Government bond investors are in a dilemma. On the one hand, they have been encouraged to switch into government bonds by new regulations as these assets are deemed safer than equities. On the other, there are fewer and fewer government bond markets that are still considered risk-free.

“In the old days, it was simple. If you wanted safe assets, you bought government bonds. But now there are not many government bond markets that are safe,” says Alan Wilde, head of fixed income and currencies at Barings,

It means fund managers have been presented with a trickier task in satisfying regulators that want them to opt for caution, while at the same time trying to provide clients with strong returns that outperform the main government bond benchmarks.

It has also sparked a fierce debate over whether a fund manager should play it safe and buy debt that is still considered risk-free or take a chance on higher-yielding bonds and equities.

Many fund managers have taken the safe option and have offloaded eurozone government bonds, leaving them underweight in markets such as Spain and Italy.

Some have taken an even more extreme position with the small, peripheral government bond markets of Greece, Ireland and Portugal, which they are now completely avoiding.

For these managers, the safe assets of governments they think are certain to pay them back, such as the US, the UK, Germany and Japan, are the only option.

Yet, there may be risks in buying this debt too.

Mr Wilde cautions against buying the so-called safe bonds of gilts, for example. He warns that they offer low returns, with the risk that investors may decide to sell because they have become so expensive. That could cause yields suddenly to shoot higher and prices to fall, leaving other investors nursing losses on gilts.

Others agree that buying gilts and other “risk-free” bonds of the US, Germany and Japan present dangers, because the yields, which have an inverse relationship with prices, are too low. The market has gone too far and is due a correction, in their opinion.

For these investors, a better option is Spain or Italy. Even though yields on these government bonds have fallen sharply since the European Central Bank announced plans for three-year loans, they still offer much higher returns than US, UK, German or Japanese bonds.

Other investors go further, saying that Portugal, despite its status as a risky, small eurozone peripheral, is a good buy because its yields are so much higher than those from Italy and Spain and even Ireland, another small peripheral.

Buying peripheral bonds because of high yields may also be a good option because of the continuing support the ECB’s emergency liquidity provisions are giving the markets. The central bank’s three-year loan tenders have helped to drive yields lower.

One senior investor at a US fund says: “As a fixed income investor, it is now all about the price – whether the price offers value. Gilts, US Treasuries, Bunds and Japanese government bonds are too expensive.

“Safe havens such as gilts are vulnerable to a turn in the market. Fiscal performance is in doubt and Germany has huge contingent liabilities. Any re-emergence of global inflation could hit the four safe havens and see yields rise sharply.”

Although the US fund investor concedes there is no sign of that yet, he still prefers the riskier government bonds such as those of Portugal. This is because inflationary pressure can take markets by surprise, particularly if it is driven by oil, which can be volatile due to unexpected events in places such as Iran or the Gulf.

He also likes the bonds of Poland, Slovakia, Slovenia and Russia. There are risks with these bonds, however, because there is no guarantee that principal payments will be met at the end of the maturity term. But he argues that in a world of diminishing risk-free assets, they offer better prospects.

This is a key point.

Even the US, the world’s biggest economy, no longer has a top-notch triple-A rating from all the agencies. For many investors, there are risks with holding US debt as well as the triple-A of the UK, Germany and Japan. The US is extremely unlikely to default, but the risks are considered high enough that yields could suddenly lurch higher. The dangers are arguably higher for German debt because of the problems in the eurozone.

In short, it is not as it was before the financial crisis when all eurozone government bonds traded at similar yields with little volatility. Those days, say investors, are gone, probably for good. It is unlikely, for instance, that Greek yields will fall below those of Germany, as they occasionally did before the crisis.

It means an investor may be better off opting for equities or riskier bonds, which offer higher yields and returns. Indeed, some global companies, such as the fast-food chain McDonald’s, are safer than the most highly rated industrialised countries.

“There is arguably no such thing as a risk-free rate or bond any more. There are risks with gilts and Bunds too,” says Mr Wilde.

Peter Schaffrik, head of European rates strategy at RBC Capital Markets, says: “We live in a more complex world. Investors have to be more discerning about what they buy – there are no longer the old certainties. Arguably, no bonds are truly risk-free in this new environment.”

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