The debt crisis in the euro zone and continuing issues in the US have finally woken investors up to the reality of sovereign risk in developed markets, according to a new report from the BlackRock Investment Institute, which proposes new methodologies for quantifying the likelihood of default.
Sovereign default in developed economies could be "catastrophic" for investors, the report noted, as many traditionally have large holdings in government debt as a very low risk, relatively low return investment.
"I feel that over the last couple of years it's not only the quantifiables that have changed, it's also the realization that sovereign risk, and particularly developed market sovereign risk exists, because most developed world sovereign was basically treated as entirely risk free," Benjamin Brodsky, managing director in fixed income allocation at BlackRock, told CNBC.com.
"With hindsight, we can say… that they have never been risk free, it's just that we have been living in a quiet time over the last 20 years."
While sovereign defaults had happened – notably in Latin America – it was assumed that developed markets were immune, according to Brodsky.
"People thought that sovereign risk was something that was reserved for developing markets, and this was something you could see in most portfolio allocations, if you look at the hedge fund industry and pension funds, you can see that they have massive exposures to developed markets and to developed market government bonds," he said.
Value-weighted market indices overweight large issuers and impede price discovery in traded debt markets, while simple measures of credit quality, including debt-to-GDP ratios, do not take into account the full gamut of political and economic factors that determine the real risk of default, the report said.
The maturity structures of debt can be as crucial as the absolute amount outstanding, BlackRock said. The United Kingdom, with its more long-term debt structure, is better able to go through a period of austerity than, for example, Greece.
BlackRock has developed an index of sovereign risk that pulls together the fiscal dynamics of countries, their external finance position, the health of their financial sector, as well as their "willingness to pay" – a combination of "qualitative and institutional traits that suggest both ability and willingness to pay off real debts."
The index does not directly include market-based factors, but in testing showed a high correlation to current credit default swap spreads, the report said.
Of the 44 countries in the index, Greece is the most likely to default, followed by Portugal, Venezuela and Egypt. Norway is by some way the least likely, with Sweden and Switzerland in second and third.
The US is approximately as likely to default as China, and Italy looks slightly more likely to default than Ireland, and appreciably more likely to default than Spain, which some analysts have suggested will be drawn into the issues on the euro zone periphery.