Bonds with no government guarantee in the benchmark
15 March 2001
The following letter was submitted to the Ministry of Finance on 15 March 2001
The current benchmark indices for the Government Petroleum Fund's fixed income investments consist exclusively of government bonds in developed markets. The regulation and guidelines allow for investments in bonds that are not included in the benchmark index. Norges Bank may invest in bonds issued by both public and private bodies as long as the instruments have a rating higher than Baa/BBB1 from Moody's and Standard & Poors respectively. Bonds with this type of credit rating are often referred to as "investment grade" bonds or bonds with medium to low credit risk.
In this submission we will use the term "non-government-guaranteed bonds" to refer to all types of bonds that are not government bonds issued in the country's local currency and that are not included in the Petroleum Fund's benchmark index. This common term covers a number of different types of bonds, including corporate bonds. In the US, mortgaged-backed securities (MBSs) with marginal credit risk and a prepayment option represent another important segment of the investment universe. MBSs are not in the benchmark index. The term will also include bonds issued by international organisations, companies with a government guarantee and government bonds issued in another country's currency. Therefore, the term "non-government-guaranteed bonds" does not fully cover this universe. In this submission, the term "bond market" is defined as bonds with more than a certain minimum amount outstanding in the market. Issuers must have a credit rating of Baa/BBB or better from the large international rating companies. Bonds with only a small outstanding amount, private placements and bonds issued by enterprises with a rating lower than Baa/BBB will therefore be excluded.2
When the guidelines for the Government Petroleum Fund were expanded in the autumn of 1997 to include investments in equities, the existing benchmark for bonds (Salomon Smith Barney World Government Bond indices) remained unchanged. Norges Bank has stressed that it would not invest in corporate bonds until it had established satisfactory systems for assessing and measuring credit risk. The Ministry of Finance has endorsed this policy. Until now, it has been necessary to concentrate available resources on high priority tasks, such as developing an organisation that is capable of handling current investments and the management of large amounts in the international equity markets.
Expanding the Government Petroleum Fund's benchmark to include all types of bonds within the investment universe may be of interest for a number of reasons:
- The benchmark will be more representative of the Fund's investment opportunities. Based on the Fund's universe, the current benchmark represents a good 27% of the investment universe in the US and a good 60% in Europe. In Japan, government bonds dominate the market.3
- The expected long-term return on the benchmark will be somewhat higher if it is expanded. This is explained below.
- Developments in the public sector's outstanding debt (not including Japan) indicate that government bonds will account for a steadily smaller share of bond markets in the future. The OECD estimates that gross public debt as a share of GDP will decline during the next few years throughout the OECD area, with Japan representing the exception. The chart below shows developments in gross outstanding debt in the public sector as a share of GDP from 1995 to 1999, with estimates for the period 2000-2002.4 In the OECD's reference scenario for the period 2002-2006, the share declines another 8% in the euro area and in the OECD area as a whole and by 18% in the US. Public debt will not contract as much as suggested in the OECD's reference scenario if the US tax cuts that are proposed for 2002-2006 are implemente