Good investors understand the importance of diversifying their portfolio by balancing risky and safe investments. Government bonds are generally considered to be among the safest investment assets as governments are less prone to default than corporates. Given the lower risk profile, government bonds offer lower interest payments compared to corporate bonds. However, adding government bonds to one's portfolio is a good hedge against investment volatility.
In this note, I will discuss the various macroeconomic variables to assess when considering investment into government bonds. One formula to familiarize yourself with is the opposite relationship between bond yields and prices. When bond yields go up, bond prices go down and vice versa. Rising bond yields therefore, lower the investment return of bonds.
Are we in a high growth and high inflation phase?
Periods of strong economic growth are generally driven by consumer spending, corporate investment, government spending and/or strong trade performance. Strong economic activity may generate inflationary pressures that force the central bank to hike interest rates and raise bond yields. Moreover, during economic boom, equity investments tend to outperform bond investments as investors are generally optimistic about the business outlook.
As economies are emerging out of the COVID-induced lockdowns, economic growth and inflation have been rising since late 2020. In such an environment, investors would wait until interest rates have peaked (and bond prices have troughed) before re-entering the debt market.
Debt market capital flows in Asia turned negative earlier this year as bond yields and inflation rose. In several economies such as India and Philippines, negative real yields (nominal yields less inflation) dimmed the attractiveness of government bonds.
Quarterly growth and monthly inflation data can be accessed through local statistics agency websites, central bank websites or the International Monetary Fund (IMF).
How is the fiscal profile likely to evolve?
A country's fiscal profile refers to the government's debt and budget deficit to GDP. A highly indebted government may face difficulties in servicing its debt as investors require higher interest payments to hold that debt. A poor fiscal profile deteriorates a country's sovereign credit rating and raises the investment risk of holding government bonds. During the pandemic, India, Malaysia and Philippines among other Asian countries found their sovereign credit rating or outlook downgraded by the rating agencies. This raised concerns among investors and weakened capital inflows into their debt markets.
Having said that, bond investors should concentrate on the trend of fiscal profile rather than absolute levels. For instance, several governments announced medium term fiscal consolidation plans post COVID, to bring their debt under control. Examples include India, Indonesia and Malaysia, where ministries of finance announced medium-term debt and deficit targets to soothe concerns. Fiscal improvements, ceteris paribus, lead to lower yields and better bond returns over the medium term.
Investors should also study the average debt maturity and currency denomination of government debt. Longer maturity profiles reduce the exigency of debt repayments and give governments the time to bring finances in order.
Foreign currency denominated debt is more vulnerable to exchange rate volatility during crisis periods. Indonesia and Philippines have higher proportion of foreign currency denominated debt. During periods of risk-off, these markets are more vulnerable to capital outflow driven by exchange rate depreciation. In this regard, although India's debt and deficit levels are generally higher than Asian peers, long average debt maturity (exceeding 10 years) and largely local currency denominated debt provides important cushion to investors.
Data on fiscal metrics is available on the websites of the ministry of finance, budget office and the IMF.
What are the demand and supply dynamics?
In Econ 101 we learnt that the price of a good is a function of its demand and supply. Similarly, bond prices depend on demand and supply. If demand for bonds is higher than supply, bond price would increase and improve the investment return.
I admit that gaining this information is slightly tedious, but not impossible. You simply need to know where to look.
Bond supply is easier to determine as the budget office or ministry of finance provides this data while promulgating the annual budget. Governments often discuss budget financing through surplus cash reserves and/or additional bond issuance.
Bond demand is onerous to determine as each country differs in its bond holders. Common sources of demand include 1) local insurance firms, 2) local pension funds, 3) local banks, 4) foreigners and 5) the central bank. For instance, in South Korea, the local pension fund called National Pension Service (NPS) is an important investor in Korea Treasury Bonds (KTBs). NPS often discusses its allocation into KTBs and its medium-term plans, which can be accessed on its website. In recent years, NPS announced its intention to raise overseas allocation in search of higher yields. With the Korean population rapidly ageing, NPS has been seeking more lucrative investment opportunities for its depositors. Greater allocation overseas implies lower allocation towards domestic assets such as KTBs. This is long term negative for KTB returns.
Similarly, the Employees Provident Fund (EPF) in Malaysia is a key sources of demand for Malaysian Government Securities (MGS). Amidst the COVID pandemic, the Malaysian government allowed citizens facing economic hardships to withdraw their EPF contributions. These withdrawals reduced EPF's assets under management and affected its MGS investment.
As the pandemic shuttered businesses across nations, banks became risk averse to lending. Rather, they preferred increasing their allocations towards the safety of government bonds. This created additional demand for government bonds and boosted prices. Banks provide data on their government bond investments during quarterly results filing.
For information into government bond holders, I would also recommend going through central bank publications. Central banks often produce deep dives on country bond markets and major bond holders.
Is the central bank assisting the bond market through QE?
Prior to COVID, quantitative easing or QE as a policy tool was used mostly in developed economies facing prolonged periods of low growth and inflation. For further information on QE please refer to this article. The Bank of Japan (BoJ) and European Central Bank (ECB) implemented QE measures to revive growth and inflation amidst demographic decline. Post the global financial crisis in 2008, the US Federal Reserve (Fed) performed QE to stimulate the economy and bank lending.
QE opens up an additional source of demand for bonds in the form of central bank bond purchases. The COVID pandemic forced several developing economy central banks to implement QE measures. These were aimed at 1) easing liquidity conditions for consumers and businesses affected by the pandemic and 2) financing governments' stimulus measures by lowering bond yields.
Several Asian central banks undertook QE measures including the Reserve Bank of India, Bank Indonesia, Bangko Sentral ng Pilipinas and Bank of Thailand among others. Central banks publish data on asset purchases on their websites.
As fiscal stimulus deteriorated government' fiscal profile, central banks mollified bond investors by purchasing government bonds and assisting government finances.
How is the currency outlook?
In a previous post, I touched upon the importance of currency return in the overall return of an asset. Foreign investors must incorporate the currency outlook when investing overseas. Suppose you are a US based investor and have invested in Indian government bonds. Over a period of time, the investment returned 15% through capital gains. However, over the same period, the Indian Rupee depreciated 10% against the US Dollar. In that case, your total return would be 15-10 = 5% from this investment.
Therefore, having some idea about where the currency is headed will add to the thoroughness of your investment analysis. Please refer to this post for case studies on currencies.
Conclusion
Government bonds are safe investment bets and considered to be good portfolio diversifiers. In order to assess the pros and cons of investing in this asset class, you can examine readily available economic variables. These include
1) Economic growth and inflation - higher growth and inflation raise government bond yields and lower bond prices.
2) The country's fiscal policy - improving fiscal outlook through lower fiscal deficit and debt over the medium term, ceteris paribus lower government bond yields.
3) Demand and supply dynamics - knowing the major holders of government bonds by country is a great first step in comparing demand and supply for bonds. Information on bond demand and supply can be found on central bank or ministry of finance websites.
4) Central bank asset purchases or QE - Another source of bond demand is the country's central bank. In Japan, the BoJ holds over 40% of outstanding Japanese Government Bonds (JGBs). This policy is aimed at lowering interest rates to boost bank lending, growth and inflation.
5) Currency outlook - investors should incorporate currency views into their investment analysis when investing overseas. Refer to my previous posts on currency discussions.
