their AAA that it would be a disaster. But that was proven not to be the case, because ultimately everything was shifted down.

“Initially, the peripheral ratings were shifted down, you had one credit agency put Ireland into high yield. If you are an Ireland or a Greece where you go from very strong to very weak, that is a much worse sign than everything just shifting down.

“As long as the UK and the US are stronger than most other countries or the vast majority of European countries, then that is the most important bit. It doesn’t mean as much as it used to, the AA is the new AAA.”

Mr Tan points out that since the financial crisis started, there have been very few instances when guidelines have required the sale of government bonds once the AAA rating had been lost. In addition, he argues the search for yield has resulted in greater investor interest in lower rated sovereigns.