Article

Government debt: a cushion during periods of uncertainty

14 March 2023
Invesco
Government debt cushion during periods of uncertainity case study

Why now?

If you think that recession is the most likely scenario this year, then government bonds would generally be expected to fare well. This is because they’re usually supported by more accommodative central bank policy and “safe haven” buying. That historical behaviour may be repeated if uncertainty persists around inflation and interest rates.

Furthermore, after a dramatic reset in 2022, government bonds are now offering attractive levels of income for the first time in years. The 10-year Treasury yield, which was around 1.5% at the start of 2022, is now over 3.9%.1 In other words, investors aren’t having to take on an excessive level of credit risk to generate a decent income from their investment.
 

What role does government debt play in a portfolio?

For investors looking to diversify their portfolio, high quality government bonds could provide a cushion in times of market uncertainty. They are useful diversification tools and are likely to form a major part of a cautious investor’s portfolio.

Backed by the world's strongest and largest economies, developed market government bonds are among the “safest” and most liquid asset classes. Government bonds tend to perform well in turbulent times and can help diversify risk in multi asset portfolios. Often viewed as a possible buffer for volatile equity and other riskier markets, government bonds serve as a core allocation for investors.
 

How does government debt fare over the course of a market cycle?

Government bonds play an important role in a well-diversified portfolio across many different stages of the market cycle. However, as shown in the below chart, their defensive qualities mean that they are typically the top performer in periods of slowing growth and recession. 

Depending on the prevailing interest rate environment, investors may choose to buy longer or shorter-duration government bonds. In other words, they can lock in higher levels of income by buying longer-dated bonds when rates look attractive. Meanwhile, if interest rates are low and likely to start rising, they can invest in shorter-dated bonds to help defend their portfolio against negative price impacts.

Figure 1. Historical excess returns on US assets during the economic cycle

Notes: Index return information includes back-tested data. Returns, whether actual or back tested, are no guarantee of future performance. Annualised monthly returns from January 1970 – December 2021, or since asset class inception if a later date. Includes latest available data as of most recent analysis. Asset class excess returns defined as follows: Equities = MSCI ACWI - US T-bills 3-Month, High Yield = Bloomberg Barclays HY - US T-bills 3-Month, Bank loans = Credit Suisse Leveraged Loan Index – US T-bills 3-Month, Investment Grade = Bloomberg Barclays US Corporate - US T-bills 3-Month, Government bonds = FTSE GBI US Treasury 7-10y - US T-bills 3-Month. For illustrative purposes only. Please see appendices for further information. Sources: Invesco Investment Solutions’ proprietary global business cycle framework and Bloomberg L.P.  

Historical case study

COVID: A full market cycle squashed into just 12 months

When COVID struck in 2020, the resulting lockdowns caused a sharp contraction in economic activity. In response, central banks acted aggressively to reduce the length of the recession. As a once in a lifetime event, it caused a huge amount of market volatility. Although different to a normal downturn and rebound, the period exhibited all the characteristics of a full market cycle. But, unlike a normal market cycle, it was squashed into a period of just 12 months. For those who study markets, this period can be used as an interesting case study.

The flows data shows that government bonds were most popular at the height of the crisis period

If we look at fixed income asset flows over the course of the year, we can see that there were some periods where investors favoured “safe haven” assets like government bonds. Meanwhile, there were other periods where riskier assets (like emerging market debt) were more in favour.

In the below chart, the bars show fixed income net new assets (NNA) by asset class. The dark blue line shows the yield on the G7 government bond yield index and the light blue line shows the spread on global investment grade credit.

Figure 2: Investors’ appetite for risk evolved over the course of the cycle

Source: Bloomberg and Invesco as at 31 December 2020. The Global Govt Yield is represented by the Bloomberg Global G7 Index, and the Global IG Spread is represented by the Bloomberg Global Aggregate Corporate Index.  

As Covid spread to become a global pandemic in February and March, the theme was a flight-to-quality as investors sold investment grade, high yield and emerging market debt, and bought developed market government bonds. These flows, followed closely by central banks slashing rates and resuming quantitative easing, drove government bond yields to rally sharply, while credit spreads widened dramatically.

However, as the central bank policy response was viewed positively by the market, investors flooded back to investment grade credit at incredibly wide spread levels in April. As confidence continued to return to markets, flows into investment grade continued over the following three months, with demand for high yield also increasing.

In the last four months of the year, while investors took some profits on investment grade credit as spreads had largely normalised, they continued to add to high yield and also started to switch into emerging market debt. In other words, they started taking on more credit risk as the economy rebounded post-covid.

Sovereign debt: what are the main ESG considerations?

Climate change will have a significant impact on governments, increasing their borrowing costs and expenditures. Furthermore, it could seriously hamper economic growth. In fact, the below chart from the Swiss Re Institute suggests that global temperature rises will negatively impact GDP in all regions by 2050, with the losses increasing significantly as the temperature scenarios ramp up. 

Figure 3. Global temperature rises will negatively impact GDP in all regions by mid-century

Source: Swiss Re Institute, The Economics of Climate Change, April 2021. Temperature increases are from pre-industrial times to mid-century and relate to increasing emissions and/or increasing climate sensitivity (reaction of temperatures to emissions), from left to right.

While no sovereign issuer has yet been downgraded on account of climate risk2, the implications could be extreme. A landmark report issued by the University of Cambridge in 2021 finds evidence that these downgrades could begin “as early as 2030, increasing in intensity and across more countries over the century”.2

The challenge for investors, then, is ensuring that their research and risk assessments take stock of the credit risk posed by climate disruption. They will have to go further than ratings providers if they want to build resilient portfolios.

Invesco’s active fixed income teams carry out detailed credit analysis before investing, incorporating ESG considerations into their analysis. This allows them to form a comprehensive understanding of the issuer, its risks, and the potential opportunities.

Invesco has also developed a tool called SovereignIntel, which provides ESG insights on sovereign debt. With over twenty inputs, SovereignIntel generates a score for countries across E, S and G categories. These are then aggregated into an overall ESG score. SovereignIntel provides an internal rating, a rating trend and a global ranking out of 160 countries.

Our government debt capabilities 

At Invesco, we have a wide range of developed market, low-cost government bond ETFs. We offer investors a choice of maturity ranges and broad exposures across US treasuries, UK gilts, and European government bonds. Whether you’re looking for broad exposure to potentially reduce volatility, or you’re targeting a specific segment of the yield curve to express your view on interest rates, we have a range of government bonds to suit.

We also manage a wide range of active fixed income strategies with exposure to government debt – including strategic bond funds that can flexibly allocate as markets evolve. 

Frequently asked questions

Countries issue sovereign debt to fund public services and long-term projects, like the construction of new infrastructure. When issued by developed economies like the US, government bonds are among the safest securities investors can buy. 

 

Government bonds can be issued with different maturities. The interest payable on government bonds is set at the point of issue and reflects current market rates. 

The US Department of the Treasury is the finance department of the US federal government. It issues different types of debt with different maturity characteristics.

  • US Treasury Bills (T-Bills): These are short-term securities, with maturities of less than a year.
  • US Treasury Notes (T-Notes): These have longer maturities – between two and ten years.
  • US Treasury Bonds (T-Bonds): The maturities on T-Bonds are longer still – between 20 and 30 years.

UK government debt securities issued by His Majesty’s Treasury are known as “Gilts”. The name originates from the gilded edges on the original debt certificates. 

  • Conventional Gilts: Conventional Gilts pay fixed coupons every six months. The coupon rate usually reflects the market interest rate at the time the security is issued. Gilts with different maturities are available however, in recent years, the government has primarily focused on issues with five, ten and 30-year maturity dates. Conventional Gilts make up around 75% of the Gilt universe. 
  • Index-linked Gilts: The principal sum and coupon payments on index-linked Gilts are adjusted to account for the effect of inflation. The UK Retail Prices Index is used to calculate the adjustment.  

Note, these are different to floating-rate securities, where the coupon rate is adjusted to reflect a changing interest rate environment.   

Bunds are debt securities issued by the German federal government. They are typically issued with maturities over seven, 10, 15 and 30 years.

The principal sum and coupon payments on these securities are adjusted to account for the effect of inflation. 

Footnotes

Investment risks

  • The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.

    Debt instruments are exposed to credit risk which is the ability of the borrower to repay the interest and capital on the redemption date.

    Changes in interest rates will result in fluctuations in value.

    Changes in interest rates will result in fluctuations in the value of a portfolio and the effects of inflation may result in a reduction in the value of an investment.

    A lower inflation rate than expected will lead to an underperformance of inflation-linked bonds in comparison to conventional debt instruments.

Important information

  • All data is provided as at the dates shown, sourced from Invesco unless otherwise stated.

    This document is marketing material and is not intended as a recommendation to invest in any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication.

    Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals, they are subject to change without notice and are not to be construed as investment advice.