FocusPoint

What to buy: countries or companies?

Ten years ago, risk-averse bond investors never had to doubt where to put their money. Government bonds were the place to be.

Today, an investment in government bonds requires some more consideration.

After all, the price to insure country investments against the risk of default is rising, sometimes even beyond the cost of default protection for their flagship companies.

Ten years ago, the IT bubble burst and many companies had too much debt. In contrast, government finances were generally in good shape. Luckily, the companies were bailed out by the subsequent consumer and financial boom and by 2007 their balance sheets were stronger than ever. When debt rich financials got into trouble in 2008, they were in turn bailed out by their governments, which saw their debt to GDP ratios rise to fifty year highs.

Now, the big debt carousel has come to a standstill. Maybe emerging markets can drive a next financing wave, as they still have room to expand their debt. If not, growth in developed markets may suffer for a prolonged period.

Recently, rating agencies have been downgrading the bonds of certain developed countries. Conversely, the balance sheets of big companies generally look very healthy. For risk averse investors who need liquidity, there is still no real alternative for investments like US treasuries or German bunds. But bonds of sizeable, well capitalised companies are gradually becoming viable investment alternatives for government bonds “with issues”.

This picture is not likely to change any time soon, as it will be difficult for governments to substantially reduce debt levels as long as unemployment remains high. In developed markets, the economic recovery is likely to be jobless, a trend which has been visible in all upturns since the early nineties.

In the US, in all recessions between the 1950 and 1990, unemployment started to decline within a few months after the worst point in economic growth. But in the recession of 91-92 it took a full year for employment to pick up, in 01-03 it took 1.5 years and now it may take even longer. After all, in a globalising world, cost conscious western companies have an incentive to recreate jobs in emerging markets or to just “digitalise” them.

Emerging markets have not only become an important source of cheap labour, but also an engine for global growth. For investors in western companies (bonds or equities), this development is automatically reflected in their portfolios, as these companies are globalising at a rapid pace.

However, countries cannot globalise! Investors in government bonds who want to buy emerging markets exposure will have to buy bonds of these countries, something that institutional investors are increasingly doing, but private investors not (yet).

It is extremely unlikely that countries will default, but the relatively high debt to GDP ratio’s in, for example, the south of Euroland will keep causing greater volatility and uncertainty. Therefore diversification remains key, even for conservative bond investors who are used to having a strong domestic focus. High quality corporate bonds should be increasingly considered as part of a “low risk’ investment mix.

For investors who are looking for yield and are willing to take slightly more risk, it is still worthwhile to look at the equity alternatives for strong corporate stories. Many telecoms, utilities, pharma’s and oil majors still pay dividends which are clearly higher than the yields on their own corporate bonds. This is currently probably still the best risk/reward proposition available in financial markets.