What are the drivers of the global sovereign debt market?

In the 10 years since the global financial crisis, interest rates have fallen, and stayed at record lows globally.

More recently, inflation has been creeping back up in the UK and US.

Jordan Sriharan, head of fund research and senior portfolio manager at Thomas Miller Investment, remarks that the difference in the market pre- and post-2007 is not surprising given where interest rates are.

“Pre-crisis, government bonds generated a healthy yield and worked well as part of a balanced income mandate,” he says. 

“Low inflation in the post-crisis period has ensured that yields have stayed low in the aftermath of central banks’ bond buying programme (QE).”

People constructing balanced portfolios of equities and bonds would traditionally rely on sovereign bonds for two characteristics – interest income and diversification.Matthew Yeates

Mr Sriharan continues: “Even as the Federal Reserve raised interest rates back in 2015, the yield on the policy sensitive two-year Treasury remained broadly flat over the following year. 

“However, as the US consumer price index has moved higher, and expectations of interest rate rises increase, nominal yields on short-dated Treasuries have risen – making them relatively more attractive.”

Being able to know where the opportunities are for income investors in the sovereign debt market means understanding what the drivers are.

Peter Elston, chief investment officer at Seneca Investment Managers, identifies three main drivers of global sovereign debt:

• Inflation.
• Real interest rates.
• Credit risk.

Bonds have traditionally been used as a source of income for investors’ portfolios. Mr Elston explains this is because they pay a coupon.

“But if you take account of inflation, this income is effectively negative income or, at best, all but wiped out,” he warns.

Matthew Yeates, investment manager at Seven Investment Management, explains: “People constructing balanced portfolios of equities and bonds would traditionally rely on sovereign bonds for two characteristics – interest income and diversification. 

“So, in this regard, they have historically been viewed as important income-generating assets in balanced portfolios.”

Demonstrating caution

Does this mean the asset class can no longer be relied upon by those constructing income portfolios?

Some bond fund managers have been expressing caution over the fixed income market, warning higher inflation might prompt a sell-off, which came true in February this year.

Bryn Jones, manager of the Rathbone Ethical Bond fund, suggests: “Globally, sovereigns look expensive over a long-term time horizon, although more recently some value is appearing following a sell-off due to concerns about inflation, central bank policy and reactions, and possibly interest rate rises.”

He told FTAdviser in December last year that in his portfolio he would be focusing on lower-risk assets in the bond market in 2018.

“With central bank interest rates globally so low and hitting negative territory in Europe and Japan, it’s hard to call government bonds an undisputed income-generating asset in the same way they could have been historically,” admits Mr Yeates.

Instead, he urges investors to think about all instruments, but especially government bonds, in a total return context.

“Income is an important part of the long-term return available from bonds, but with bond yields at such a low base, it is easy for income to be eroded quickly by rising yields,” he suggests. 

This asset class is meant to be safe and boring, but this has not been the case – as evidenced by the recent volatility.Andrew Jackson

“An investor in UK government bonds could have been perfectly [positioned] with their income yield of around 1.2 per cent in December last year, only to have had more than three years of income wiped out through capital losses as the yield moved to a value of around 1.6 per cent.”

For some, the opportunity to move further up the risk scale provides more opportunities for income in this market.

Mr Sriharan has spotted an opportunity for income investors in sovereign emerging market debt (EMD).

“While QE had the unquestionable effect of raising asset prices, through the portfolio rebalancing effect, the impact on EMD was less clear as the wider region navigated the post-crisis period without the luxury of their own central bank support. 

“This would suggest that EMD is less likely to suffer from steep falls in price as global monetary policy begins to tighten towards the end of the cycle.”

He notes: “When combined with synchronised growth in the global economy and a more stable domestic picture (both financial and political), the income opportunities in the large and diverse universe of EMD should not be ignored.” 

But Mr Jones maintains a more cautious stance, having previously told FTAdviser it is “complacent” to think inflation will rise, so therefore the higher yields offered on riskier bonds do not justify the additional risks.

He has reduced his exposure to emerging market bonds in the fund.

BlackRock's global chief investment strtaegist, Richard Turnill, explains why he is long on short bonds, arguing that "a rapid rise in short-term yields in US government debt is restoring their appeal".

Source: BlackRock Investment Institute/Thomson Reuters

He says: "The steady increase in shorter-maturity bond yields provides a thicker cushion against concerns around further rises in interest rates. The light green line in the chart (above) shows interest rates would need to jump more than one percentage point to wipe out a year of income in the two-year Treasury note.

"This is nearly double the cushion on offer two years ago – and far larger than the thin insulation provided by longer-term bonds today."

Safe and boring?

But with rising inflation and interest rates set to be hiked and possibly at a faster pace by the Fed this year, convincing investors of the opportunities in sovereign debt may be the biggest challenge.

Andrew Jackson, head of fixed income at Hermes Investment Management, points out: “The unwind will have the largest impact on the segment of the market most affected by the recent low-rate environment – sovereign debt. 

“Uncertainty over how this extraordinary experiment unwinds means investors have lower confidence in the direction of sovereign debt and the path for rates than in previous cycles.” 

He adds: “This asset class is meant to be safe and boring, but this has not been the case – as evidenced by the recent volatility.”

Mr Jackson suggests any recent volatility in bond markets has recalibrated the market, opening up more opportunities for investors.

eleanor.duncan@ft.com