‘True sovereigns’ immune from eurozone contagion

There are plenty of doomsayers who think it is only a matter of time before the sovereign risk crisis spreads from the eurozone to other countries, including the US, UK and Japan.

This is not going to happen in my view. That is because the obsession with public debt ratios fails to distinguish between different levels of sovereignty. The US, UK and others can maintain high public debt ratios for longer, especially given the amount of deleveraging being carried out by the private sector.

Not all sovereigns are the same. The US, UK, Japan and Canada are examples of what I call “true sovereigns”. For these countries there is zero default risk. Investors should not worry about credit fundamentals, as they will always receive their coupons and original investment on redemption.

A “true sovereign” can issue freely in its own currency, has full taxing power over the population and ultimately, if required, can create more of its own money. None of this means that true sovereigns can afford to be profligate, far from it, but it does mean there is no externally imposed timetable on fiscal retrenchment.

Investors in the “true sovereigns’” should worry about the level of interest rates and inflation, but not about credit risk. These factors, rather than the level of supply, will be the most critical in determining bond yields.

Market participants mixed up the different contributions to risk in government bond markets earlier this year when they started pricing in some element of default risk. Short sellers, sitting on significant losses, have been forced to cover their positions. The traders who thought 10-year US and UK government bonds were expensive in January when the yield was 4 per cent will not find them good value at close to 3 per cent.

But those who are worried about deflation and understand the different categories of risk will buy these bonds to maintain purchasing power. After all, investors have recently been gobbling up 10-year Japanese government bonds with a 1 per cent yield. They know that sovereign risk is zero so any amount of positive yield is attractive when inflation is negative.

By contrast, there is sovereign default risk in eurozone bonds. The countries that adopted the single currency immediately relinquished some policy sovereignty. But that only became crystal clear this year when Greece faced a liquidity crisis. This was caused by the market’s loss of confidence in the Hellenic Republic’s ability to pay bondholders as large redemptions approached.

Receiving refinancing help from the eurozone and the International Monetary Fund dealt with the near-term concerns over ability to pay but did nothing to remove longer-term concerns over willingness to pay. That is true credit risk.

Greece is an extreme example of what happens when a country loses sovereignty over its economic policy. And it cannot be compared with the UK position, for example. Indeed, it was extraordinary that market professionals made the mistake of comparing Greek and UK budget deficit and outstanding debt ratios. Understandable, perhaps, if you are a politician trying to win an election but not if your job is to invest in the bond markets.

Within the eurozone, France and Germany have more sovereignty over the euro than some smaller states because they can freely sell bonds denominated in the single currency to investors all over the world. France and Germany have the lowest yields because the sovereign risk premium is minimal and without these countries there is no monetary union.

At the other extreme Greece cannot issue bonds at the moment because investors cannot be sure they will get their money back and, as high-yield investors know very well, yield spreads become less relevant the higher they go. For example, offering a yield pick-up of 10 percentage points is wholly irrelevant if the issuer of that bond later fails to repay the principal in full.

The sovereign crisis for the eurozone is not over and markets are likely to require a greater risk premium for some of the weaker members if economic conditions become more challenging. Moreover, there is a significant deflation risk in some of these countries as austerity measures start to bite. Without the policy options available to the true sovereigns, there will always be risk of default.

This is not the case for countries such as the US and UK. Yields there will be determined by the outlook for interest rates and inflation. The latter will be particularly important when policy rates are close to zero. Also, the fact that private sector borrowing has been contracting at a faster rate than budget deficits have been growing adds downward pressure to inflation.

What may be more relevant for the UK and US is less the eurozone sovereign debt crisis than a Japanese scenario, where a long period of private sector deleveraging has helped keep government bond yields low. Under that scenario, US and UK inflation rates will stay very low and 10-year government bond yields could continue falling towards 2 per cent.

Steven Major is Global Head of Fixed Income Research at HSBC