Countries – like companies, households and individuals – sometimes have to take out loans to fund their investments and manage their economies. But, as anybody who’s borrowed or lent money could tell you, there’s always a chance of defaulting on your debts or obligations. The same can apply to a country – it’s rare, but it happens with recent examples including Russia in 1998, Greece in 2015, Zambia, Argentina, Ecuador and Lebanon in 2020. But what does this have to do with your retirement fund and your retirement savings?

In South Africa, Regulation 28 (issued under the Pension Fund Act) allows retirement funds to invest up to 40% offshore. In utilising that allowance, retirement funds get exposed to sovereign credit risk.

‘Sovereign credit risk is premised on the narrative that there is an inherent possibility of a country defaulting on its foreign debts and obligations,’ explains Phelisa Qina, Investment Consultant at Old Mutual Corporate Consultants. ‘Retirement funds are exposed to this risk either through directly investing their assets outside the country’s borders as allowed by their local regulations, or indirectly through what is termed “pure-play”. This occurs when retirement funds buy securities in multinational companies.’

Investment risk and reward in emerging markets

For investment managers, emerging markets present a powerful combination of risk and reward. These markets often promise high growth, but – as in the cases of Turkey in 2021 and Russia in early 2022 – it sometimes comes with higher sovereign credit risk.

‘Investment managers balance this risk in two main ways,’ says Qina. ‘One is by exposure management, which involves diversifying across different emerging market sovereigns, and another is by obtaining emerging market exposure through dual listings – particularly in multinational corporations listed on developed market bourses, but with operations in emerging markets.’

It’s easy to think that developed markets like the United States or Europe don’t feel the effects of sovereign credit risk. However, there’s still that pure-play risk. ‘Pure-play exposure is when investors are exposed to emerging markets through companies listed on developed market stock exchanges,’ Qina explains. ‘Investors will still be exposed to emerging-market sovereign credit risk through the possibility of a collapse in the price of a stock that emanates from the country of operations. However, the severity of such an event would be muted by the robust governance frameworks of these stock exchanges.’

And it’s not all bad news. Qina says that while sovereign credit risk is real and can impact investors negatively, it can have positive results for retirement fund investments, too. After all, the risk of market instability or a sovereign debt crisis is always counterbalanced by the opportunity of risk premiums and diversification.

Your retirement fund and sovereign credit risk

Qina’s message to retirement funds is clear: while global headlines are scary sometimes, there’s no need to fear that a sovereign debt crisis in a faraway country will doom your retirement savings.

She emphasises that exposure to sovereign debt risk cannot be avoided, but it can be monitored and managed. ‘That is the silver lining,’ she says. ‘One of the risk management approaches investors can adopt to manage sovereign credit risk is through diversification in terms of countries. Funds can also delegate decisions around sovereign credit risk to asset managers, as they typically have more knowledge of this and more access to information.’

More good news is that sovereign debt crises don’t happen overnight. These events build up over months or years, giving investors and portfolio managers an opportunity to adapt their strategies.

‘Sovereign credit risk takes time to build up,’ says Qina. ‘This means that the probability of such a risk is more important than the actual risk, as it serves as a signal for retirement funds to start the winding-up process of their allocations in the respective jurisdictions. Thus, the probability of sovereign credit risk buys investors time – and by the time the actual risk plays out, the fund’s allocations would have been completely wound up.’

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