Joseph Mariathasan looks at how investors are adapting to the new world of sovereign bond risk

Legend has it that when Chinese prime minister Chou En-Lai was asked by US president Nixon what he thought had been the impact of the French revolution on western civiliation, he replied: "It's too early to tell."

Similarly, what is now called the Great Recession has led to much soul searching, and the full implications might not be understood for many decades. But already certain long-held assumptions have been overturned.

"The most important delusion that has been destroyed is that the government bonds of the developed countries are risk-free and it is only the sovereign debt in emerging markets that defaults," says Christian Boehm, CEO of Austrian pension fund, APK Pensionskasse.

The implications are quite profound. "The real concern is that there is no risk-free interest rate any more," says Philip Menco, CEO and CIO of De Eendragt Pensioen in the Netherlands. "Five years ago, that would have been unimaginable."

Another result has been a massive shift from the ‘common market' ideal of the euro-zone back to a clearly-defined set of independent markets, where local institutions exhibit a strong home bias. Investors are also faced with a regulatory environment, particularly at the national level, that has become an instrument of financial repression. Some point to Solvency II as an example. De Eendragt, structured as an insurance company, comes under its scope. "Solvency II treats all euro-zone countries as having the same risk; equities are seen as being much riskier; hedge funds require a 50% capital requirement," Menco observes. "Greece would be seen as a safer bet than dividends from Royal Dutch Shell."

As Benno Weber, head of fixed income at Swisscanto Asset Management, argues: "Financial repression means essentially taking money from those who have it in order to reduce the burden of debt for borrowers. Pension funds have money and they are faced with the prospect of longer-term rising inflation as a result of the huge incentive to tackle the debt burdens of the developed nations by, essentially, printing money."

Longer term, the ramifications of this on asset allocation and liability-matching investment for European investors in particular will depend on the future shape of the euro-zone itself. In the short term, investors have no choice but to adopt pragmatic solutions to these immediate problems.

If sovereign debt in the euro-zone is no longer assumed to be  risk-free, then what is?

"The idea of a risk-free interest rate is becoming more of a nebulous concept," says Josh Thimons, a portfolio manager at PIMCO. "There is no such thing as a clean shirt any longer, but US government bonds may be the cleanest dirty shirt available."

But determining how risky a country's debt is on a relative and an absolute basis is very much dependent on the view of the observer. PIMCO distinguishes between those countries able to print money and those that can't: "Clearly, for the same structural conditions, we would want to invest in the sovereign with the printing press."

For Menco, deciding what is risky and what isn't requires continuous re-appraisal. "In 2008, post-Lehman, we sold off all our risky bonds and limited our exposure to the sovereign bonds of Germany, France and the Netherlands," he says. "Last year, with the mounting euro crisis, we came to the conclusion that the credibility of France was decreasing and that it might have problems as well."

Menco and his team suggested to the pension fund's investment committee that it should sell its French holdings - which accounted for one-third of its portfolio - but the committee felt that the spread of 40 basis points over German bonds was already pricing-in the risk.

"But in August 2011, the spread moved to 50 basis points," Menco recalls. "I took the decision to sell France and told the investment committee afterwards. The spread widened to 200 basis points at its peak."

Now, De Eendragt buys Dutch bonds if spreads are greater than 35 basis points over German yields and sells if they are less than 10 basis points; Menco adds that "we don't trust" Austria, and while Finland is an option based on the fundamentals, it is too small and illiquid for the fund.

Boehm, by contrast, does hold Austrian bonds, feeling that the spread over Germany properly reflects economic risk - but he also admits to a home bias. And indeed one common thread linking most investors is an increasing home bias. This is not necessarily irrational: we are not out of the disaster zone yet, and it is easy to envisage scenarios where capital controls and re-denominations of debt could follow a euro-zone collapse. And the actual risk an institutional investor faces in any specific bond market may vary as countries move towards creating incentives and regulations to ‘encourage' domestic institutions to purchase their own sovereign debt.

"We do see Italian and Spanish pension funds buying local bonds," says Alasdair Macdonald, head of investment strategy, UK at Towers Watson. "Governments may treat local investors differently with their tax treatment, solvency requirements, and so on."

But he also points out that if Greek sovereign bonds were to be re-denominated into new drachma, so would Greek liabilities, so the perceived volatility of Greek bonds would be much less for a Greek pension fund than for non-Greeks.

This is very much the LDI-centred view, where the liability-matching asset is, by definition, ‘risk-free', almost regardless of its underlying fundamentals. So, for Macdonald, the disappearance of the concept of a risk-free interest rate has perversely simplified Towers Watson's framework for LDI.

"In the UK, we were in a world where it was all Gilts and everything was priced off them," he explains. "Swaps had a bit more risk and yielded a bit more. Then we moved to a world where Gilts yielded more than swaps, so having a different reference point gave different results. Now we are seeing that Gilts are not risk-free, so everything is referenced from the swap curve. It is not  risk-free, but nearly so."

But there is no doubt that super-low government bond yields adds to the controversy around LDI - and that the existence of negative yields on parts of some yield curves creates even more confusion. For Boehm, the end of ‘risk-free' is also the nail in the LDI coffin.

"I am a strict opponent of LDI," he says. "I won't like to invest in negative yields in Germany or inflation linked bonds with negative real rates." He adds that DB schemes must understand the true risks they face. "I wouldn't like to invest in an asset in any market just because it is claimed to be a natural hedge to liabilities. There are no natural hedges to liabilities."

Jon Taylor, head of fixed income at Principal Global Investors, concurs. "For anyone not already matched on duration, it would be insane to match a basket of liabilities with a basket of high-quality government bonds," he insists.

Still, as Macdonald suggests, pension funds, in the UK at least, have no choice. "In 30 or 40 years, they have to be invested in bonds as they become mature with only retirees," he observes. "So the name of the game is when do they make that transition? Do they delay that decision and rely on the corporate sponsor? The market says that now is not a good time to invest, but there will be better times in the future and a lot of our clients wouldn't switch now but would over the next two decades."

Outside of the liability-matching context - or in the cash-plus portfolios that are designed to meet the obligations of the floating leg of an LDI swap portfolio - do we see further home bias? Not necessarily. There is certainly a shift into home markets and ‘safe havens' occurring within Europe, but it is paired with a greater willingness to look further afield. In the UK, especially, MacDonald sees pension funds buying global bond portfolios rather than 100% Gilts as they look to buy more bonds over the next decade.

"We encourage the use of more diversified indices, whether they are capped market capitalisation or based on something like GDP weightings," he says. "The important thing is that allotting the most capital to the largest borrower does not make sense. Which methodology is used to get round this does not matter and we are happy with whatever is easiest to implement. We are encouraging clients to move into global sovereign credit, which would include Italy and Spain but also Mexico and Brazil which are as good, if not better, credits." Moreover as he points out, if sovereign bonds are no longer risk-free, why would you want to have 60% or more in just one issuer? When risk is involved, diversification becomes your friend.

But heading down this road eventually leads to the decision on how to choose fund managers for absolute return-focused bond mandates. "With a global aggregate bond mandate, should investors go for balanced managers or specialist?" MacDonald asks. "That is the issue."

Towers Watson sees debt portfolios as potentially including, alongside sovereign debt, investment grade corporate bonds, ABS and covered bonds.

"It is an interesting period for bond managers if they could take advantage of the opportunities that are being thrown up," Boehm notes. "But only a few have the capability to take advantage of all the opportunities. We are in an environment now where elements of classical long-only management needs to get nearer to hedge funds, and some hedge fund managers have very good expertise to exploit the current environment through techniques such as volatility arbitrage."

Perhaps specialist managers may offer advantages, but deciding on the mix will, in itself, throw up further challenges and even raise the issue as to whether it makes sense to include stable equities within portfolios designed to beat floating-rate benchmarks such as SONIA and EONIA. After all, if sovereign bonds are no longer risk-free, the distinction between them and other asset classes becomes just a matter of degree.