Spain has the ability and willingness to undertake the needed reforms and also benefits by starting from a more favourable public debt position, but it has to limit the expansion in its debt over the next few years as the economy works through a serious recession.Photo: Bloomberg

Safe havens are now risky

Developed countries' sovereign debt is losing some of its appeal, writesCarrie Lam

Sovereign debt forms, or sovereign bonds, are one of the oldest types of investments and are considered one of the safest.

This type of investment is divided into two categories. Developed countries that carry very high credit ratings are viewed as safe options. However, they offer comparatively lower yields.

Emerging countries, meanwhile, usually come with lower credit ratings but offer higher returns.

This was the traditional definition of sovereign bonds that has been a textbook guideline for many investors over the past decades.

However, since the European debt crisis swept in, developed countries have been viewed as risky.

"The European crisis has presented some compelling investment opportunities in sovereign bonds, but they are not without risk and further volatility," says Owen Murfin, managing director and portfolio manager in BlackRock's global bond portfolio team.

He says the risk profile of peripheral economic and monetary union government bonds varies significantly across countries, with the path to debt sustainability less clear in Ireland and Portugal than in Italy and Spain.

Murfin believes Italy is already generating a primary surplus and merely has to continue doing so in order to reduce its debt load.

Spain has the benefit of starting from a more favourable public debt position, about 60 per cent of GDP, but has to limit the expansion in its debt over the next few years as the economy works through a serious recession.

But Murfin explains Italy and Spain are solvent with the ability and willingness to undertake the needed reforms, and the current 5 to 6 per cent yields in the two countries represent good value.

Maggie Tsui, managing director, deputy head of investment services, Asia, at BNP Paribas Wealth Management, shares this view.

She says that "selective European sovereign debts are relatively cheap, but with reasons".

Tsui says among the peripheral sovereigns, Ireland's and Italy's bonds are more resilient in the recent rounds of sell-off with the Italian 10-year yield rising from 5 per cent to mid-6 per cent only, whereas Ireland's yield has been improved to 5.5 per cent lately. But she believes the tide will be turning for these two countries.

Tsui says the problem Italy is facing is structural, but Prime Minister Mario Monti seems to be doing the right things to correct some structural issues.

She believes Italy will be sensitive to funding cost, but if the European Central Bank's (ECB) bond purchase programme materialises, it will be advantageous to the country and it should be able to make up its government's deficit.

Gary Dugan, chief investment officer, Asia and Middle East, for Coutts, says he sees "little value in investing in European sovereign debt at the moment", as investors are facing a greater risk of significant losses in periphery country debt markets should they decide to leave the euro zone.

However, Dugan says if investors still insist on purchasing sovereign bonds in this high-risk zone, he suggests they remain focused on core countries.

"The yields in Germany are already extremely low and have a safe-haven premium already priced in, whereas the Netherlands, among the core countries, offers the highest yields [10-year bonds at 1.88 per cent].

"However, there is a risk that the elections this coming week could return an anti-euro zone government," Dugan says.

The picture painted by investment firms on European sovereign bond is bleak and they say this may continue or worsen.

"I believe there is still a considerable risk that the euro-zone crisis will worsen. The problem is that the fiscal discipline needed to satisfy the ECB and the International Monetary Fund may keep countries, such as Spain, Italy and other periphery countries, in a prolonged recession.

"With unemployment rates already high the social and political problems in these countries can only increase," Dugan says.

But BlackRock reminded investors that even though the road is not easy, those who are willing to hold out and wait would be rewarded for their patience in the end.

This article appeared in the South China Morning Post print edition as: Safe havens are now risky