Against an increasingly complex global backdrop, Mark Dunley-Owen from our offshore partner, Orbis, reflects on the risks of relying on perceived “safe-haven” government bonds and outlines how a disciplined focus on fundamentals and valuation guides the balance of risk and return in the Orbis SICAV Global Cautious Fund.
“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” Mark Twain didn’t say this, but like much of history, the lesson is more important than its accuracy. Nowhere is this more evident than in the “known” safety of developed market government (DM) bonds.
Lower-risk multi-asset funds, such as the Orbis SICAV Global Cautious Fund (the Fund), tend to have big bond allocations, often skewed towards DM bonds. For much of recent history, these bonds offered predictable returns, low risk of loss and diversification against equities. They have become a default building block in multi-asset funds, on the assumption that they will continue to offer low-risk returns. We are more circumspect.
There are three key risks to consider when owning bonds:
- Credit risk: “Will I get my money back?”
- Inflation risk: “Will I be able to buy the same amount of stuff when I get my money back?”
- Currency risk: “Will I be able to buy the same amount of stuff abroad when I get my money back?”
Governments borrowing in their own currencies are uniquely able to control all of these risks. Repayment is a choice: the government can always raise taxes and the central bank can always print money. Inflation is a choice: it can be fuelled or quenched by the state and central bank. Currency strength is a choice: to be bolstered with high interest rates and fiscal rectitude or weakened by low rates and lax budgets. These unique privileges confer an exclusive status on governments with a history of sound policy. Investors have always “known for sure” that they would get their money back with its purchasing power intact.
This assumption is however being questioned as the finances of DM borrowers deteriorate. Government debt levels are near historical highs and set to rise further as spending continues to exceed revenues. The US is a prime offender, but not alone. Japan’s new prime minister, Sanae Takaichi, has signalled higher government spending despite an already stretched fiscal position. Germany and the UK, neither in strong fiscal health, face growing pressure to follow suit.
Hard choices are needed to slow the slide, but they are both difficult and limited. Governments must earn more, spend less, or continue to appeal to the kindness of lenders.
The holy grail is earning more tax revenue through stronger economic growth and, unsurprisingly, most governments promise some version of this. The doing is harder. Politicians are notorious for not doing the hard things and we expect most of their growth forecasts are optimistic.
If governments cannot grow the overall pie, they may try to take a larger slice of the existing pie through higher taxes. This is theoretically appealing but often self-defeating. Beyond a certain point, higher tax rates weaken incentives, reduce investment and ultimately lower total tax revenue. Governments could keep more of their slice of the pie by spending less, but they probably won’t. Today’s instant gratification model of democracy requires pandering to popular sentiment to survive. Despite the obvious unsustainability of many government spending programs, they are unlikely to be constrained until forced to by a crisis.
Governments may be left with no choice but to rely on the kindness of lenders to fund persistent deficits. Domestic lenders are preferable because they are kinder and can be coerced through policy and regulation. Countries without sufficient domestic savings do not have this luxury and must look abroad, competing for foreign capital to plug the gap. This is where the “kindness of strangers” becomes less assured, particularly when that kindness is not reciprocated. The US is the poster child of this dynamic, relying heavily on foreign investors to fund its deficits. This reliance carries risks, not least as the current administration appears willing to pick fights with the very investors the US depends on.
While we share concerns about the US’s financial position, we also recognise the strength and depth of its economy and do not believe US government debt is approaching a reckoning, at least not yet. The Fund is thus underweight the US compared to most global benchmarks and peers but does have significant US government debt holdings. These are concentrated in short-maturity bills and treasuries, and longer-maturity Treasury Inflation-Protected Securities (TIPS). This combination limits the exposure to US risks while benefiting from the liquidity and yield available in the US. Long-term TIPS currently offer real yields around 2% or higher, and their prices reflect expectations for benign long-term inflation. In our view, that looks optimistic.
The Fund’s other government bond holdings are spread across the world in countries that are, in our view, ignored or mispriced but are being soundly managed. Rather than relying on traditional “safe havens”, we look globally for countries offering a better balance of risk and return. These include the likes of Brazil, Iceland, Norway and Australia, whose bonds make up roughly 14% of the Cautious portfolio.
Brazilian government bonds stand out for offering the highest real yields (the return after adjusting for inflation) across the sovereign markets we monitor. The official Brazilian interest rate is 14.75%, underpinning bond yields of around 14% versus inflation of about 4%, allowing investors to earn high single-digit real returns. Emerging markets like Brazil come with risks, including political uncertainty and loose fiscal policy, evident in President Lula’s socialist agenda and uncertainty ahead of the October election. However, these risks are well understood and, in our view, largely priced in. With high yields, a reasonably valued currency, tight monetary policy, and support from strong commodity exports, the risk-reward looks attractive.
Iceland is classified by MSCI as a frontier market, ranked below Brazil and alongside countries such as Pakistan and Mali, largely due to the capital controls imposed during the global financial crisis. Despite the scarring from its banking crisis and subsequent default, Iceland has a highly developed economy that has been prudently managed in the years since. Its small size and exclusion from major indices leave it off the radar for many investors, creating attractive opportunities for contrarian investors. The combination of solid fundamentals, strong governance, attractive yields and steady inflows from tourism makes Icelandic bonds appealing.
At the other end of the spectrum, we view Norway as a strong sovereign and one of the safest harbours in a sea of drowning government borrowers. While the US is expected to end 2026 with gross government debt of around 125% of gross domestic product (GDP) and a fiscal deficit near 6%, Norway stands in stark contrast. It has a net cash position thanks to its more than US$2 trillion sovereign wealth fund and a large fiscal surplus thanks to its oil and gas revenues. It may not yet rival Switzerland’s safe-haven status, but unlike Switzerland, its government bonds offer reasonable yield and its currency appears undervalued.
More recently, we purchased Australian government bonds which offer higher yields than their US counterparts while benefiting from prudent fiscal management. Low government debt to GDP, a trade surplus backed by a resource-rich economy, and an attractively valued currency make for an attractive proposition.
As the opening quote reminds us, it is often what we assume to be true that carries the greatest risk. The perception of “safe-haven” status may be just that – perception. In constructing the portfolio, we focus on fundamentals and valuation rather than perceived safety and only invest where we believe we are being adequately compensated for the risks we take. In doing so, we seek to live up to the Fund’s mandate: to provide a cautious balance of risk and return, and deliver positive absolute returns over a reasonable time horizon for our clients.