Eighteen months ago, markets were fretting about the huge debts carried by major banking institutions. Now the worry is over the debts carried by the governments who bailed the banks out. So what's an investor to do?

This crisis-driven transfer of large private sector debt obligations from wounded banks to public sector balance sheets is certainly the talking point "du jour" in financial market and media circles.

There is little doubt that the financial crisis and subsequent recession in many developed economies have placed a heavy burden on the fiscal positions of those nations. The IMF, for instance, has forecast that general government gross debt in the advanced countries will rise, on average, from 75% of GDP at the end of 2007 to about 110% of GDP by the end of 2014.¹

The news story out of this is that the financial crisis hasn't really gone away; it's just been transformed from a banking crisis to a potential sovereign debt crisis. This has many people asking where the safe havens will be for investors if even sovereign borrowers are judged as too risky.

There are a few observations to make in answering that question. The first is to observe that no investment is totally risk free. Even sovereign borrowers with the power of the printing press at their disposal can and have defaulted.

The second observation is that markets already have made a judgement about rising sovereign risk, as reflected in prices. Spreads — or the margin that investors demand for investing in government securities perceived as riskier than the top-rated 'AAA' debt — have blown out as concerns have mounted.

The third point is to reflect on the fact that not all sovereign borrowers are equally challenged in terms of their public finances. Most attention in recent weeks has been on Greece and other southern European states like Portugal.

But the debt of other major developed nations — including the US, Japan and Australia — is relatively unaffected.

Just as in equity markets, investors in fixed income markets demand a greater expected return for taking on additional risk. That is why the spreads on Greek government debt blew out so much in recent times.

And, of course, these relative prices can quickly adjust to new information as it comes to hand, which is why spreads retraced a little on speculation of a European rescue package for Greece.

As no-one knows what the future will hold, fixed income investors can deal with the uncertainty by holding a diversified portfolio spread across a wide range of sovereign, supra-national and corporate issuers, by limiting exposure to any single issuer and by restricting the eligibility of certain countries of risk.

For those who want a more conservative strategy, they can restrict their investments to only top-rated borrowers and in short-term instruments. Also, there is no compulsion to diversify globally if the risks of doing so are not commensurate with the returns.

To the claims being made in some quarters that sovereign debt will start to behave more like corporate debt, the answer is the same: No investment is risk-free and markets will make their instantaneous judgements on relative creditworthiness — whoever the issuer - which means all investors need to do is diversify around risks they are willing to take.

So the message is the same — markets are quick to price in new information, risk and return are related, diversification is the antidote to country or company specific risk and, in considering a fixed income strategy, investors should take note of a range of risks — including default risk.

Magus use the Dimensional Short Dated Bond fund as the fixed income within its portfolios. 

What Dimensional Does

Not surprisingly, this is how Dimensional runs its fixed income strategies. First, it has always recognised sovereign risk as just that — a risk. This is why it places strict limits on the proportion that each strategy can carry in the securities of any one issuer — whether that issuer is a foreign government or a semi-government agency or a company or a supra-national organisation.

Second, Dimensional limits the number of eligible currencies its fixed income strategies can invest in. At time of writing, this pool of eligible currencies amounted to 11 — the US and Canadian dollars, the UK Pound, the Euro, the Swiss Franc, the Danish and Norwegian Krones, the Swedish Krona, the Japanese Yen and the Australian and New Zealand dollars.

Third, Dimensional restricts the eligibility of countries of issuers its fixed income strategies can be exposed to and reviews this list regularly. For instance, none of Greece, Portugal or Italy — three sovereign states at the centre of recent market concerns — is currently an eligible country of risk.

Fourth, outside the country of origin for each strategy, there are percentage limits on the exposure the strategy can have to other countries of risk. But portfolio managers still have the flexibility to increase exposure to the domestic sovereign borrower to 100 per cent if there are not sufficient opportunities to diversify in other countries' yield curves.

All these rules are ways of controlling and spreading risk and recognise that there is no such thing as a "risk less" investment, even if the borrower is a sovereign state or government agency.

As always, it is about working with the market, understanding the dimensions of risk and return, diversifying to limit risk and implementing in a smart, efficient way that focuses on factors within our control.

¹John Lipsky, 'Three Post-Crisis Challenges', IMF, March 1, 2010.