Dying Breed

08/06/2012 at 4:06 pm

Last month we looked at the various refuges available to investors in the event of market panic. One of our conclusions was that:

The most effective hedge against panic is government bonds (though only those seen as safe).

Since then, both the broad statement and the caveat would appear to have been proved. From the US through Europe to Japan, developed market equity indices lost between 6% and 10% of their value (in local currency terms) during May. Gold and silver suffered by similar amounts. And government bond yields in several countries reached record lows, with ten year issues in Europe and the US posting gains of 3.5-4.5%.

As for the caveat: well, the price of the ten year Spanish benchmark fell by over 5% last month. Spain is certainly not a country seen as “safe” at the moment – as yesterday’s downgrade by ratings company Fitch underlined.

In fact, since we last looked at government bond ratings around the world, those rated “AAA” (as near as it’s possible to get to risk free) have become even more of a dying breed. The eurozone, of course, saw France and Austria fall to AA+ at S&P back in January. Finland, Germany, Luxembourg and the Netherlands are the only AAA rated euro countries left – and even they were subject to “negative watch” until a few months ago.

Outside the zone, the AAA club includes Switzerland, the Scandinavian countries and the UK – though even here there is uncertainty. S&P downgraded the Isle of Man to AA+ last November, and of course Fitch reminded us all yesterday that (along with Moody’s) they see the mainland’s AAA rating as being at risk over the next year or two as well.

There has been less drama in other developed countries. Japan suffered a couple of downgrades, but in any event has not been a AAA debtor for many years. The same goes for New Zealand. Outside Europe – following last summer’s US downgrade, again courtesy of S&P – the only other members of the AAA club remain Canada, Australia, and Singapore.

And yet there is a limit to the importance of all this. If bond markets close to an economy with deficit funding or debt refinancing needs, that is a serious development with potentially grim consequences. But if credit ratings fall, bond yields remain affordable and markets stay open, it’s a different story.

So it is interesting that ten year US and UK government bonds yield less than Dutch ones, even though their ratings and / or outlooks are “officially” worse. And Japan’s low bond yields are notorious despite the slow deterioration in its credit ratings over the years. At the other end of the scale, Spanish bonds have sold off today – but not by much (the ten year bond yield is currently 6.19%, 0.15% higher than yesterday’s close). And in Ireland, which is still rated junk by Moody’s, the same five year bonds that reached yields of over 17% a few months ago have spent most of 2012 below 6%.

Of course it is hardly necessary in these nervous times to remark that ratings companies may simply be getting ahead of the game. Perhaps Spain will follow Portugal into bailout country, despite the protestations of its government to the contrary, its relatively low debt burden and the yet more unpalatable fiscal trajectory that it might subsequently face. But bond market reactions to some of the higher profile sovereign downgrades we have seen in recent months suggest that they might have lost some of their power – to surprise, or influence, or both.

After all, take a step back and there is something rather funny about seeing Fitch downgrade Spain because it has to stand behind its banking system. A few short years ago, the ratings industry was citing likely sovereign support as a reason for being positive on rating bank debt through the cycle (banks being, by coincidence, among the keenest issuers of debt and the ratings companies’ biggest clients). Moody’s notoriously upgraded the big Icelandic banks – Glitnir, Landsbanki and Kaupthing – from single A to Iceland’s then sovereign rating of AAA in February of 2007, just as the first signs of the subprime crisis were becoming visible over the Atlantic, on this very logic. Within two years they had all got their sovereign support – and defaulted anyway.

The desirability of owning paper issued by a dwindling band of “safe” governments is understandable in a crisis. In recent times, however, investors have clearly looked beyond credit ratings in betting where safety really lies. Perhaps the ratings companies’ agitated caution will prove more insightful than their pre-crisis complacency. What is certain is that AAA-rated sovereign borrowers aren’t the only ones who don’t like the idea of numbering a dying breed.

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