Government bonds are a key asset class for pension fund investment, allowing matching of long-term fixed liabilities. Sovereign risk, understood as the risk of default on government bonds, has historically been seen as low or zero in many developed economies. Government bonds have been perceived as “risk-free” instruments in part due to an implied capacity for countries to print more money should the ability to meet interest or maturity payments be called into question.
With the global financial crisis of 2008, and subsequent debt crisis in Europe, several eurozone economies have seen government bond yields rise well above what might be considered risk-free rates within the market. The implied sovereign risk reflects high levels of public debt in these countries together with the lack of any real room for manoeuvre given membership of the eurozone.
With COVID-19, the devastating effect on major economies of the pandemic is likely to mean that these governments are going to find it even harder to balance budgets. They may need to increase borrowing significantly, and the probability of sovereign default and/or possible exit from the eurozone can increase further.
What should pension plans and insurers with exposure to domestic sovereign risk within the eurozone consider? How might they manage the risk? In this article, Milliman’s Dominic Clark provides some insight and suggestions.