Bond markets could be about to change gear

Kathleen Brooks
SOVEREIGN risk has risen as the debt problems facing Greece have come out into the open. And volatility in the bond markets is likely to continue after Fitch, the ratings agency, downgraded Spain late last week, reigniting concerns about credit risks.

All of this has caused a massive divergence in bond yields and countries perceived as having low sovereign credit risk, such as Germany and the US, have seen theie borrowing costs fall.

But there is a strong argument that yields for “safe haven” bonds are now too low and don’t reflect the actual economic reality. This argument is supported by investment bank UBS, which recommends an underweight position in both nominal and inflation-linked government bonds.

It argues that yields on government debt, especially in Germany and the US, have been artificially depressed during the credit crisis, and at this level the risk of a reversal is growing. “Bond markets in the US, Germany and Japan are overvalued relative to the cyclical drivers of growth and inflation outcomes, but potentially also relative to longer-term questions about fiscal sustainability,” UBS analysts wrote last week.

Investors who plan to hold bonds for the long term need to be aware of the sovereign risks of the future, most notably the age-related liabilities facing the G7. UBS notes: “the costs of the financial crisis pale in importance when compared to the costs governments are likely to face from unfunded pension liabilities.”

Using its sovereign risk index, which measures future liabilities and interest payment burdens, UBS has found that countries with the most at-risk bond markets include Italy, Belgium and Japan, although France, the UK, Germany, Canada and the US also score fairly highly.

It would have been a very gutsy fund manager who would have been happy to short US, Japanese and German bonds in recent weeks, but this is exactly what UBS research suggests. So how can investors prepare for the future?

Choosing a dynamic fund manager is one way to do this. Morningstar, the fund ratings service, recently upgraded BlackRock’s Euro Bond Fund to superior. It says that one of its strengths is fund manager Michael Krautzberger, who uses quant models combined with his own judgment to generate ideas. This worked to good effect in the run up to the financial crisis back in 2007 when the fund went against the trend and boosted its holding of government debt. It has continued to perform well, and outperformed its benchmark, the BarCap Euro Aggregate 500m+ Index, to return 4.32 per cent in the year to 31 March.

It’s not just equity markets that can move both up and down: bond markets can too, and the pressure is rising.