Government bonds are the largest, most liquid asset class in the world. Traditionally, developed economy yields and prices were driven by inflation expectations; but Central Bank QE policies now dominate. A growing proportion of Government bonds (currently $15trn) now trade at negative yields (despite positive inflation), and this total is expected to increase.
Within this “Bonds Through the Looking Glass” world, Sovereign credit risk remains a constant feature. In less developed or distressed economies it has always been present, but for developed countries, Sovereign risk has historically been very low. It is true that bond yields have, at times (e.g. the 1970s), been very responsive to fiscal deterioration – an element in Sovereign risk. But the growth of Central Bank balance sheets in the wake of the 2008/09 financial crisis has put developed economy Sovereign risk under scrutiny.
The larger, developed economy Government bond markets are very liquid. This, together with historically low price volatility, has made them the first choice as collateral for most financing trades. It also means that they can provide a benchmark for the market price of credit risk, without distortions due to the liquidity risk premium and other technical sources of pricing noise.
But the market price of credit risk is itself subject to short-term variations and noise. Consensus credit data, sourced from leading financial institutions, provides a new type of medium-term estimates of credit risk that are typically more stable than market implied estimates but also updated more frequently than ratings from Credit Ratings Agencies (CRAs).
The latest whitepaper from Credit Benchmark presents promising evidence that, in some markets and under certain assumptions, simple trading rules applied to the differences between the two metrics may offer scope for excess trading profits. This suggests that consensus credit risk data can be used in some markets to identify tradeable short-to medium-term anomalies in Government bond prices.
