Calculating risk and return in the new world of sovereign debt

New research sheds light on how investors can enhance their sovereign bond market creditworthiness and risk assessments to ultimately achieve better market outcomes

National economies around the world have been on a rollercoaster over the past few years. During the early stages of the pandemic, countries faced significant economic challenges and sought to raise capital through loans by issuing sovereign bonds to support their economic stimulus and recovery plans.

The scale of the economic impact caused by the pandemic led to unprecedented levels of bond issuance, both in developed and emerging market economies. According to a recent analysis by the World Economic Forum, debt securities have grown sevenfold over the past 40 years and last calendar year the global bond market totalled US$133 trillion. Government bonds made up the majority of the debt market, and the US share of the total bond market came in at 39 per cent (equivalent to US$51.3 trillion) followed by China at 16 per cent (equivalent to US$20.9 trillion) and Japan at 8 per cent (equivalent to US$11 trillion).

Another crucial trend impacting the sovereign bond market is the diverging creditworthiness among nations, accentuated by the economic fallout of the global pandemic. The pandemic-induced recession led to varying degrees of economic resilience and recovery, which in turn affected the creditworthiness and perceived risk of different countries. Standard & Poor’s Global Ratings reported that credit rating downgrades outnumbered upgrades by a ratio of 3-to-1 in 2021, reflecting the strain on the sovereign debt market. Notably, emerging market economies faced heightened challenges, with countries like Argentina, Turkey, and South Africa experiencing significant downgrades and increased borrowing costs.

Sovereign bond market research

These trends serve as notable examples of recent research conducted by Alexandre Jeanneret, an Associate Professor in the School of Banking and Finance at UNSW Business School. “Recent events have provided compelling evidence supporting our findings regarding the significant returns associated with high exposure to macroeconomic risk,” said Associate Professor Jeanneret, who co-authored the research paper, Sovereign risk premia and global macroeconomic conditions, which was recently published in the Journal of Financial Economics.

“Our objective was to understand why certain government bonds in emerging countries offer higher returns compared to others,” said Associate Professor Jeanneret. Together with the paper’s co-authors, Adelphe Ekponon, an Assistant Professor in Finance at the University of Ottawa, and Sandro Andrade, an Associate Professor of Finance at the University of Miami, Associate Professor Jeanneret developed a model that considers the possibility of sovereign defaults and examined how this risk is priced in the bond market.

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The research paper focused specifically on analysing the compensation that investors demand for holding bonds that are expected to become more credit risky during global economic downturns. These periods are characterised by lower expected growth and increased economic uncertainty, making investments in such bonds particularly risky for global investors. “Our model indicates that government bonds from countries that are more sensitive to the global business cycle, indicating higher long-run macro risk, should offer higher expected excess returns,” Associate Professor Jeanneret explained.

To test this hypothesis, the research paper team conducted a thorough empirical analysis using quarterly data on sovereign bonds from 43 countries between 1994 and 2018. Each country’s exposure to the global business cycle was measured by observing how bond excess returns vary in response to changes in expected growth and volatility of U.S. consumption.

“Our findings demonstrate that the cross-sectional variation in risk exposure across countries leads to significant differences in average excess returns,” he explained.

Key research findings

Sovereign bonds, despite being perceived as relatively safe investments, are subject to various influences that can affect their returns, said Associate Professor Jeanneret, who explained these factors encompass macroeconomic conditions, fiscal policies, geopolitical events and market sentiment.

“In our analysis, we uncover a crucial finding: the average excess return on government bonds is primarily a reflection of a country's exposure to macroeconomic risk. We observe that countries with the highest sensitivity to the business cycle, as indicated by significant declines in their sovereign bond prices during recessions, offer the highest returns on average. Conversely, countries with the lowest sensitivity to recessions provide the lowest returns. This difference in average return between the most and least exposed countries amounts to an impressive 8.11 per cent per year,” he said.

In addition, the research paper challenges the notion that bond returns are solely determined by local economic fluctuations. Instead, it found the global business cycle, heavily influenced by the performance of the US economy, plays a pivotal role. “Bonds from countries experiencing lower economic growth and heightened uncertainty during global recessions carry elevated levels of risk and consequently demand a higher expected excess return. By shedding light on the drivers of return disparities among government bonds in emerging markets, our findings offer valuable insights for investors seeking to enter the rapidly growing sovereign bond market,” said Associate Professor Jeanneret.

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Research and real-world events

The findings of the research have been reflected in a number of real-world trends experienced in recent years and, more recently, with the US debt ceiling crisis. “During the spring of 2020, sovereign bonds experienced a sharp decline of approximately 30 per cent in value. However, they subsequently made a substantial recovery by early 2021,” said Associate Professor Jeanneret.

“Currently, another significant challenge facing sovereign bonds is the rise in US interest rates aimed at combating inflation. This development has exerted downward pressure on government bond prices. Not only are bond prices negatively correlated with interest rates, but the increased cost of debt also raises the risk of debt refinancing, further amplifying the potential default risk.”

Consequently, Associate Professor Jeanneret said sovereign bonds have recently experienced significant value losses, underscoring the inherent risk associated with this asset class. “It becomes evident that the high returns observed in sovereign bonds are indeed reflective of the corresponding high risk involved,” he observed.

These recent market dynamics highlight the importance of understanding and monitoring the risk factors that can impact sovereign bond prices. “Investors must recognise that sovereign bonds are subject to both macroeconomic risks and interest rate fluctuations, which can have profound effects on their value. By taking a comprehensive and informed approach to assessing the risk-return tradeoff in sovereign bonds, investors can navigate the challenges more effectively,” Associate Professor Jeanneret explained.

Implications for industry

Sovereign bonds play a crucial role in the investment portfolios of various market participants, including institutional investors, pension funds, and individual investors. So Associate Professor Jeanneret said comprehending the factors that influence sovereign bond returns is essential for making informed investment decisions, allocating capital across countries, managing risk effectively, and striking the right risk-return balance.

The research emphasises the importance of recognising global economic interconnectedness. The US economy, as a major driver of global economic growth, exerts significant influence on emerging countries, and Associate Professor Jeanneret said changes in US economic conditions have far-reaching implications for these countries, impacting the prices of their government bonds. “Therefore, understanding the dynamics of the US economy is crucial for assessing potential spillover effects on emerging countries’ bond markets,” he said.

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“Specifically, by examining the factors that shape sovereign bond returns and highlighting the role of the US economy on emerging countries, our research empowers investors to proactively monitor and navigate potential spillover effects. This enables a more comprehensive assessment of creditworthiness and risk in the sovereign bond market,” said Associate Professor Jeanneret. With this knowledge, he explained investors can allocate capital effectively across countries and implement risk management strategies that consider the interconnected nature of the global financial system.

“Overall, understanding the drivers of sovereign bond returns and the influence of the US economy on emerging countries' bond markets is essential for investors. By incorporating these insights into their decision-making processes, investors can enhance their assessment of creditworthiness and risk, and ultimately achieve better outcomes in the sovereign bond market,” he concluded.