Thus, pessimism could return to plague the markets once more, as confidence takes another beating amid the current market rally — one which has already been met with considerable scepticism.
Pacific Investment Management Company’s (Pimco) Bill Gross, who runs the world’s largest bond fund, was concerned that the US could lose its “AAA” rating, another sign of disapproval of the sustainability of the recent market optimism. In the same week as the negative rating action on the UK, Moody’s realigned Japan’s foreign currency rating down from “Aaa” to “Aa2” to reflect equivalence in repayment capabilities for both domestic and foreign debt, given that Japan’s ability to repay foreign debt has weakened as the fiscal deficit widens, compromising the positives of its strong foreign exchange reserves and high level of domestic savings. Do note that Malaysia’s rating drivers bear similarities with that of Japan, given the ballooning size of the fiscal deficit, engaged in a balancing act with the high level of domestic savings and foreign exchange reserves. It is at these crucial times that public sector spending should not turn profligate and lag economic value generation, especially when even economies which had top-notch ratings are sliding down the sovereign credit curve.
In fact, the recent rating actions had turned initially vague concerns into substantial losses for holders of government securities in the world’s largest bond markets, where 10-year US and UK government bonds lost 2.2% and 1.5% respectively over a single week to May 22.
Besides these short-term losses, the official endorsement of weaker government credit profiles will also have widespread implications of how we view the “risk-free rate” going forward, and therefore, longer-term valuations.
In financial theory, the risk-free rate essentially unifies valuation models across several different asset classes, such as equities or bonds. It reflects the lowest level of risk and forms a base at which investors price expected returns in compensation for money lent or invested.
From a global context, US government bonds, with their “AAA” rating, essentially reflects this risk in the long term, although short-term vagaries in risk appetite could cause temporary variations or arbitrage opportunities.
From a domestic perspective, assets price themselves partly on local government bonds, which in turn are partly based on expectations of interest rates formulated via monetary policy.
Due to its core role in valuation models of financial securities, implications of the risk-free rate are pervasive and very relevant for today’s investor, especially when we cannot take the stability of sovereign ratings for granted.
As the risk-free rate increases due to the expansion of fiscal deficits and the erosion of sovereigns’ creditworthiness, investors would require a higher rate of return, driving up bond yields, pulling down bond prices, raising the discount rate used in equity valuations and pressuring down stock prices. This is an important reason behind the explanation of periods of coupling between risk-return profiles across equities and bonds, as the market risk premium rises in conjunction with the higher risk-free rate.
Therefore, the rise in sovereign risk premiums could actually lead to positive correlations as systemic risks become more prevalent, at least for the period in which it occurs as most salient, between different asset classes which are traditionally expected to have contradictory risk-return profiles.
In the current context, do note that the credit market crisis is in fact, centrally connected to sovereign risk, given its link to the banking system, and therefore the risk-free rate, which is why the recent volatility hit world markets and created losses with positive correlationships, highlighting the severe degree of systemic risks.
It is inevitable that investors, whether retail or institutional, would have to bear some risks in investing. As a sovereign’s credit rating or risk premium tends to follow changes in the macroeconomic cycle, it not only has broad, but also long-term implications for future investing and the way we perceive future returns.
From the perspective of corporate bonds, it may be difficult to expect credit spreads to reach historically low levels in a sustainable manner as the economy as a whole gears up, raising the scarcity of available funds for lending or investing.
As a result, with at least greater frequency, if not absolutely, investors will need to look into the upside risk of credit spreads and gradually discard historically low yield levels as points of reference on which to base expected investment upside.
For government bonds, it may also be a prudent measure for investors to demand a greater rate of return than was the case during the boom years post 2001-2007. No doubt this would raise borrowing costs for the government, but all’s fair and square considering the increasing scarcity of capital and the difficulty of reviving the old days of excess liquidity when oil prices approached US$150 per barrel.
Even for equities and other riskier assets, historical highs may not be reached for a long time to come, as price-earnings compression comes alongside a general increase in the discount rate used in valuations, be it for the valuation of future dividends or for the capitalisation rate of rental income properties.
Historical data show that during periods following an economic crisis, both real returns and yields on low-risk assets tend to rise, in compensation for investors’ demand for taking on greater risk amid a weakened economy, and in reflection of the dent in investor confidence.
As an example and a gauge, the real returns on the 10-year MGS during the 1997/1998 Asian financial crisis was as high as +5%, but continued to show a choppy but generally downward trend as sovereign risk volatility declined alongside an improving economy and consolidating fiscal deficit. However, as things became “too good” with excess liquidity at its height in the first half of 2008, the real 10-year MGS yields fell to as low as -4.6%, almost a mirror image of the +5% real yield. At this turning point, real yields started to climb in conjunction with higher risk aversion and a renormalisation of returns reaped from investments.
Central to these thoughts are the fact that the risk-free rate in itself makes little sense during periods of global economic crises. It throws out traditional assumptions that bonds and equities are negatively correlated and that the former is a “safe haven” although a better description would be “safer” at best. In the world of investing, there is no such thing as “risk free”, especially during economic crises when sovereign ratings are threatened, base risk premiums will rise, denting the equilibrium valuations of almost all asset classes.
Ray Choy is head of debt market research at RHB Research Institute
This article appeared in the Capital page of The Edge Malaysia, Issue 757, June 1-7, 2009.