Government bonds have long been considered a safe haven in times of economic and market turbulence, but for how long...
Indeed, the asset class continues to see healthy inflows and good performance, particularly amid the heightened volatility within the other asset classes since April this year.
However, given the condition of government balance sheets, a strong case can now be made to support the fact high-yield corporates, viewed as the riskier proposition in comparison, are now a more attractive bet than government debt.
Returns have been positive for both government bonds and high-yield corporates so far this year and it is easy to understand why both remain attractive – high-yield amid a persistently low interest rate/low-yield environment and government debt, which historically offers lower risk in times of volatility.
Portents
The most obvious sign high-yield corporates may be about to pull ahead of government debt is the sheer amount of funding the UK, US and European governments will have to source versus high-yield corporates.
At the beginning of 2010, one major concern was the imminent ‘wall of maturities’ facing high-yield bonds with 2012-14 being particularly heavy in terms of refinancing requirements.
Demonstrating admirable initiative, corporates began the arduous process of arranging refinancing earlier this year, with companies extending the maturity on shorter-dated bonds to lessen the impact of the refinancing requirements in the years to come.
The market has so far been happy to absorb the new issuance, heralding a positive start to this process. The European high-yield market now has less than €10bn equivalent of bond debt maturing in the next 12 months. The UK Government budget deficit however was £12.6bn in June alone with net debt rising to £926.9bn, leading to the requirement for an unavoidably hefty issuance schedule for the foreseeable future.
There are also significant differences in credit fundamentals for the two asset classes.
Harnessing costs
During the last two to three years, particularly heading into the downturn of 2007-08, high-yield corporates were quick to act and have been reasonably successful in harnessing in their costs, deleveraging their balance sheets and retaining cash within their business, particularly at the better quality end of the scale (BBs). This is highlighted by the default rate falling as well as the rating drift plateauing.
By contrast, governments face an uphill struggle in terms of improving the current state of their balance sheet. Since the onset of the downturn, government spending has increased hugely and they are significantly behind the restructuring game in comparison to high yield corporates. More recently we have seen some governments being downgraded, indicating that they are still heading towards the trough of the cycle.
Going forward, high yield will also benefit from their financing and operational flexibility in comparison to governments. As above, corporates are currently benefitting from the cost-cutting initiatives launched as we entered the downturn. Many names are also exposed to the more buoyant emerging markets economies so performance remains robust.
For governments, they are generally limited (except for currency impacts) to their domestic economies. Funding is also limited to fiscal changes and spending cuts and both of these will take some time to implement, so budgets will remain stretched. Short-term performance and the fundamental credit positions of the two asset classes are therefore likely to persist for the time being.
Concerns
For government bonds there are some prevailing concerns around the rescue package launched to help Greece and other periphery countries, in that they have only solved the short-term liquidity problem. Therefore, sovereign risk remains a very real risk and this may have some longer-term impacts on overall yield levels.
In terms of valuations, government bond yields have fallen to their lowest level for over a decade due to the prevailing low interest rates and their safe-haven status. It remains to be seen how sustainable these yield levels are against such a supply background, although the low inflation environment will be of benefit.
For high yield, valuations remain attractive compared to historical levels and coupled with the improving fundamentals and technical position they continue to offer interesting investing opportunities. They are also likely to provide investors with some protection should government bond yields start to rise.
Mervyn King’s comments in late July that the Bank of England is in no hurry to raise interest rates further supports the case for high yield. Given many experts predict low interest rates will remain in place for at least 18 months this, combined with the Government’s planned spending cuts and refinancing requirements, may swing investor opinion away from governments and towards high-yield bonds in their search for much-needed income.
Confidence
A modicum of confidence can be taken from the fact governments have performed incredibly well this year, outperforming the other bond classes in Q2 2010 and retaining their “safe haven” status while so much volatility has impacted the other asset classes.
As long as this volatility continues, some investors may maintain their view governments are a safer option, despite there being increasing doubt over their future stability.
Regulatory changes, particularly in the capital requirements for banks, may also increase demand for the asset class. Low inflation will help demand for governments, but while the consensus opinion remains Europe is about to enter a deflationary period, it is hard to see this area sustaining investor interest in the coming years.
Despite the “safe-haven” attractions of government bonds, when considering the future stability on a fundamental basis and their outlook valuations, we believe they are no longer as attractive in comparison to other asset classes. The asset class has done well to remain enticing to investors, however we anticipate a real shift in traditionally held views once it becomes clear governments are inevitably set to enter a period of difficulty.
Rebecca Seabrook is co-manager of F&C’s Strategic Bond fund
