WHICH SOVEREIGN BONDS TO CHOOSE?

BOND MARKET ANALYSIS

First of all, it is important to remember that debt is neither harmful, nor a defect, nor a failure, nor even a "dirty word". On the contrary. Public debt, for example, is used to finance part of the state's investments in education, health, security, infrastructure, defence, pensions and many other strategic areas, with the aim of stimulating long-term economic growth. Sovereign debt also provides financial flexibility to deal with unexpected expenditures or economic shocks. In a recession, the government may choose to spend more to stimulate private investment and create jobs, rather than cut spending and deepen the crisis.

As with companies, governments with good credit ratings can borrow money at relatively low interest rates. Their investments will more easily generate returns above interest rates. Thus, in a conventional situation, borrowing money is a financially sound decision for the state.

Debt becomes dangerous when it is accumulated excessively, increasing the risk of default. Increased interest costs reduce the government's ability to invest productively and sustain economic growth. When some investors believe that the government will not be able to pay back its debt, demand for sovereign bonds dries up, raising interest rates and further increasing interest costs (see Fig. 2). In extreme cases, the debt burden can become overwhelming (see Fig. 3). Governments end up having to choose between defaulting or monetising their debt. In the latter case, the central bank becomes the buyer of last resort, making the debt sustainable but causing a devaluation of the currency. Therefore, in order to assess the risks faced by the yields offered, investors closely monitor the sustainability of government debt.

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To simplify their task, rating agencies assess credit risk. The "Big Three", Standard & Poor's (S&P), Moody's and Fitch, account for more than 90% of the industry's turnover. Next in line are DBRS Morningstar, ARC, or the Asian JCR, Dagong, Chengxin and ICRA. As their name suggests, these agencies issue ratings to quantify the ability of a debt issuer to pay back its bonds. They are very useful, although not perfect. They have been criticised for their role in the 2008 financial crisis, when they underestimated the probability of default by banks and other financial institutions. Since then, the quality of their credit assessments has improved considerably.

We have developed a proprietary, simple, mathematical evaluation method based on a scoring of economic and financial ratios: primary balance, interest charges, average coupon, maturity dispersion, national saving rate, foreign ownership, central bank intervention, cost of insurance against default, etc. In total, 13 criteria are compiled.

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This scoring does NOT represent a probability of default, but it serves two functions:

• The primary objective is to rank the risk of the main public debts. The lower the score, the lower the risk (see Fig. 4).
• The second objective is to compare the results of this scoring to the ratings assigned by the main rating agencies (see Fig. 5), and to the yields demanded by bond investors (see Chart of the Week).

Thus, some sovereign debts appear as "risky" or, on the contrary, "cheap".

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Among the high-risk countries whose ratings could be downgraded (see Fig. 5) and whose interest rates could rise (see Chart of the Week), not surprisingly, are the European peripheral countries, Greece, Italy, and Portugal, as well as the UK, France, Belgium and Slovenia. From this point of view, the recent downgrading of France's rating by Fitch from AA to AA- and the upcoming downgrading by S&P on 2 June seem perfectly justified.

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Also in this basket of debt to watch are the two largest global bond markets, the US and Japan.

Certainly, Uncle Sam has the world's largest economy, a significant technological lead, high productivity, a hegemonic currency in trade transactions, a powerful military force, and consequently a massive international capital flow into its sovereign debt. As a result, US Treasuries are considered by investors around the world as the "risk-free asset". Despite this special status, the quality of US debt is deteriorating. In addition, the US will have to refinance 39% of its debt by the end of 2024 (see Fig. 6). Both Republicans and Democrats mistimed the threat of default, as early as June, by refusing to raise the debt ceiling (see Fig. 7). From any angle, neither the AAA rating from Moody's and Fitch, nor the AA+ from S&P seem warranted. A downgrade of the US rating would not be a surprise. On the other hand, as in 2011, it would cause a temporary panic in the financial markets, whether for bonds, equities, currencies, or commodities.

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The case of Japan is different. The debt is close to being unsustainable and current ratings could be downgraded again, increasing the distrust of yen assets. Despite this, rates will not rise as the Bank of Japan (BoJ) is pursuing a policy of yield curve control (YCC) and de facto monetisation of public debt. The new governor, Kazuo Ueda, has no choice but to pursue this strategy, at the risk of causing a historic fall for the yen.

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At the other end of the spectrum, and this is where investors are concentrated, is Denmark. It is the country with the best score, according to our methodology. Its sovereign debt is one of the very last on the planet to carry the prestigious AAA rating. Only 10 countries now hold the top rating from each of the Big Three (see Fig. 8). Like Switzerland, Denmark's fiscal position is exemplary: revenues exceed expenditures, interest costs are low, and the outlook is promising as the necessary policy reforms have already been implemented. Its debt is only 33% of Gross Domestic Product (GDP) and it will be the first of the AAA-rated countries to return to its pre-pandemic level. Although Danish bonds are not a safe haven in the event of a major crisis, not least because the Danish krone (DKK) is pegged to the euro, their 10-year yield is 32 basis points higher than Bunds (see Fig. 9). This makes them a good alternative for investors who hold too many German bonds.

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Among the riskier bonds, but where the perception of risk is probably too high, are Ireland and Bulgaria.

‍During the past 12 years, Ireland has undergone a sensational transformation. From being under the thumb of supranational institutions (EU and IMF) during the European debt crisis, it now ranks third in our Eurozone scoring, behind Luxembourg whose debt market is tiny and Germany whose dynamics are improving at a much slower pace. To get to this point, Ireland has made significant efforts. First, it sought to isolate the real economy as much as possible from the harmful effects of the financial crisis. Then, and this is a specific Irish feature, it sought to attract foreign companies, particularly American ones, by pursuing a very attractive tax policy. In Ireland, companies pay 26% of their profits in tax, compared to an average of 39% in other European countries. This fiscal strategy has allowed companies such as Google or Apple to domicile their European headquarters in Dublin, in order to repatriate profits from their activities in EU countries. The result is clear: over the last ten years, Irish economic activity has grown 10 times faster than the rest of the Eurozone, +140% compared to +14% (see Fig. 10). Irish 10-year sovereign bonds offer 2.68% to their holders, 45 basis points above those of Germany (see Fig. 11), while the likelihood of an upgrade from AA- to AA by one of the agencies cannot be ruled out over the next 18 months.

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Bulgaria is rated BBB by S&P and Fitch, and one rating above (Baa1) by Moody's, with a stable or positive outlook in all three cases. Despite the energy crisis and economic slowdown caused by the Russian invasion of Ukraine, the economic fundamentals remain good. To become better, Bulgaria will need to stabilise its inflation, which reached 15.3% in 2022. The country will also need to break the current political deadlock by ending the interim government and electing a stable governing coalition. Until these issues are resolved, Bulgaria cannot converge towards the Maastricht criteria and hope to join the Eurozone. The challenges are real but not insurmountable. Even if the adoption of the euro is unlikely to happen before 2025 or 2026, investors will try to anticipate the resulting credit rating improvement. This is not necessarily the case for Czech, Polish or Hungarian bonds, whose yields also seem very remunerative (see Chart of the Week) but whose rating by the agencies seems perfectly in line with our scoring (see Fig. 5). With a currency pegged to the euro and a 7-year yield of 4.3%, compared to 2.6% in France (see Fig. 12) with similar fundamentals, Bulgarian bonds offer a credible alternative for risk-taking investors.

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Conclusion

Bond investors are concerned about the ability of the US Congress to raise the debt ceiling on schedule. At the same time, they are alarmed by the downgrading of the French rating by the main agencies. In this environment where "risk-free" assets are poorly labelled, very high-quality sovereign bonds, such as Denmark's, or those likely to be upgraded, such as Ireland's and Bulgaria's, will have an advantage.

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