A look at Government bonds

Jan 6 2010 by Andrew Miller, The Journal

GOVERNMENT bonds proved a popular safe haven in 2008-09 as investors, frightened by market traumas, plumped for the security government debt seemed to give - despite low, or even negative, real yields that were on offer for this asset class.

During the course of 2009, investor risk appetite recovered, with sharp rises in the price of equities and corporate debt. As a result, the appeal of government bonds rather declined - although they retained an important place in many investors’ portfolios, due in part to lingering doubts over market recoveries.

However in recent weeks, the markets have been taking a more critical look at the pluses and minuses of government bonds. Markets have become increasingly worried by the large volumes of government debt that have accumulated during the course of managing the financial crisis, the result of both increased spending and reduced government revenues. There are major concerns over governments’ ability to rein in their fiscal deficits and, over the possibility of government defaults.

Such worries may have been overplayed. S&P followed in Fitch’s footsteps in December, and downgraded Greek government debt by one category, but we still believe Greece (or any of the peripheral euro area sovereigns) is unlikely to default. Their higher yield may make these countries’ short-term debt attractive for more risk-tolerant investors, aiming to hold such debt to maturity. (However, the likelihood of continued market volatility will make longer-duration bonds from these countries less attractive.)

Problems have not been confined to the smaller euro area economies. Among the larger markets, price falls in the UK were the sharpest, but the US also sold off. (German bonds lagged the sell off, bolstering our view that in the long term, German yields will suffer the least.)

As well as being concerned about the health of government finances, markets remain worried by the prospect of an upturn in inflation. These worries resulted in a strong and prolonged rally in inflation-linked bonds in 2009 and inflation-linked bonds look less attractive as an investment opportunity, although they may appeal to certain investors.

Government bond markets might not seem the most exciting, but they will be worth keeping an eye on. Many governments’ financial problems will take time to fix and, we think the US and UK markets will remain nervous and that yields will trend higher.

Andrew Miller is regional office head of Barclays Wealth in Newcastle