Safe assets have been all the rage since the financial crisis. They’re in high demand as collateral in repo transactions, for use to meet regulatory requirements, and, of course, as protection during bouts of market turbulence. In response to this trend, the ECB recently published a paper on their determinants, The fundamentals of safe assets. The authors, Maurizio Michael Habib, Livio Stracca, and Fabrizio Venditti ask what makes some country’s bonds safe assets while others more risky?
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Safe assets have been all the rage since the financial crisis. They’re in high demand as collateral in repo transactions, for use to meet regulatory requirements, and, of course, as protection during bouts of market turbulence. In response to this trend, the ECB recently published a paper on their determinants, The fundamentals of safe assets. The authors, Maurizio Michael Habib, Livio Stracca, and Fabrizio Venditti ask what makes some country’s bonds safe assets while others more risky?
Scope of study
Unusually for such a topic, they don’t just look at the US and a handful of developed countries; they study 40 countries (Table 1). They also look at long time period, from 1990 to 2018 – a period that covers numerous market shocks from the Gulf War to Y2K to the financial crisis.
Indicators
The researchers look at a range of market, economic, and political variables. They use US equity market volatility, VIX, as the indicator to determine market turbulence. A jump in this would imply heightened risk aversion allowing the authors to see which bonds act as safe havens (i.e. their yields fall as investors pile into them).
Then they use a battery of indicators for a country’s bonds to see which can explain best their “safeness”. These include:
• The level of bonds yields. This can help determine whether the bond market is used as a “carry trade”. Higher yielding markets would likely suffer in bouts of turbulence.
• Openness of capital account. Countries with tighter controls on cross-border flows could experience less capital flight.
• Currency peg or not. Less flexible exchange rate regimes could experience sharper capital reversals.
• They include a simple variable that looks at how the bond market behaved in previous bouts of turbulence. Essentially, they look at correlations between VIX and bond yields over past episodes.
• GDP growth and inflation. Low numbers could indicate vulnerability.
• Government deficit and level of public debt (as share of GDP). High numbers indicate vulnerability.
• Current account balance and net foreign asset position (as share of GDP). Big negative numbers here indicate external vulnerability.
• Political risk rating, based on the measure from the International Country Risk Group. This captures conflicts, government stability, and rule of law.
• Overall size of debt market. They look at the countries’ share of world public debt as a measure of the depth and liquidity of the bond market. The deeper the better in terms of the “safeness” of a bond.
Results
The most reliable indicator turns out to be the “inertia” term. So, what has worked in the past is the best indicator of whether the bond market will act as a safe asset in the future. This is a bit disappointing, but nevertheless it shows that there are certain intangibles that fundamentals cannot capture.
That said, some of their other indicators did also perform well in statistical tests, particularly the political risk rating and size of the debt market. These two were both statistically significant and acted in the way the researchers expected – that is, politically stable countries and those with large bond markets saw their bonds behave as safe haven assets.
Importantly, the reseachers did find some differences between advanced and emerging economies. Both were heavily influenced by inertia. But for advanced economies, political risk and size of markets were also important. For emerging economies, real GDP growth and current account balances were important.
Of the other variables, the level of yields often mattered too, while indicators such as capital account openness, fiscal deficits, and inflation failed to explain much in the presence of the other indicators.
They also found that for the US, indicators that captured the depth and liquidity of its markets helped explain best why it was a safe asset. They also found that the source of the shock to VIX (DVIX) did not affect the results – so it didn’t matter if it was a financial or a monetary policy shock. A summary of the results is shown in the table below.
Bottom Line
It seems that history matters. Bond markets that have recently behaved like safe assets are likely to behave as such in the future. Outside of that, political risk and depth of markets are crucial ingredients for safe assets. This helps explain why the likes of US, UK, German, and Japanese bond markets are viewed as safe assets.
However, you might be cautious about expecting Chinese bonds or even a synthetic euro bond to become safe assets. The depth of these markets are, or would be, small. And in the case of China, the political risks could be high.
Stefan Posea is a Research Analyst at Macro Hive. His research interests lie in macro-financial interactions and monetary policy analysis. Stefan graduated with an MSc in Economics at Birkbeck, University of London and previously held roles in M&A and the Public Sector.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)