The global financial crisis, and subsequent fears of European sovereign debt chaos, have overturned traditional notions of risk-free assets and heralded a new mood of caution among investors. Writer Joanne Hart

In theory, even AAA assets have a two-in-10,000 chance of default. The rating may be the highest on offer but it does not confer entirely risk-free status. That, at least, is the narrow definition of the term 'AAA'. In practice, however, 'risk-free' is a rather more subjective concept.

Before the financial crisis, many investors seemed barely cognisant of risk. The market was awash with liquidity, most asset classes were going from strength to strength and the thirst for yield appeared to outweigh much in-depth analysis of potential problems. "Three years ago, people acted as if there was not a great deal of difference between sovereign risk and agency risk, or between sovereigns and AAA corporates, or even between AAA and BBB credits," says Sean Taor, head of rates syndicate at Barclays Capital.

A harsh lesson

Now, of course, the situation is very different. The financial crisis highlighted, in the most graphic way possible, that prices can go down as well as up. In the process, it exposed a widespread lack of risk management among investors, issuers and the wider banking community. Collective panic ensued across the market and asset managers sought out what they perceived to be safe havens - almost at any price.

"If you look back at the last quarter of 2008, in the post-Lehman days, we saw negative Treasury-bill rates in the US. In other words, there was such an extreme flight to quality that investors were paying the US government to lend it money," says Andre de Silva, deputy head of fixed-income strategy at HSBC.

The trend for negative T-bill rates was short-lived, for obvious reasons, but investors are still extremely mindful of the injuries inflicted in 2008: for the vast majority, caution is their new watchword, an attitude that has been brutally reinforced by events in Europe over recent months.

"People's confidence has been jolted. The subprime crisis and the packages of collateralised debt obligation proved that AAA ratings are not always reliable. Now the sanctity of sovereign debt has been called into question as well," says Mr de Silva.

Greek catalyst

The catalyst for this questioning of sovereign debt has, of course, been Greece, which sank to the brink of collapse at the beginning of 2010 and only avoided complete catastrophe thanks to intervention from stronger countries in the eurozone, particularly Germany. Even now, the threat of Greek default looms large, forcing investors to look even more closely at risk management and the definition of 'risk-free'.

"Two years ago, the difference between Greek and German sovereign spreads was less than 0.5%. Now, 10-year Greek bonds are yielding about 10% while German Bunds are on a 2.5% yield," says Mr Taor.

The ability of the Greek government to repay its debts has been a topic of particular concern but doubts have been raised about the other so-called 'peripheral' countries of the eurozone - Ireland, Italy, Portugal and Spain. These fears have sent yields soaring on the government debt of out-of-favour euro-dominions. Instead, risk-averse investors have scuttled to the relative safety of US Treasuries, German Bunds and, to a lesser extent, UK gilts. "Globally, the real beneficiaries of the financial crisis have been Bunds and Treasuries," says Mr Taor.

Dollar assets benefit

Indeed, dollar assets in general have benefited from the cautious new zeitgeist. US Treasury International Capital data - showing who holds US assets - reveals a record inflow into dollar-denominated assets in April this year. The US administration's relative lack of fiscal restraint has caused some concern but Treasury bonds are still in demand and two-year Treasury yields have hit record lows this summer.

The appetite for US paper has a certain logic. First, the US has a AAA rating. Second, the likelihood of US default is perceived to be infinitesimally small. Third, the US is seen as 'too big to fail' and fourth, crucially, it can print its own money.

"If a country can print money at will and is therefore in control of its currency, it is effectively default risk-free," says Pavan Wadhwa, head of European rates strategy at JPMorgan. "The US and the UK have that ability, so their debt should be considered risk-free. The eurozone is more complicated because no single country has control of the European Central Bank."

The eurozone is highly unusual in this respect. "Risk assessment is difficult in the eurozone," says Paul Reynolds of Rothschild. "Each country has sacrificed the ability to inflate its way out of trouble. That is the cost of the political compromise that lies behind the creation of the euro."

Indeed, the very existence of the eurozone forces investors to look more closely at the definition of sovereign bonds (issued by a government in a foreign currency) and government bonds (issued by a government in its own currency). Bonds issued in euros by governments in the eurozone are a strange hybrid, and investors have responded to the situation in two particular ways. First, they have continued to assess separate countries as separate risks, creating a wider yield gap than ever before between one eurozone sovereign issuer and another. Second, many investors have done what people invariably do when they are nervous: they have gone back home.

"There has been a distinct migration to domestic markets. A number of investors are sufficiently concerned about the pressures on the eurozone to hedge against the risk of it breaking up entirely. If it does, they would rather be in home debt," says Mr Wadhwa.

The attractions of home are not confined to Europe. Investors the world over are increasingly drawn towards the comfort of the domestic market.

"The world is generally much more risk-aware. Local currency sovereign bonds have risen 5% or 6% in recent times. This is not down to specific investment strategy but more an indication of widespread risk aversion. People are sceptical about the predictability of returns even on assets that were once deemed to be safe," says Mr Reynolds.

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Sean Taor, head of rates syndicate at Barclays Capital

Not without risk

Even bonds issued by governments in their own currencies are not without risk. Default risk is virtually non-existent but there are other considerations to take into account.

"Holding sovereign bonds exposes you to inflation risk. You have to think about what risks you care about and how much you care about them. If you are looking for a sensible, risk-free asset, then local-currency, index-linked sovereign bonds are the most appropriate investment - they are safe but offer muted absolute returns," says Mr Reynolds.

For the time being, many investors are more interested in safety than in yield.

"Capital preservation is a top priority," says Domenico Crapanzano, head of European rates sales at investment bank Jefferies. "But the only really risk-free place is under the mattress."

While keeping money under the mattress is not an option for most investors, the reduction in liquidity since 2008 indicates that many asset managers are still mistrustful of financial markets in general. Mr Crapanzano believes this mistrust has been intensified by the behaviour of authorities around the world since the collapse of Lehman Brothers - and, more recently, by the reaction of eurozone countries when Greece began to fall apart.

"The system is not free to find an equilibrium. No one is allowed to go bankrupt," he says. "The ability of Greece to repay its debts is seriously questionable. For now, it has been bailed out, but this is not a very comfortable situation. Many economists believe letting Greece go would have been more sensible. It would have allowed the system to move on."

Steering clear

Intriguingly, some investors are responding by steering clear of erstwhile safe havens almost completely. Disillusioned by bank debt, in the wake of Lehman, and sceptical of sovereign debt, in the wake of Greece, they would prefer to put their capital into the corporate sector.

"Corporate bonds have become more expensive than some government bonds. In several cases, the yields are lower in the corporate sector," says Laurence Mutkin, interest rate strategist at Morgan Stanley.

Some investors are even turning to junk bonds for inspiration. "Investors, in some cases, would rather be in junk bonds or emerging markets, where they feel the return is commensurate with the risk. Italy, for example, is offering a 3.5% yield for five-year paper but there is a chance of not getting your money back. At least with junk, investors get a decent yield," says Mr Crapanzano.

The range of investor behaviours, the range of yields and continued pressures across the market are evidence of persistent uncertainty among the investment community, reflecting a perception that the past was chaotic, the present is unpredictable and the future is unknowable. Under such circumstances, volatility is heightened. "An eight-year credit boom was followed by nearly three years of crisis. We are now in a price discovery period - where everything has to be considered afresh," says Mr Mutkin.

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Laurence Mutkin, interest rate strategist at Morgan Stanley

Buyers' market

Issuers are well aware of the changing mood. Where they were in pole position before the financial crisis, now they are in a buyers' market, a shift that has widespread behavioural implications.

"Issuers are really trying to keep their ratings and this has a huge influence on the way they act and the way they try to manage their economies," says Giambattista Atzeni of Bank of New York Mellon.

In other words, issuers, particularly sovereigns, are doing everything they can to make their paper as appealing as possible to the risk-averse investor. Perceptions of 'risk-free' may have altered radically since the financial crisis but governments are hoping that investors will continue to see their bonds as sufficiently low-risk to find them attractive.

"This is the one silver lining in this clouded situation. Markets want to see that governments are serious about reducing budget deficits. They are imposing discipline on the authorities and they are the only force big enough to do so," says Mr Wadhwa.

The stakes are high. Western governments have run up huge deficits over the past few years and can only repay them by issuing sovereign debt worth trillions of dollars. Investors, many of whom have been badly burnt, will only play their part in this game if they are comfortable about the risk. The concept of risk-free has been seriously challenged - now issuers, be they sovereigns or corporates, have to prove that they can manage risk before they can win back investor trust.

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