In Part II of our Investing in Global Bonds series, we take a much closer look at the largest subset of the global fixed income landscape: developed market (DM) sovereign bonds. Our objective is to better understand both the risk and return characteristics of this market segment on a standalone basis, as well as to discuss the potential benefits from a diversification and risk-reduction standpoint relative to domestic government bonds. In subsequent papers, we will address the role of global bonds in an objective-oriented investor’s portfolio, as well as active management and implementation considerations.
Background
In our last paper, we divided the global bond market into three major segments: developed markets, emerging markets, and high yield. The first segment, developed markets, can be further segmented into sovereign and investment grade corporate bonds. Each of these market segments are exposed to varying degrees of interest rate risk and credit risk, which in turn impact their return and risk characteristics. Since developed market sovereign bonds typically exhibit lower sensitivity to conditions in credit markets relative to the rest of the opportunity set, there is an intuitive rationale for examining them on a standalone basis. Furthermore, investors will almost always include some exposure to this market segment in their portfolios for very specific reasons – liquidity, risk stabilization, or liability matching, for example – that can differ from the reasons for holding other types of bonds.
The developed market sovereign landscape is primarily comprised of bonds issued by G7 countries that are ultimately underwritten by those nations’ population. Generally speaking, these bonds are considered to be the closest thing to a risk-free asset in modern financial terms, primarily due to the countries’ high creditworthiness. However, despite extremely low expected risks of defaults, there are differences in demographic, economic, fiscal, and monetary policy dynamics across developed market sovereign issuers. Notably, as illustrated in Figure 1, these differences are reflected in the range of sovereign credit ratings across the primary issuers, including Eurozone nations that operate under a unified monetary policy and common currency. However, since a nation has at its disposal a considerably greater array of tools to service its debt (e.g., domestic power of taxation, control of the money supply, international political influence) than other types of issuers, the notion of “risk-free” relative to the rest of the bond market remains justifiable.
Figure 1: Range of sovereign credit ratings
*Top 3 countries of the Eurozone
Components of the ICE BofA Global Government Index as at December 31, 2019.
Index does not include quasi-government bonds. Credit ratings as reported
by Moody’s. Note that Standard & Poor’s downgraded the United States’ AAA
rating to AA+ in 2011. Weight according to each sovereign issuer’s total market
capitalization.
Source: ICE Data Indices, LLC
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