Sovereign debt, when issued
by governments of developed
nations with long enough track
records of not defaulting on
their debt, usually command a
premium on that debt. This is
expressed primarily through
lower relative yields across the
board. U.S. treasuries, for
example, are frequently viewed as quasi “risk-free” investments1 and used as benchmarks to price other instruments.
In portfolio construction, such “low-risk” instruments are frequently used as “shock absorbers” to counter adverse market conditions when everything else is heading south. There is, of course, a tradeoff involved in owning such instruments: the expected returns tend to be very limited and highly predictable.
This would appear to be a fair enough tradeoff, were it not for the occasional risk altering events that happen when people least expect them. Greece’s 2010 sovereign debt crisis took investors by surprise, not because Greece ever had a pristine track record with its debt, but more because the perception of risk had changed markedly the day it joined the Eurozone.
Like in the example with Greece, there are certain conditions that can engender a substantial mismatch between perceived risk and actual risk. The underlying instrument may appear safe in a vacuum, but changes in the environment can radically alter the realities on the ground.
In statistics the notion of skewness refers to probability distributions that are stretched in one direction2. An example of this would be high yield or junk bonds that offer a high enough probability of expected returns and a low, but real probability of defaulting. Sovereign debt of the “risk free” sort has very different return probability distribution resembling a bell-shaped curve. Skewness is absent because default risk is close to nil.
The current unusually low interest rate environment seems to have altered its distribution. Until recently negative interest rates were thought to be isolated occurrences of limited degree and duration. Now that the zero rate cap has been breached, however, there is no theoretical limit to the size of the “negativity”3.
The skewness in this example arises from the much larger potential for a surge in interest rates. The further interest rates turn negative, the greater is the potential for a sharp reversal. Given the change in the economic environment, U.S. treasuries may very well be at the cusp of a sharp reversal.
Then there is the significant surge in the dollar since the start of the year, another externality that is affecting the risk/return dynamics of sovereign debt in certain segments of the market. Emerging markets have been huge borrowers of U.S. debt over the last couple of years. Low interest rates and the weak dollar have made such borrowing highly attractive in many of these countries where local rates tend to be much higher.
Unlike with the Asian financial crisis of 1997, where the majority of the dollar exposure stemmed from government borrowings, this cycle’s exposure buildup is mainly in the corporate segment. Given that the currency exposure of most of that borrowing was unhedged, the sharp appreciation of the dollar has substantially increased the cost of servicing the debt.
There is an additional “hedge” factor to consider for corporations. It concerns the amount of business (if any) that is conducted in the currency in which the borrowing is taking place. For a firm that conducts all or a large chunk of its business in the currency in which it also borrows, the impact should be minimal. On the other hand, if most or all of its business is conducted domestically, the impact of the exchange rate will be harsh.
This is why the sharp appreciation of the dollar is a source of market risk in China, Brazil, Russia and Turkey. The longer the dollar remains strong, the more pronounced will be the crisis in the private sector of emerging markets.
If there is any consolation, it may be that the exposure is largely limited to the private sector, reducing the potential for contagion from spreading like it did with the Asian currency crisis of the 90’s. The global economic expansion is unlikely to reverse course, but it could weaken in the second half of the year.
1 The last debt restructuring in the U.S. occurred in 1971. The one before that was in 1933. This contrasts with Venezuela in 2004 and 1998 before that.
2 In contrast to the traditional bell-shaped Gaussian curve where both sides are identical, the skewed curve stretches more in one direction with increasingly lower probabilities of large deviations from the mean.
3 There does come a threshold point where a further rise in the negative interest rate will trigger a massive enough sell off in bonds. That moving target is most likely determined primarily by market conditions and investor sentiment.
example, are frequently viewed as quasi “risk-free” investments1 and used as benchmarks to price other instruments.
In portfolio construction, such “low-risk” instruments are frequently used as “shock absorbers” to counter adverse market conditions when everything else is heading south. There is, of course, a tradeoff involved in owning such instruments: the expected returns tend to be very limited and highly predictable.
This would appear to be a fair enough tradeoff, were it not for the occasional risk altering events that happen when people least expect them. Greece’s 2010 sovereign debt crisis took investors by surprise, not because Greece ever had a pristine track record with its debt, but more because the perception of risk had changed markedly the day it joined the Eurozone.
Like in the example with Greece, there are certain conditions that can engender a substantial mismatch between perceived risk and actual risk. The underlying instrument may appear safe in a vacuum, but changes in the environment can radically alter the realities on the ground.
In statistics the notion of skewness refers to probability distributions that are stretched in one direction2. An example of this would be high yield or junk bonds that offer a high enough probability of expected returns and a low, but real probability of defaulting. Sovereign debt of the “risk free” sort has very different return probability distribution resembling a bell-shaped curve. Skewness is absent because default risk is close to nil.
The current unusually low interest rate environment seems to have altered its distribution. Until recently negative interest rates were thought to be isolated occurrences of limited degree and duration. Now that the zero rate cap has been breached, however, there is no theoretical limit to the size of the “negativity”3.
The skewness in this example arises from the much larger potential for a surge in interest rates. The further interest rates turn negative, the greater is the potential for a sharp reversal. Given the change in the economic environment, U.S. treasuries may very well be at the cusp of a sharp reversal.
Then there is the significant surge in the dollar since the start of the year, another externality that is affecting the risk/return dynamics of sovereign debt in certain segments of the market. Emerging markets have been huge borrowers of U.S. debt over the last couple of years. Low interest rates and the weak dollar have made such borrowing highly attractive in many of these countries where local rates tend to be much higher.
Unlike with the Asian financial crisis of 1997, where the majority of the dollar exposure stemmed from government borrowings, this cycle’s exposure buildup is mainly in the corporate segment. Given that the currency exposure of most of that borrowing was unhedged, the sharp appreciation of the dollar has substantially increased the cost of servicing the debt.
There is an additional “hedge” factor to consider for corporations. It concerns the amount of business (if any) that is conducted in the currency in which the borrowing is taking place. For a firm that conducts all or a large chunk of its business in the currency in which it also borrows, the impact should be minimal. On the other hand, if most or all of its business is conducted domestically, the impact of the exchange rate will be harsh.
This is why the sharp appreciation of the dollar is a source of market risk in China, Brazil, Russia and Turkey. The longer the dollar remains strong, the more pronounced will be the crisis in the private sector of emerging markets.
If there is any consolation, it may be that the exposure is largely limited to the private sector, reducing the potential for contagion from spreading like it did with the Asian currency crisis of the 90’s. The global economic expansion is unlikely to reverse course, but it could weaken in the second half of the year.
1 The last debt restructuring in the U.S. occurred in 1971. The one before that was in 1933. This contrasts with Venezuela in 2004 and 1998 before that.
2 In contrast to the traditional bell-shaped Gaussian curve where both sides are identical, the skewed curve stretches more in one direction with increasingly lower probabilities of large deviations from the mean.
3 There does come a threshold point where a further rise in the negative interest rate will trigger a massive enough sell off in bonds. That moving target is most likely determined primarily by market conditions and investor sentiment.
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