In an era of downgrades managing sovereign risk is a growing concern, and in the current environment investors need to actively manage their fixed income portfolios, says Russell Investment’s Andrew Pease.
Pease (pictured), Russell’s Asia Pacific chief investment strategist, notes that investors which follow a fixed income index will find it hard to manage their risk. This is because, while equity indexes reward successful companies which, therefore, have large market capitalisations, fixed income indexes are dominated by large debt issuers.
“Basically, if you follow the index in fixed income you are essentially taking more and more exposure to entities that are issuing the most debt, and that may not always be the best thing to do,” Pease says.
When it comes to sovereign exposure investors should look closely not just at the balance sheet and the economic fundamentals of a country but at its particular domestic political situation.
“In addition to the level of debt, there are two factors that determine whether a sovereign default actually occurs,” he says.
“These factors are the ability and the willingness to repay. A country can default selectively on its obligations even when it has the capacity to service its debts. Willingness to repay the debts is very much a political consideration.”
Pease, who will be speaking at the Top1000funds.com Fiduciary Investors Symposium from October 23-26 in Beijing, compares the current situation in highly indebted Japan to that of Russia when it defaulted in 1998.
Russia defaulted with a debt to GDP ratio of 57 per cent, far below Japan’s debt levels, now hovering around 200 per cent debt to GDP.
“Japan is a high-debt country, but the issue with Japan is that it still runs a significant current account surplus, so they are getting more money from overseas than they send overseas,” Pease says.
“Something like 90 per cent of Japanese government bonds are also either directly or indirectly through their pension funds owned by the Japanese people. So, it makes it very hard for the Japanese government to default on its own electors.”
With credit ratings agencies lagging the market, it is also important that investors pay attention to changes in market expectations regarding a country’s sovereign debt, says Pease.
“Ratings agencies are forced to stand behind these static recommendations; it is very hard for them to change their views, whereas the market can change its views daily,” he says.
“Hence, the need for active management in fixed income.”
Outside of sovereign debt, Pease says that a low-returns environment, risk aversion in financial markets, and strong corporate balance sheets will see continuing strong demand for high quality corporate debt.
Traditionally, the difference between the corporate and sovereign debt yields has been approximately 150 basis points. But Pease says he expects this yield differential to narrow to around 100 basis points in the next five years.
From a regional standpoint Pease says credit default swap rates have improved for many countries in Asia, indicating that emerging markets are seen as less risky than they were in the past.
However, he says investors still need to consider issues of capital controls, and currency interventions by governments trying to shield their economies from the problems in Europe and the US.
He also cautions about the Chinese economy, saying it faces considerable challenges in the medium term as it seeks to re-balance its economy.
“China has got a relatively unbalanced growth model, with high reliance on investment and a declining share of consumption as a share of GDP,” he says.
“I think that is going to have to be one of the issues that will have to be resolved. The Chinese government’s stated plan is to lift the share of consumption from somewhere around 35 per cent to about 50 per cent over the next 10 years or so.
“But it is going to be very hard to achieve. The ability of China to be able to transform its economy will be one of the key watch points in the region.”
In a low-returns environment, where active management is increasingly needed to achieve alpha, Pease says deciding to use scarce active management resources on the fixed income side of the portfolio makes sense.
“It is about having a much better understanding of where risk is,” he says.
“Particularly on the sovereign side, it means thinking harder about what relative risk spreads mean and whether you are being adequately compensated for the risk you are taking.”
