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Sovereign Debt Buyers Search Far and Wide

The pool of countries with AAA credit ratings keeps shrinking, putting buyers of high-quality government bonds on a global search for stable sources of income.

The ongoing European debt crisismost recently knocked France from the AAA perch and has put much of the Euro zone off limits to investors buying sovereigns as a safe haven.

Japan doesn’t look much better with yields barely positive after factoring in inflation.

“Most of the problems are with the old developed markets,” says Tony Norris, co-manager of the Wells Fargo Advantage International Bond Fund. “As soon as one moves away from those economies, government deficits are less, and economic growth is more sustainable.’’

Norris points to Australia and New Zealand as economies supporting sovereign bonds backed by sound finances and attractive yields.
WisdomTree AustraliaandNew Zealand Debt Fundprovides focused exposure to these bond markets.

“Australia has run close to a textbook macro policy before, during, and after the global financial crisis,’’ adds Michael Hasenstab, portfolio manager of the $61 billion Templeton Global Bond Fund , which invests primarily in sovereign bonds across developed and emerging markets.

Australia is benefiting from low debt levels, prudent economic policies, and its position as a leading exporter to China, he says.

Hasenstab is also finding opportunity in Europe in places like Ireland. The country has dealt aggressively with its debt problems and its bondshave rebounded strongly from distressed levels. A stronger-than-expected recovery in exports should provide further support to bond prices.

Kenneth Orchard, a sovereign debtanalyst for T. Rowe Price, also likes the sovereign debt from select EU countries.

One is Austria, whose economy has never experienced a housing or credit bubble and enjoys a trade surplus. Another favorite is the Czech Republic, due to its low level of government and consumer debt.

Iceland, which suffered a currency devaluation in 2009 before improving its fiscal policies, is a value pick.

Strong fundamentals also exist in the developed markets of Sweden, Denmark and Norway as well as Hong Kong and Canada, analysts say. The rigor of this latter group, however, has already been recognized, and their bonds are on the expensive side, Norris says.

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The EU debt saga has taught bond investors to no longer assume that sovereign means safe. Determining the creditworthiness of government issuers now requires an analysis of economic fundamentals including GDP growth , annual deficit, and long-term debt levels and trade balances.

Stability comes from having the capacity to easily repay outstanding debt obligations, a feature of a growing number of emerging markets .

Brazil, Malaysia and Mexico, for instance, are now rated investment-grade markets and are part of global sovereign benchmarks like the Barclays Capital Global Aggregate Index.

“Emerging markets are a completely different ballgame than 10 years ago,’’ Orchard says. “The asset class had gone through six years of crises, but now a wide range of investors are looking at EM, not just for the better fundamentals, but also the [higher] yields.”

The widespread fiscal health of emerging markets makes ETFsa good way to gain sovereign exposure.

PowerShares Emerging Markets Sovereign Debt fund (PCY) and iShares JPMorgan USD Emerging Markets Bond Fund (EMB) invest in EM sovereigns denominated in U.S. dollars, which eliminates currency risk. PCY holds government bonds of 22 countries equally while EMB owns debt from 34 countries with weightings determined by market value.

Stronger emerging market economies should support currency appreciation versus the U.S. dollar, euro and yen. Franklin Templeton’s Hasenstab is particularly bullish on currencies in the Asia ex-Japan region.

Investors can participate in currency gains by owning sovereign debt issued in the local currency of each government. WisdomTree Emerging Markets Local Debt owns sovereigns denominated in 15 local currencies.

For higher quality sovereign exposure, the Legg Mason BW Global Opportunities Bond Fund invests primarily in sovereigns with a credit rating of A or better. The fund currently overweights fundamentally sound countries including Australia, Mexico, Poland, Malaysia and South Korea. The quality focus has enabled it to beat 97 percent of its world, bond-fund peers over the last three years while delivering a current yield of 3.5 percent.

Recent actions of the European Central Bank , including a series of long-term refinancing operations offered for the region’s banks, has supported a sovereign recovery in Italy and Spain, among others.

The increased liquidity provided to banks gives them the cash to reinvest in sovereign bonds, but analysts say it’s too early to take on bullish position in Europe’s largest issuers — especially when much better bond stories exist elsewhere.

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