Prior to the global financial crisis (GFC), nearly $17 trillion of developed nation bonds were rated AAA. Now there are less than $2 trillion. Not only has supply been restricted, but also diversity, with the number of AAA rated countries falling from 15 to 9.

Only 10% of countries are rated AAA by all of the big three rating agencies. As the table below shows, apart from Germany, each of the AAA rated countries represents less than 2% of total outstanding sovereign investment-grade bonds. However, countries like the US, The Netherlands and the UK, which represent 46% of outstanding sovereign bonds, are all AAA rated by at least one of the big three rating agencies.

Country Global Bond Market Share of Foreign Investors FX Reserves Allocation Rating
Australia 1.19% 70.00% 1.90% AAA
Canada 1.35% 28.00% 2.00% AAA
Denmark 0.59% AAA
Belgium 1.98% AA
France 7.28% 65.00% AA
Germany 5.93% 88.00% AAA
Netherlands 1.88% Aaa/AA+
Italy 7.16% BBB
Spain 3.89% BBB
Sub-total
for EuroZone
28.11% 24.20%
Japan 24.53% 8.00% 4.00% AA-
Sweden 0.41% AAA
Switzerland 0.00% 0.30% AAA
UK 7.48% 30.00% 3.90% AAA/Aa1
US 36.34% 48.00% 60.70% Aaa/AA+
Other 3.00% 3.00%
Total 100.00% 100.00%

Source: Bloomberg, IMF, JP Morgan, German Finance Agency

The US is the largest issuer in the sovereign bond market and as the global reserve currency; the US dollar still represents 61% of reported foreign exchange reserves. However, smaller countries like Australia and Canada have seen increasing use of their currencies as foreign exchange reserves. Both countries have a high foreign ownership of their bonds, with around 70% of Australian sovereign bonds owned by offshore investors. In Australia’s case, this has caused the currency to be pushed to a higher level than should be warranted by the terms of trade and may have lowered the neutral cash rate to around 3.5% from its old neutral rate of 5%.

Decline in European credit quality

The decline in the credit quality of European countries has seriously affected the availability of AAA rated European collateral for those wanting to invest in the Euro. The only country rated AAA by all three agencies is Germany, representing just 17% of total European bonds outstanding. Countries with at least one AAA rating now represent only 6% of European outstanding holdings, with countries like France (representing 21%), Italy (26%) and Spain (11%) all rated AA or below. With foreign exchange reserve managers investing around 24% of their holdings in the Euro, it is unsurprising that German Bunds have high amounts of foreign investment compressing their yields. If an investor wants to buy Euro-denominated assets but requires a AAA rating, there’s nowhere else they can turn – therefore 88% of German Bunds are now held by overseas investors.

Bunds also have trading liquidity of around 6 times outstanding bonds – this is around half of US Treasury liquidity, but double that of France, the second most liquid European market. The high level of foreign investors would help explain why the free float in Bunds is seen to be equivalent to the US Treasury market where the Federal Reserve alone accounts for nearly 20% of outstanding US bond holdings. This calls into question whether the European Central Bank (ECB) can use Bunds to engage in sovereign quantitative easing because of market liquidity concerns. It also implies that the reason Bunds are so expensive is not only due to European deflationary worries, but also foreign buyers looking to invest in Euros but only in high quality and liquid collateral.

Increasing competition over a smaller pool of assets

The reduction in supply of high quality sovereign bonds means that overseas investors are competing over a limited pool. This is further exacerbated by the fact that many of these markets are small and that Basel III’s bank liquidity regulations means that such investors are also competing with local banks for supply. More and more investors are competing in small AAA rated markets and most of these buyers are largely price insensitive.

The dynamics are worsening in markets that have seen sovereign bond buying by their central banks, with the Bank of England and US Federal Reserve holding around 20% of domestic government bonds outstanding.

Conclusion

High quality bonds will continue to be in demand by investors that want good quality AAA or AA assets. This could limit any sovereign bond sell-off in the longer or medium term. The use of sovereign bonds for downside protection for equities will become increasing more expensive, so other downside protection means may be needed. Low Bund rates may not just be about deflationary concerns, but are likely to be also due to this reduction in quality assets available to investors looking for Euro exposure.

The lack of quality assets could alter global bond market dynamics and the spreads of non-sovereign securities could become more volatile than sovereign spreads. Interest rate views may become more embedded in local swap rates in high quality markets. The interest risk/return measured by standard deviation may see sovereign bonds fall against swap markets where historically the opposite is true.