Tuesday, August 9, 2016

"Is it safe?" for sovereign bonds - Definition of safety elusive

The concept of a safe asset is flexible. It is relative. It is time-varying. It does not exist. US Treasuries have always been viewed as safe. Triple-A rated EU bonds are supposedly safe. In fact, there are some who argue that there is a shortage of safe assets and this is what is driving some yields lower. Yet, the meaning of safe is unclear. There are different meanings of safe, but one thing is clear, risks exist and are not going away

  • Default free - The Iceland and Ireland crises, the Greek debacle, and the downgrade of US Treasury in the developed world tell us that default risk is relevant even for governments in developed countries. Certainly, any faith in ratings is misplaced given the abject failure of rating agencies to adjust ratings in a timely fashion or to get them right in the first place.
  • Stable yield - Stable yield is elusive. Short-term yields in the US are stable but near zero. If by stable yield, you mean a positive real yield, you can forget about it. Central banks have made it their policy "right" to drive real yields negative when they choose.
  • Limited downside - Aside from the negative yield question, there is growing downside risk just because nominal yields are low by any measure of history. If monetary policy is effective and gets 2% inflation, there will be real loses. Compounding this effect is the extended duration of bonds in a low rate environment. There is more risk with bonds today than 10 years ago.
  • Store of value - The search for safety in alternative currencies exposes investors to currency risk. They may pick a currency which is strong today but there are no guarantees that they will continue to be strong. Safe stop of value currencies have seen their central banks try to reverse this strength. 
Perhaps the most prudent view is that there is nothing safe. A view of buy and hold for bonds is risky given the changing dynamics with credit risk. 

No comments: