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Much has
been learned from the ongoing financial debacle that has been painfully
rattling the world’s financial structure in recent years. Foremost
among these valuable lessons is the realisation
that all financial assets have risks.
Even the
bonds of many sovereign nations are being called into question, and rightly
so. Though often deemed to be “riskless” because of a
country’s ability to extract tax from its citizens, logic tells us that
nothing in life is risk-free. This conclusion can also be reached by even a
cursory reading of monetary history, or in a more meaningful and instructive
way, just by closely observing financial events in recent years.
Unquestionably, sovereign bonds have risks.
In fact,
there are three of them. Each of these risks needs to be seriously considered
and analysed before purchasing the bond of any
sovereign nation.
1) Currency
risk – There are two types of currency risk. The first is inflation,
which has been eroding the purchasing power of currencies ever since
governments abandoned the classical gold standard decades ago. This risk is
particularly acute in today’s environment in which continuous central
bank intervention manipulates artificially low interest rates, with the
consequence that the interest income earned on a bond is not likely to
completely offset the loss of purchasing power of the currency in which the
bond is denominated. The other currency risk comes from fluctuating exchange
rates. A declining exchange rate will reduce the value of bonds denominated
in a foreign currency. For example, any euro-based investor who owned bonds
denominated in British pounds saw their wealth eroded when the pound’s
exchange rate collapsed against the euro a few years ago.
2) Interest
rate risk – Although central banks have been actively intervening in
the credit markets to keep interest rates low, it is inevitable that interest
rates will again rise. Rising interest rates mean that bond prices will fall.
Bond prices will fall so that the yields of the bonds’ coupons will
always equal the prevailing interest rate.
3)
Counterparty risk – Most devastating of all is the risk of default. A
country will repay its bonds only if it has both the financial capacity and
the willingness to repay. In this regard, investors are learning from recent
events that many countries have exceeded the ability to repay its debts, even
if they want to do so.
Despite
these recent events, many bondholders still believe that they can achieve a favourable risk/return ratio by owning a government bond.
While that assertion may have been true in the past, most governments today
are over-leveraged and stretched to the limit. It is no longer reasonable to
expect that a government bond can be bought and held to maturity. They have
become a trading vehicle, to be bought and sold like commodities in an
attempt to profit from price fluctuations. This task requires unique skills,
so it is best to leave the ownership of sovereign bonds to professional
traders and speculators.
As a
consequence of countries living far beyond their financial capacity, many
promises made by politicians are going to be broken. This will include the
insincere promise to always honour a
country’s debts. The plain truth is that many governments around the
world are running out of money, and in that environment, sovereign bonds are
not risk-free.
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