Government debt levels concern investors. Robin Marshall, a FTSE sovereign bond expert, helps describe the landscape, and how it has developed, through the prism of the FTSE World Government Bond Index. DB pension schemes could be net buyers of bonds and the 60/40 portfolio may see a resurgence, he says.
US government shut-downs are possible again as the world’s largest economy reaches its ‘Debt Ceiling’ – the maximum amount of money the country can legally borrow. Shutdowns save money and avoid the need for further borrowing.
But it’s not just in the US where government debt levels are a concern for pension funds, credit rating agencies and other government bond holders. Credit ratings for bonds in the FTSE World Government Bond Index (WGBI) were, overall, “triple A” in 1984, when the index was launched. Now only 11% of its issuance is rated as triple A, while 57% is double A. The US has no triple A-rated bonds. The best it’s got is a “double A-plus”.
According to Robin Marshall, director, Global Investment Research, FTSE Russell, owned by the LSEG (London Stock Exchange Group), bond investors are more concerned at debt-to-GDP ratios. These ratios have increased in the last 15 years since the Global Financial Crisis (GFC), from around 50-57%, to over 100% for major sovereigns.
This reflects an increase in government borrowing at a time of lower growth, which has caused some countries to be downgraded by credit rating agencies, owing to concerns about how they will pay lenders back.
At the same time, the yield curve of the index has steepened. This means that investors with longer dated bonds – for example, 30 years – are demanding higher yields to offset default risk over the lifecycle. Default risk, says Marshall, is still very low in local currency government bonds but it has nevertheless increased and since 2022 governments have issued more shorter duration bonds in which repayment risk is lower.
Vigilance about debt to GDP, he says, has increased interest in the FTSE Debt Capacity World Government Bond Index – a variant of the original WGBI but adjusted for debt-to-GDP ratios and debt-servicing costs. The US has a much lower weighting in that index – about 15% lower than in the main WGBI.
“A Curate’s egg”
Marshall, who is a former University of London economics lecturer, describes the US economy as “a bit of a curate’s egg”. Despite some widening in US sovereign spreads since Covid, in 2020, its economy is “good in parts, notably in productivity and growth performance” and has grown faster than Europe.
A large fiscal stimulus in the US, related variously to Covid and a huge infrastructure programme, helped drive faster growth. However, debt-to-GDP ratios have increased in Europe, too, while growth is more sluggish, notes Marshall. In Europe, a change to watch is how Europe’s greater commitment to defence spending will impact the EU’s debt-to-GDP ratio.
“Three of the weakest years”
Overall, the WGBI has seen a 5% annualised return, depending on currency, over its history, with very low risk. The last three years’ performance returns were “perhaps three of the weakest years”, reflecting a transition to higher yields and lower bond prices as interest rates rose to combat inflation.
In US dollar terms, the return on bonds with a maturity of 1-3 years – the “short end” of the WGBI – is 6.1% and the return on 10-year bonds is 5.8%. However, for 20-year plus maturity bonds there is a 3.3% loss.
“It’s a reflection of yield curves, which have been bear steepening, and the extra duration in the long end, which has been underperforming as a result. The 30-year Treasury now yields 5%. The short end of the curve benefited from central bank rate cuts, but the long end has suffered due to concerns about deficits.”
Marshall, who works with a team of fixed income and multi-asset research analysts, provides regular written and podcast content around fixed income and other asset classes, including what they say about the wider economy, adds: “When Covid struck, yields went to all-time lows for WGBI as rates came down and there was a deflation shock. Then we see yields back up since 2021 as inflation re-bounded, and central banks raised rates.”
Concern about debt-to-GDP ratios have increased in recent years, even if the topic was on agendas right back in the early 2010s, after the Global Financial Crisis caused government debt to increase sharply. Investors are worried about whether countries are going to be able to grow enough to pay their coupons.
“That’s become a bigger market concern with lower trend growth rates, and that’s why we have 30-year bonds yielding 5% in the US and 5.5% in the UK.”
At least one “collateral effect” is worth mentioning, says Marshall. Some defined benefit (DB) pension schemes have gone back into a funding surplus after 20 years of deficits, thanks to higher yields. This may drive higher bond flows.
“Higher yields mean that when you discount future liabilities, using higher discount rates, the present valuation of liabilities falls. The valuation of fixed income assets has fallen too, but not as much as liabilities. After 20 years of funding deficits, DB schemes have now moved in surplus and that means it is more attractive to derisk portfolios by buying more government bonds to match future cash flows through LDI [liability-driven investment] schemes, particularly as government bonds are now much cheaper, relative to equities.”
The complexity of correlation
Higher inflation and interest rates had the effect of increasing correlations between equities and bonds, after years of low, or even negative correlation from the mid-1990s to 2020, when equities and government bonds were seen as strong diversifiers for investment portfolios. In the period 2020-2024, the correlation of returns has become much stronger, reaching 0.8 and 0.9 (maximum correlation is 1.0, or 100% correlation).
However, in 2024-25, “as rates came down some of these older, weaker correlations started to reassert themselves”, says Marshall.
This is an important point for portfolio diversification purposes and for the survival of the popular 60/40 equity-bond model.
In higher yielding corporate debt (or “high-yield credit”), correlations are traditionally higher with equities. However, corporate issuance of debt has fallen while sovereign issuance has increased. Correlation overall between fixed income and equity has mean-reverted to around 0.4, says Marshall. This is roughly a halving from two years ago.
“Also, government bonds have an income aspect. With yields in the 4-5% area – or 5-6% in good quality corporate credit – they are attractive to income investors.”
FTSE research also found that adding in gold and digital assets to a portfolio – creating a “60/20/20” portfolio – improved performance over 60/40.
But does the re-emergence of diversification suggest the 60/40 model – which in recent years has been questioned exactly because of strongly positive correlations between asset returns – is back in play?
Marshall says it’s too early to tell. However, he adds: “You could say that the portfolio diversification attraction of fixed income has returned, though.”
About FTSE Russell:
FTSE Russell is a leading global provider of benchmarks and indices. Our category-defining solutions are used across the globe to benchmark investment performance and create the next generation of investment funds, ETFs, structured products, and index-based derivatives.
Read more:
The FTSE World Government Bond Index (WGBI): A global standard for the sovereign debt markets
Higher correlation of multi-asset returns – temporary legacy of Covid, or permanent change?
Government debt sustainability: An examination of the FTSE Debt Capacity World Government Bond Index after 10 years
