The evolution of global bonds

The global bond market is in the midst of a giant step in its evolution from a market dominated by developed-country debt to a much more diverse market that better reflects today’s global economy. Evolution is a long process, but the sovereign-debt challenges in Europe suggest the bond market’s evolution is picking up speed. Accordingly, I think now is the time for investors to begin adapting their approach to capturing both the diversification benefits and return potential of the bond market.

The long evolution

Economic globalisation should naturally lead to a more global bond market. However, the bond market’s evolution toward greater globalisation has been distorted by a self- reinforcing cycle of excess saving in the developing economies and excess borrowing in developed economies.

As emerging economies lent their savings to developed economies, and developed countries used this financing to import from emerging economies, the balance of debt and growth became increasingly distorted.

Today, even though developed economies account for about 60 per cent of global growth, they account for almost 90 per cent of the global bond market. As a result, emerging-market debt-to-GDP ratios have dropped from 50 per cent in 2001 to about 35 per cent in 2011, while developed- country debt-to-GDP ratios are closer to 100 per cent, according to IMF data.

Investors may have overlooked the distortions in the bond market in the past because they evolved relatively gradually and carried economic benefits. The European sovereign-debt crisis should serve as a wake-up call. Bond investors are lenders, and lenders who want their money back focus on the borrower’s ability to service debt, not labels like “emerging” or “developed”. And as investors look at the fundamentals, I think they are increasingly shocked at the seismic shift in debt fundamentals that has occurred in many developing and developed countries.

Consider two countries. One is growing at 6.2 per cent, has debt of about 27 per cent of GDP, a budget deficit of 1.2 per cent of GDP and a current-account surplus of 0.8 per cent of GDP. The other is growing at 2 per cent, has debt of about 75 per cent of GDP, a budget deficit of 9.8 per cent of GDP and a current-account deficit of 3.3 per cent of GDP.

In a blind test, most lenders would probably choose the first economy, which is growing faster, owes less and has more money coming into the country than going out. The first country is Indonesia and the second is the United Kingdom.

That is not to say I expect the UK to default or think that investors should avoid developed bond markets. But Indonesia’s bonds are considered risk assets, while UK government bonds are considered among the safest assets in the world. As a result, Indonesian two-year notes yield about 4.7 per cent, while UK two-year notes yield less than 0.5 per cent.

Shift toward balance

Distortions in debt and growth may have obscured the giant evolutionary step underway in the bond market, but I think recognition of the change is growing. I believe most would at least agree that traditional labels in the bond market are blurring.

For example, the eight largest “emerging-market” economies – Brazil, Russia, India, China, Mexico, South Korea, Turkey and Indonesia – accounted for 39 per cent of global GDP growth in 2011. I think “growth economies” is a much more accurate designation for this group, which now represents 25 per cent of the world’s economy.

The line between safe and risk assets is also being blurred. Europe’s sovereign debt crisis, along with the loss of triple-A ratings by the US, France and Japan, clearly illustrate that developed-country sovereign debt has an element of credit risk, in addition to interest-rate risk.

As a result, the IMF projects the segment of the global bond market perceived as safe could shrink by some $9 trillion, relative to its projected growth, by 2016.

As investors recognise the changes in the bond market, I expect the evolution to a more globally balanced market to accelerate. Many developed countries have embarked on fiscal austerity measures in an effort to reduce debt to levels that are more sustainable. Emerging and growth economies are issuing more and more debt in their local currencies rather than the US dollar or euro, which reduces currency risk for these countries and allows them to invest in the infrastructure needed to support strong economic growth without generating higher inflation.

These are positive steps that enhance debt sustainability and add to the attractiveness of emerging and growth-market debt for foreign investors. Corporate bond markets are also developing rapidly in the emerging and growth economies.

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