While some central banks have tightened monetary policy – Australia  increased interest rates again this week, Norway tightened in December and the Bank of Canada sounded somewhat less dovish after its policy meeting – an increase in interest rates by the Fed, the ECB or the Bank of England is unlikely in the near future. Thus sentiment towards government bonds is being driven by concerns about high levels of borrowing and creditworthiness. This has resulted in a divergence in borrowing rates and a focus on sovereign credit ratings.

The divergence in bond yields within the developed bond markets reflects the divergence in economic fundamentals. We have looked at a range of fundamentals for a large number of OECD countries and ranked them from good to bad. The indicators include the current account deficit, the household savings rate, the government debt to GDP ratio, the debt service ratio and inflation.

Some countries come out bad on all indicators – Greece for example – while others come out good on all indicators – Norway and Sweden being the stars. The ranking of these countries does, for the most part, correspond to the prevailing government bond yields. Norway and Sweden have some of the lowest bond yields whilst Greece has the highest.

If we take the five best-performers in this ranking and equally weight them, we get a ten-year yield of almost exactly 3%. These are all AAA-rated sovereign borrowers and the pay off for being 'safe' is that the return to investors is low. At the other end of the scale the average yield would be closer to 4.5% and includes some countries that are already at the lower end of the sovereign ratings scale and some that might see their AAA-status come under pressure. So the return for higher yield is more risk in terms of countries that are already struggling to meet their debt obligations (Greece) or are seeing a rapid deterioration in their fiscal status.

Minimise risk

So how does a global government bond investor get higher yield without being overly exposed to the most at-risk borrowers? The first thing to note is that there are some outliers. Yields on Australian and New Zealand government bonds are much higher than US Treasury yields or yields on most European government bonds. Yet the fundamentals for these two are not so bad, especially on the government debt side. Indeed, Australia and New Zealand rank close to the top on debt/GDP, fiscal deficits and debt service indicators. The macro negatives for these two are large current account deficits and higher inflation.

However, I would argue that this is more than compensated for by the level of yield, which in part reflects higher official interest rates than in the US and Europe. Together these two only account for around 5% of the global government bond market but I would certainly want an exposure greater than that. Any exposure to these would also tend to benefit from the prevailing trend in the currency market as well. Although the Aussie and Kiwi have both appreciated strongly in the recent past, further gains are likely a these economies benefit from Asian growth.

Asia for government bond yield

Where else can we find higher government bond yields? We have to travel beyond the major markets. In Asia a number of government bonds yield more than the OECD top 5, so as well as Australia (5.5%) and New Zealand (5.7%) we can earn 4.9% in Korean government bonds, 4.2% in Malaysia and 9.4% in Indonesia. These are economies that are growing strongly and have much better fiscal profiles than some southern European economies.  What is more, Asian currencies are likely to continue to appreciate as growth outpaces that in the US and Europe. Plus, the correlation between returns from Asian bond markets and the developed markets is low. Since 1998 the correlation of weekly returns from a Citibank Asian government bond index and the UK gilt market has been just 20% while the correlation between returns from gilts and US Treasuries over the same period was 60%.

Latin America

There are higher yields to be found in Latin America as well. Brazilian debt yields 4.8% and the country now sits on $240bn of foreign exchange reserves (up from just over $50bn five years ago). Apart from during the height of the financial crisis, the real has been on an appreciating trend reflecting the much improved economic fundamentals. And on the subject of World Cup hosts, South African government bonds currently yield 8.9%. This is a country that has the same credit rating as Greece with outstanding debt of less than a fifth of the Athens government.

A number of factors influence the yield on bonds including inflation, the level of interest rates and the credit rating. Yields are typically higher where central banks have higher interest rates, or inflation is picking up or where there is a credit issue related to rising government debt or insufficient foreign exchange reserves. However, the global bond market is diversified enough to provide opportunities for investors to find higher yields without necessarily taking on a lot more risk. Many Asian economies have fiscal profiles that most of the members of the European Union can only dream about (not to mention stronger economic growth and younger populations). They are not faced with the onerous longer term fiscal and health care liabilities that are evident in the west (although social security will increase as those economies mature) and, for the time being, are more likely to see currency appreciation against the euro and the dollar.

I feel that a combination of Asian government bonds, Scandinavian government bonds and Antipodean government bonds would give a higher yield and better risk adjusted return than most market weighted bond indices or single market strategies. Sustainable income generation is out there, you just have to search for it.