December-January 2013

SOVEREIGN BONDS: A job for polymaths

BooksFrom demographic data to farms and forests, the range of subjects sovereign bond managers must understand seems to be growing, writes George Mitton. Not so long ago, the sovereign bond market was a fairly well-ordered place, where investors could follow a benchmark and trust credit ratings to guide them. “That was the time when it was in vogue to advertise the use of ETFs [exchange-traded funds] for government bonds,” recalls Kommer van Trigt, head of fixed income allocation at Robeco. “This was perceived to be an efficient market where it was difficult to add value.” Not any longer. Debt crises, volatility and downgrades of formerly triple-A rated countries have destabilised the market and led to a renewed appetite for active management. Van Trigt says clients once more appreciate managers who allocate dynamically across sovereign bond markets. But if understanding benchmarks and credit ratings is not enough any more, what else must managers know? Quite a lot, it seems. For a start, a working knowledge of the politics driving the eurozone crisis is essential for managers who buy European sovereign bonds. This means studying speeches, interpreting announcements from eurocrats and guessing the mood of the electorate across the continent. Beyond that are a range of economic indicators that bond managers say are more important than ever. Unemployment rates, GDP per capita, indebtedness of the private sector and age demographics affect creditworthiness. A report from the United Nations Environment Programme says bond managers should examine freshwater, forests and grazing land, since supplies of these natural assets will in future affect the creditworthiness of issuers. KNOWLEDGE
With all this knowledge to consider, it is a taxing time to invest in bonds. It seems managers must become polymaths. The UN Environment Programme report supports its claim that environmental factors will become linked with sovereign credit risk with country-specific analysis. Overuse of domestic ecological assets in Japan trebled between 1961 and 2008, says the report, and the country is increasingly reliant on imports. Meanwhile, Turkey demands one and a half times more from its ecological assets than they can sustainably provide. The implication is that the sovereign credit risk of each country could increase in future if these problems aren’t addressed. According to Van Trigt, the argument is persuasive, though he says Robeco research from three years ago indicates that environmental factors are less important than social or governance factors when it comes to sovereign credit risk. “My own country, the Netherlands, doesn’t score that well in terms of air pollution, waste disposal and so on, but there is not an issue with regard to the perceived creditworthiness of the country,” he says. “The same goes for a country like Finland, which is quite heavily dependent on nuclear energy. It is not the case that bond investors are cautious with Finland.” Van Trigt says environmental factors could become more important in future, though. He is interested in how countries meet their energy needs – whether a country is a net importer or exporter of energy, whether it invests in renewables, and how efficiently it uses its energy. Just take Germany, a country that has invested so heavily in solar power that on midday of May 26 it met 40% of its energy needs from this source. Germany’s solar infrastructure is reassuring because it lowers the country’s dependency on imported resources such as oil and gas and makes it less exposed to inflation should energy prices rise. “Germany would be much better placed to handle a supply shock [of oil or gas] than countries that are fully dependent on external energy, like Turkey,” says Van Trigt. Environmental, social and governance (ESG) concerns are increasingly important to clients, adds Van Trigt, though he has found the bulk of research on the market applies to corporates rather than sovereigns, which is a challenge for government bond investors. Emerging markets are notably lacking in data on ESG criteria due to a shortage of accurate reporting on subjects such as the environment, political corruption or industrial relations. The experience of Gilles Lejeune, a bond fund manager at Dexia Asset Management, demonstrates the shift in investment approach that has come about in recent years. Initially, his fund was a purely European triple-A fund. “Once we saw the downgrade of France and Austria, our investment universe decreased to Germany, Finland, Luxembourg and the Netherlands,” he says. “We decided we needed a new approach. We think the most important lesson of the eurozone crisis is that simply investing in a country because it’s in the benchmark is not the right solution. You need now to have a specific approach for each country to determine if it’s worth investing in or not.” Lejeune’s team analyse a range of economic indicators from unemployment rates to the dependency ratio projected 25 years into the future. This last measure can reveal if an economy is likely to be weighed down by social security payments to retired people. The team also studies a range of indices that measure corruption, peace and political, economic and religious liberty. He takes advice from Dexia’s socially responsible investment (SRI) team, which includes a government bond specialist. “The environmental measures have an important weight in the SRI team’s analysis. It makes sense to take them into account especially in the natural and human part,” says Lejeune, in reference to the UN Environment Programme report. Lejeune’s colleage, Nicolas Forest, head of rates and foreign exchange at Dexia Asset Management, believes the instability in sovereign bond markets means it is no longer advisable to follow benchmarks weighted by market capitalisation. “It’s not a long term and sustainable approach to have a strong exposure on Germany just because Germany has triple-A status,” he says. “From a long-term view, it’s not a good idea for an investor to have 30% in US Treasuries just because of the market capitalisation.” Of all the subjects bond managers must know about, the eurozone crisis is perhaps the most crucial in the short-term. There are potentially large returns for managers who correctly interpret the politics of the situation. But it is not only politics that is shaping the crisis. “We look at metrics like unit labour cost, which takes into account wages and productivity,” says Cosimo Marasciulo, head of European government bond and FX, Pioneer Investments. “Clearly, a reduction in unit labour costs increases the competitiveness of countries. In Ireland, Greece, Spain and Portugal, there has been a significant reduction since 2008. There is a convergency story of competitiveness between peripherals and core.” REBALANCING
Marasciulo believes the eurozone is rebalancing between the core and periphery – a trend that will help to heal the damage left by the crisis. As well as rising productivity in the periphery, he sees signs of wages rising above historical averages in Germany, which will help right the balance. This is a story that may be missed by investors who focus merely on benchmarks and credit ratings, and yet it could determine the future of the currency union. Of course, many investors are more sceptical about the eurozone crisis than Marasciulo. But even these sceptics must be able to defend their views with evidence. With the growing emphasis on environmental, social and governance concerns, and an expanding toolkit of economic measures, it seems the dialogue on bond investing is more complex than ever.
The range of subjects these managers must know grows longer by the day; perhaps bond managers should consider taking some more reading home from the office. ©2012 funds europe

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