Evercore Pan Asset

Many investment advisers, actuaries and other experts tell their clients that lending to governments is one of the safest things you can do. You buy a sovereign bond, safe they say  in the knowledge that the country concerned will pay you regular interest on time and repay the loan in the full at the end of the contract. Pension fund advisers like this, as they seek to “match” the cash flow you receive on your portfolio of bonds, with the money you have to spend to pay the pensions. In recent years owners of US, UK, German and Japanese bonds have on the whole made good money. The markets have become ever more appreciative of the sterling virtues of these bonds. Interest rates on them have gone to low levels, driving the prices of existing bonds higher.

In recent days owners of Irish bonds have not fared so well.  Nor in recent months have owners of Greek government bonds been too happy either. The markets have been awash with rumours that these countries might not after all be able to pay all the interest on time, or may have to negotiate a new deal with their bondholders. Frau Merkel added to the worries by suggesting that some weaker countries in the EU might indeed have to renege on part of their obligation.

One of the problems with Irish or Greek government debt is that it is no longer truly sovereign. If you lend to an independent country government with its own currency there is no need for that country to struggle to pay its bills to its bondholders. The country can simply print more of its money to meet its obligations. This may result in more inflation, which can reduce the value of the money it pays back, but there is no technical default. The US and UK governments do not default on their debt repayments, but they have often in the last hundred years triggered inflations which reduce the real cost of servicing the borrowings.

Ireland and Greece are now in a limbo land. They are no longer sovereigns in that special sense. Some want them to be more like the sovereign debt state financed organisations issue in sovereign countries. Some of the debt issued by government institutions is also sovereign debt, because the sovereign government of the country guarantees it as if it were government debt. One way to resolve the immediate Euro crisis would be for the EU to issue an EU sovereign guarantee over all government debt in the zone. Some apparently sovereign debt is not so, because it carries no such guarantee. Local government in the UK, for example, can issue its own debt which has no government guarantee. Councils could get themselves into substantial financial difficult and be unable to meet all their debt obligations.

Today Ireland and Greece are not guaranteed by the EU authorities or by the European Central Bank. There is a long argument underway over the extent to which they should be supported by the central authorities of the Euro area. Some would like the European Central Bank to have a more clearly defined duty to buy in Irish or Greek government bonds to keep their prices higher and the interest rates lower. The US and UK Central banks have done this on a huge scale to keep their debt costs down. If a Central bank at the same time creates extra money to buy in the bonds, it can also drive down its currency, making its exporters more competitive in the process.

Many of the other Euro countries and Commission officials want Ireland to seek financial support from the EU Stabilization fund. This would enable Ireland to borrow at a lower rate than it can currently borrow in the market, whilst giving the EU more direct control over Ireland’s economic policy. The deal would be to let a member state borrow at a lower rate of interest reflecting the better credit rating of the area as a whole, in return for more common and more prudent economic management.

All of this should serve to remind investors that sovereign bonds are not always safe. Investors should understand the difference between a government bond of a country where they still have the power of the printing presses to meet their monetary obligations, and the bonds of countries that share a Central bank and a currency with the neighbours. Investors also need to be reminded of the difference between a so called sovereign bond issued by a government body which does have a true guarantee from a sovereign government, and a bond issued by a government body without such a guarantee.

Our advice to investors is to avoid western government sovereign bonds and EU government bonds. The former offer low rates of interest and have enjoyed a long bull market, the latter have their own special problems.  A sovereign government which borrows too much can still lose market confidence and lose you a lot of money if you own its debt, even if it does meet all the bills on time.  Money printing and inflation are attractive options to countries which have borrowed too much. A government that is no longer sovereign can lose you money if it does not have the support of its governing institutions.

As published in Investment Week