Default Swaps Lift Sovereign Ratings From Brink of Junk
The risk of owning sovereign bonds has fallen to a two-year low, setting the stage for more gains by the riskiest government securities as the investors look to a healing world economy.
The amount of risk priced into government issues is the least since 2011, lifting the average implied ratings for more than 80 debt markets to Baa2 from Baa3, or one step above junk, according to Moody’s Analytics. Credit-default swaps show the securities to be safer after more than $5 trillion in stimulus by the world’s central banks since 2009, according to data compiled by Bloomberg and Bianco Research LLC.
Even after returning 18.5 percent last year, bonds of Portugal, Ireland, Italy, Greece and Spain may produce more gains for investors. Their debt yields average 2.57 percentage points more than Treasuries, double the average gap of 1.26 percentage points of the past 10 years, according to Bank of America Merrill Lynch indexes. Investors from Brandywine Global Investment Management LLC to Prudential Financial Inc. are turning to government securities.
“There is still risk out there, but the wave of accommodation has set the stage for the reflation of the global economy,” Jack McIntyre, who manages $44.5 billion in assets for Brandywine, said by phone from Philadelphia on Jan. 22. He is buying debt in Brazil, Portugal, Italy and Ireland.
Concern that major economies will default has all but disappeared. Twenty-two of the 34 developed-world members of the Organization for Economic Co-Operation and Development have credit-default swaps, which protect against losses on their debt, at less than one percentage point, or 100 basis points, meaning they are viewed as almost risk free. Six months ago only six fit that category, data compiled by Bloomberg show.
One indication of further gains is that the implied rating of Baa2 for the world’s sovereign bonds is below the actual average of Baa1. That suggests investors are becoming less pessimistic, said Jerry Tempelman, a director at Moody’s Analytics in New York, an arm of Moody’s Corp. that’s separate from the company’s credit-rating business.
Ireland’s implied rating has risen eight steps to Baa3, the lowest investment grade, from Caa2 in August 2011. The price of credit-default swaps tied to the nation’s bonds fell to 183 basis points from a record high of 1,195 in July 2011.
Irish two-year notes yield 94 basis points more than German bunds, down from more than 2000 in 2011. The nation’s five-year notes yield 3 percent, compared with 2.91 percent for Italy, which is rated two levels higher by Moody’s.
Spain’s ranking is up one level to Ba2 from Ba3 in July 2012, and its default swaps have fallen by more than half to 261 basis points. Its five-year notes, at 3.79 percent, yield about 3 percentage points more than bunds.
The bonds of Ireland and Spain have returned 58.4 percent and 12.1 percent since their lowest implied ratings.
Investors are growing more confident as the three biggest challenges to sovereign ratings -- slowing growth in China, a breakup of the euro region and U.S. political stagnation over the fiscal cliff and the debt ceiling -- diminish, Raman Srivastava, head of global fixed income at Standish Mellon Asset Management Company LLC, which manages $170 billion, said in a telephone interview on Jan. 24.
China’s gross domestic product grew 7.9 percent in the fourth quarter after a seven-quarter slowdown, the National Bureau of Statistics said Jan 18. Since European Central Bank President Mario Draghi said July 26 he would do “whatever it takes” to save the 17-nation euro, the currency has appreciated versus 16 major counterparts. U.S. lawmakers raised taxes Jan. 1 and last week suspended the debt limit until May 19.
“There are still a lot of hurdles to clear, but things are looking more encouraging globally,” Srivastava said. He has been purchasing global inflation-linked debt and bonds of Italy, where benchmark 10-year note yields have fallen to 4.15 percent from a high of 7.24 percent in November 2011.
“Slowly we are transitioning to an environment where growth is driven by fundamentals rather than fear,” he said.
The improving risk outlook has lured investors away from Treasuries and German bunds, which gained 1.84 percent and 3.3 percent last year after returning 9.79 percent and 9.69 percent respectively in 2011, according to Bank of America indexes.
Both are off to the worst start to a year since 2009. Benchmark 10-year Treasury yields rose today to 2 percent for the first time since April 25, according to Bloomberg Bond Trader data. The 1.625 percent note due November 2022 fell 7/32, or $2.19 per $1,000 face amount, to 96 28/32.
Bonds in emerging markets and the most-indebted European countries are producing world-beating gains. The almost 19 percent returns for debt of Portugal, Ireland, Italy, Greece and Spain last year came after an average loss of 6.87 percent in 2011. Emerging-market debt has increased 9.14 percent since the start of 2012.
Central bank stimulus won’t guarantee growth and risks sparking global inflation, according to Scott Mather, head of global portfolio management at Pacific Investment Management Co., which runs the world’s largest bond fund.
“Like any drug, you can become addicted to easy monetary policy,” Mather said in a telephone interview on Jan. 23. “It certainly feels good, but it doesn’t mean you are becoming healthier. The vulnerabilities in the system are all still there, and when the good feeling wears off reality will hit, and hit hard.”
Pimco’s $285 billion Total Return Fund (PTTRX) raised its holdings of Treasuries to 26 percent in December, the highest level since July, keeping non-U.S. developed nations’ bonds at 12 percent and cutting the fund’s emerging-market debt to 7 percent from 8 percent.
While the International Monetary Fund cut its global growth forecast Jan. 23 to 3.5 percent for this year, from 3.6 percent in October, the pace would still be faster than the 3.2 percent in 2012.
Global sovereign bond yields have fallen to 1.45 percent, near the record low yield of 1.35 percent in December 2012, from about 1.8 percent a year ago, according to Bank of America Merrill Lynch Indexes that goes back to 2001.
Yields may stay low as the world’s leading economies cut supply, refinancing $220 billion less sovereign debt this year than they did in 2012.
Bills, notes and bonds coming due for the Group of Seven industrialized nations plus Brazil, Russia, India and China will drop to $7.38 trillion from $7.60 trillion in 2012, according to data compiled by Bloomberg.
The U.S. government will reduce net sales by $250 billion from the $1.2 trillion issued in fiscal 2012 ended Sept. 30, a survey of the Fed’s 21 primary dealers found.
“This deleveraging cycle has not been in a straight line, but it is going on, and as it continues government balance sheets are getting better,” Stuart Thomson, an international fixed-income fund manager at Ignis Asset Management in Glasgow, who oversees $110 billion in assets, said in a telephone interview on Jan. 24. He is investing in commodity producing countries such as Australia and Brazil.
Benchmark U.S. interest rates have been zero to 0.25 percent since December 2008, and the Fed has injected more than $2.3 trillion into the financial system through bond purchases to ignite economic growth and keep borrowing costs near record lows. It’s buying $85 billion a month in mortgage securities and Treasuries.
The Bank of Japan increased its asset-purchase fund on Oct. 30 by 11 trillion yen ($121 billion) to 66 trillion yen. Draghi said Oct. 4 the ECB is ready to start buying government bonds to help the debt-ridden nations in the region.
Yields about record lows in the biggest developed countries are creating a “virtuous cycle” in troubled nations, bringing capital back in which has pushed down borrowing costs, which will ultimately help growth, Robert Tipp, chief investment strategist in Newark, New Jersey, for Prudential’s fixed-income division, which oversees $350 billion, said in an Jan. 23 telephone interview.
“We are certainly not out of the woods, but the Fed has been very vigilant in controlling downside risk for the U.S. and Draghi has removed a lot of systemic risk out of Europe,” Tipp said. His firm is staying away from Bunds and Treasuries in favor of Irish and Italian debt.
Investors are moving into riskier assets as better bond performance has spilled into global equity markets. The MSCI All-Country World Index (MXWO) of stocks in developed and emerging markets has risen 3.8 percent this year, on pace for its best monthly gain since June.
U.S. investment and junk-rated corporate bonds have returned 0.417 percent this year, compared to a 0.359 percent loss for Treasuries, after company debt returned 11.3 percent in 2012.
“There is still a desperate reach for yield among global investors,” Nic Pifer, head of global fixed-income for Columbia Management Investment Advisers LLC in Minneapolis, which oversees $340 billion, said in a telephone interview on Jan. 23.
“We are in an incrementally improving global economy with less concern of event risk due to the warm blanket provided from central banks. If you want return you have to look beyond the safe haven assets,” he said.
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