30/04/2010: When riskless returns mutate into returnless risks

With the news that Greece has been downgraded to "junk" status by Standard & Poor's, it now looks almost certain that investors in Greek bonds will have to book major losses on their positions. Meanwhile, intervention by the International Monetary Fund and the European Monetary Union to stave off a Greek liquidity crisis has become unavoidable. While Greek sovereign bonds were never thought to be completely “riskless” like bonds issued by the US, Germany or the UK (as reflected by their relatively higher coupons), one could until recently assume that they were a safe investment. However, over the past eight months, Greek sovereign yields have moved from 4.5% to 10% for the 10-year benchmark and even beyond 10% for shorter maturities.

Even more important than Greece's fate, however, are the dire implications the current crisis has for the Eurozone and, indeed, for the rest of the world. The first wave of contagion from Greece has hit that unfortunate group of Eurozone countries known by the acronym PIIGS (Portugal, Ireland, Italy, Greece and Spain). The next victims are likely to be Portugal (which was also downgraded along with Greece but is still investment grade) and then probably Spain.

However, amid all this negative news for the PIIGS, we still remain puzzled why the bond vigilantes have not spotted some of the other big elephants in the room of fiscal profligacy. In the Eurozone, for example, it is a bizarre fact that there is very little scrutiny of Belgium, which has a debt to GDP ratio above 100% and a government that has just resigned amid concerns the country could break apart, or France, which is likely to see its debt to GDP ratio hit 100% in the next two to three years.

Moreover, outside the Eurozone, investors do not seem bothered by Japan's 200% debt to GDP or the fact that both the US and the UK are galloping toward the 100% debt to GDP mark while keeping interest rates very low. It seems as though the famed riskless asset of yore is mutating into a returnless, and rather risky, asset instead.

Interest rates will certainly go higher for a number of reasons: First, in some countries the printing press will be used to inflate away some of the debt. Second, rates will have to rise in order for the bond market to clear the USD 5 trillion in new sovereign debt expected each year for the next five to ten years. Third, in the case central banks are serious about fighting inflation, they will have to hike, moving the whole yield curve higher.

How should investors react to such an odd environment? First off, they should look for less risky alternatives to the returnless but risky government bonds. For example, a better risk-return tradeoff may be available via bonds from supranational or sub-national entities, or from government agencies. High-quality corporate bonds might be another alternative. And then there is, of course, the equity market. Stocks with high dividend yields, especially those that deliver better returns than many bonds should be considered, as should consumer staple stocks of companies with high pricing power.

Many investors think of consumer staple stocks as boring, because they are less volatile than your average stock. In a bull market they go up less than cyclicals, but in a bear market they fall along with everything else. One thing that makes consumer staple stocks dull is that those companies sell the same things every year. At the same time, they sell a little more (almost) every year, and improve their operating processes as well. The result is higher profits and bigger dividends almost every year. Hence, you can compare a consumer staple stock to a perpetual bond with an ever-increasing coupon. But there is one caveat: there is no guarantee that as earnings and dividends grow (effectively providing a rising coupon), the shares also gain in value every year.

Be it by finding alternative bonds or be it by looking after categories of safe stocks, in this highly contagious financial world we live in, one needs to explore new paths because nothing can be taken for granted anymore - not even the idea that government bonds are riskless.