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A profitable diversification vehicle The Swiss bond market plays an important role in international asset allocation. Generally, Swiss yields have been well correlated with German yields. On a monthly basis, the correlation between 10-year Swiss and German government bond yields has been 82% in the period from 1987 to 1995. However, the Swiss market continues to exhibit sufficient divergent behaviour for Swiss bonds to be an important and profitable diversification vehicle for international fixed income portfolios, particularly in periods of heightened international risk. In the 1994 bear market, Swiss 10-year government bonds posted the most favourable performance of the major government bond markets in both local currency and dollar terms, underlining Swiss bonds’ value as a defensive investment. In 1995, as global inflation expectations fell and bonds rallied, Swiss 10-year government bonds again posted the strongest performance of the major markets in dollar terms, suggesting that the Swiss market could be viewed by international investors as offering more than just a safe-haven. While the Swiss government bond market is modest in size, the inclusion of Swiss bonds in the Salomon Brothers global bond index is a testament to their importance. In January 1996, the Swiss franc denominated bond market comprises something over 2,000 issues which total, on a nominal basis, an outstanding value of around Swfr 305 billion. Of this total, 60% can be termed domestic issues, with the remainder foreign. The most important issuer in the domestic market is the Swiss government. Central, cantonal and municipal government bonds outstanding total Swfr55 billion, around 30% of total domestic outstandings. Tax is deducted in Switzerland from the interest or dividend payments on all domestic bonds. The nominal rate of taxation deducted at source is 35%. However, Switzerland has established double taxation treaties with a number of countries resulting in the effective rate of tax deducted often being lower. A summary of Switzerland’s double taxation arrangements is provided in Table 1 (opposite). Swiss Government bonds are tendered by Dutch auction. Since 1996, the tender schedule has been bi-monthly (odd months). Normally, in auction months the terms of the issue are published in the morning of the third or fourth Tuesday of the month. The subscription period then runs until the following Thursday at 11.00 CET. The result of the auction is published shortly after 12.00 CET. All of the paper auctioned is allocated at the last considered price. The Treasury has total discretion over the characteristics of the bond offered at auction. The modest size of Switzerland’s bond market is a reflection of its public sector debt to GDP ratio which, at 50%, is low by international standards. However, it should be noted that since 1991, when the ratio was just 30%, the trend has been upward. The cause for this rise can be traced back to a bout of atypical fiscal profligacy at the end of the 1980s. Despite the current economic weakness, however, efforts are underway to overhaul the federal government’s finances. The parliament approved a spending freeze in 1995 which requires a qualified majority for additional spending over Swfr10 million, and the new finance minister is proposing a universal freeze on spending. This would involve incorporating the goal of reducing the deficit to a “reasonable” level into the Swiss constitution, with this target to be reached within six years. In addition to such general steps, specific measures to bring down spending over the medium term are also in the pipeline. Switzerland is a confederation of 23 “sovereign” cantons with its construction embodying the principles of subsidiarity and collective decision making. These principles have two important implications for bond market valuation. Firstly, the dispersion of fiscal responsibility to cantonal and community level has encouraged fiscal self-responsibility. Secondly, Switzerland has enjoyed an extremely stable political environment by international standards. Despite the rise of the public sector deficit, the Swiss Treasury is in a very comfortable financial position. The 1994 deficit was Swfr1.4 billion less than budgeted, allowing the Treasury to build a net-cash position for the second year in a row. As a consequence, the government revised down its net borrowing target for 1995 from Swfr4.5 billion to Swfr3 billion. In fact, just Swfr2.01 billion net of new bonds were issued in 1995. It should be noted that the auction in November 1995 counted for the 1996 period, where the Treasury’s net target has been set at Swfr2.8 billion. The pressure on yields from government issuance in the near term is therefore likely to remain modest. Like its bond market, Switzerland’s economy is modest in size but well developed and sophisticated. The trend growth rate of productivity in Switzerland is around 2% on an annual basis. However, Switzerland’s growth has been lacklustre throughout the nineties, allowing an output gap to develop. Given this estimate, and our forecast that the Swiss economy will again expand at a rate below its potential this year (0.7%), it is expected that the Swiss economy could sustain a period of above trend growth before capacity constraints impose upward pressure to prices. The lack-lustre outlook for growth and absence of inflationary pressures suggests that official interest rates will remain low for some time, supporting the short end of the curve. Paul Lambert, Senior Analyst
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