On the contrary, the Omega research has shown that the application of its proprietary risk-controlled methodology is a highly reliable indicator of the likely performance of sovereign bonds issued by a range of nations.

The research is particularly significant because it provides guidance for investors in the face of the dramatic shift in the status of sovereign investing since major world events: the GFC, the actions of major governments in addressing it and the subsequent European sovereign debt crisis. 

“Not so long ago, sovereign debt from major developed nations was considered about as low-risk as you could get,” explained Mathew McCrum, joint head of investments at Omega.  “But post GFC, experience shows us that some of those assumptions no longer apply. The challenge for investors is how to make decisions according to information that’s accurate and relevant in the new environment.”

The desire to pinpoint the factors most relevant to sovereign bond investors in today’s environment has driven this latest Omega research, which back tests the efficacy of the ‘Omega Financial Health Rating’. This is one of a number of risk control tools that’s been used by Omega since its inception in 2008. It is focused on limiting exposure to losses resulting from sovereign defaults and downgrades.

The Omega system assesses both the financial strength and political risks associated with the country it is rating. The financial strength measures focus on a government’s ability to repay debt, and are currently based on the net debt to GDP ratio.  Political risk measures, on the other hand, address a country’s willingness to repay it.

More recently, Omega wanted to explore the potential benefits of enhancing the rating by including additional financial health measures.

“Within a fluctuating financial environment we wanted to see if certain additional measures will help provide a more robust account of a country’s financial health and are therefore a valuable indicator of the likelihood of default,” said Mr McCrum.

Those additional measures include the bonds’ cost based on ten-year-yields; length judged by average maturity; and momentum as assessed bysix-month changes in net debt to GDP.

The research and its findings
The research involved testing the existing Omega Financial Health Rating to see whether it limited exposure to downgrades; and whether it supported improved returns. Proposed additional health measures were also then tested. The benchmark used was the JP Morgan GBI Broad Index.
Ratings downgrades findings: 45 investment grade countries were split into quintiles based on the Omega Financial Health Rating for each year since 1999. The findings show a clear correlation between the resulting rating and future downgrades. For Omega’s investors, this translated to zero exposure to any of the 22 countries that experienced downgrades during the relevant period.

Returns findings: The yearly quintiles created from the Omega Financial Health Rating were compared with the one year forward total returns. The findings show that countries with a superior Omega rating had both larger average returns and reduced volatility of returns. For Omega’s investors this translated to increased return of 9% which was 1.10% over the performance benchmark.

Additional health measures findings:  The next step was to back test performance in relation to each of the proposed additional financial strength measures. For all four measures, the countries with the superior financial health rating tended to have lower volatility of returns, with all but the maturity measures also delivering higher average returns.

“One of our real concerns at Omega was that the current extreme risk aversion in the market would result in an approach that placed all sovereign debt into one basket, irrespective of its quality – and that investors would miss out as a result,” said McCrum.

“However our research clearly shows that using a comprehensive risk-control tool that’s built on a strong platform of objective economic and political measures gives us an accurate picture of the true risks that apply, and helps us make investment decisions accordingly. We’ve had some very good results in our funds this year and one of the key motivations for undertaking this research is that we are keen to maintain the high performance.

“We want to stay in front of changes to help us continue offering investments that deliver both maximum upside potential and protect on the downside. Because that’s what fixed income investing should be all about.”

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