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The missing link between sovereigns and corporates

Country risk is key

All too often sovereign and corporate credit risk metrics are segmented resulting in a a compartmentalised view, which can misjudge the aggregate economic risk of a country.

Misjudging country risk matters

Many investors are familiar with the concept of corporate risk ceilings which impose a limit on the extent to which a corporate can be rated above its home nation. This means that investment returns for corporate bonds can be tied to the prospects and risks for a country, as ratings downgrades and upgrades can change the cost of borrowing.

A ‘mis-rated’ country can result in mispricing of credit risk for both corporate and sovereign debt. Similarly, a shift in the perception of country risk can result in repricing of exchange rates and interest rates as well as credit spreads. This can exacerbate economic risk and amplify the negative impact on the credit quality and profitability of the private sector issuers. These consequences are not positive for holders of corporate or sovereign bonds.

The Greek experience

The implications of mispriced sovereign risks have become apparent in recent years. European governments such as Greece were able to borrow heavily to finance expenditure as a result of market mispricing of risk. When the economy collapsed, corporates and banks were caught in the downdraft both from ratings agencies and recession. The results were negative for both government and corporate bonds.

Iceland and the crash

Critically, country risk does not just come from government metrics. All too often, government risk metrics are affected by developments in the private sector and imbalances in the corporate, financial or public sector can threaten the health of the economy. The way the financial crisis affected Iceland helps illustrate the link.

The symbiotic relationship between the country ceiling and corporate ratings allowed banks to borrow heavily from abroad, while sovereign metrics remained healthy. When finance was withdrawn, the impact on the economy and government finances was so dramatic that it saw agencies slash the credit rating, affecting returns of both the sovereign and corporates bonds alike.

Experience shows that countries can sustain a vulnerable economic model for extended periods of time. However, when a trigger threatens the availability of finance, these models collapse leading to dramatic consequences for the economy and its corporate and sovereign bonds alike.

Using NFA to look at the big picture

As a consequence, analysis of country risk is critical to our investment process. We believe we have a unique approach which focuses on country vulnerability at an economy wide level rather than compartmentalising government and corporate risk.

Avoiding risk in debtor nations

We aim to measure a country’s reliance on the foreign funding of its liabilities as it more accurately reflects the level of a country’s indebtedness.

This Net Foreign Assets approach is based on the premise that countries dependent on a large foreign investor base face more acute risks when things take a turn for the worse. This approach can be used as an explicit screen as in the New Capital Wealthy Nations Fund or as an approach to assessing country risk relative to valuations of corporate and sovereign debt.

Appreciating the risks associated with a country can help to avoid downside risks when investing in both corporate and sovereign bonds and enhance returns by avoiding the weakest performers.

 

Sovereigns exert a gravitational pull on domestic corporates

Links to fund pages

Further reading

Learn more about the advantages of our wealthy nations approach read our whitepaper Giving Credit to the Creditors.

 

Part of the Bonhill Group.