A sharp rise in sovereign spreads suggests this could be an alarming possibility.
On January 9, Standard & Poor’s announced that Greece, Spain and Ireland were on review for a possible downgrade, indicating that a Eurozone country could default. If financial crises have taught us one thing, it is to take such “black swan possibilities” (as Nicholas Nassim Taleb would describe it) seriously. A sovereign default by a small country could wreak havoc on the markets for credit default swaps (CDS) and might even destroy financial institutions in other Eurozone countries. It could trigger panic rise in bond yields and the threat of contagion could turn into a self-fulfilling prophecy. A far more serious threat would be a cascading series of defaults that would eventually include one or more of the Eurozone’s large countries. The 10th birthday of Eurozone seems to be holding out ominous portents.
Of late, sovereign CDS prices of the world’s rich nations have increased dramatically. In the past three months, the US Federal Reserve has created more credit than it has ever done before. The sum of its earning assets, known in trade parlance as reserve bank credit, has grown at the outstanding rate of 2,922 per cent. The CDS price of the US has risen to a record 57 basis points in the face of deteriorating credit conditions of banks and non-finance companies and concerns over the $1,000 billion it needs to raise in bonds to tide over the crisis. On similar grounds, the CDS on Spain, which like the UK and the US has seen its property bubble burst, rose to 106 basis points, while that of France has risen to 56 basis points and Germany to 43 basis points.
It now costs £110,000 to insure £10 million of UK debt against default over five years, or £50,000 more than it did in the middle of November 2008. The same cost £8,000 in February 2008. The rise is due to concerns of the amount of bonds the government will have to issue to bail out the banks and stimulate the economy. The UK is forecast to raise £135 billion annually — three times more than in past years, until 2013. To add to the woes, the collapsing UK housing market will add to the strain. Ironically, it costs more to insure the UK against default than some of its major banks such as HSBC and Lloyds.
Italy’s CDS price is the highest amount the G-7 nations at 161 basis points or ¤161,000 to insure ¤10 million of debt over five years. The reasons being that Italy’s debt/GDP ratio has escalated to 103 per cent or the highest in the Eurozone. Among the highest sovereign CDS prices are for Argentina (trading at 4,050 basis points) and Ukraine (trading at 2,400 basis points). The economies of Latvia, Bulgaria, Ukraine, Pakistan and Iceland are being singled out as the most vulnerable and Moody’s has placed them on negative watch.
Greek bonds are trading at a significantly higher yield than Germany, showing a perceived default risk. The spread of Greek bonds over German bonds is 2.32 percentage points, almost 10 times its level two years ago. Spanish spreads have risen above 90 for the first time as well. An Intrade prediction puts the odds on a current Eurozone member leaving the euro by the end of 2010 at about 30 per cent. The market is nervous about other nations on the Eurozone’s periphery, notably Ireland and Spain, which got over-extended during the credit bubble. Argentina, Venezuela and Iceland have the highest default risk, with Russia not far behind. Germany, Japan and France all have lower defaults risk than the US at the moment.
In 2006, Pakistan issued a 30-year bond at a spread of just 300 basis points over Treasuries. That is a very low level for a country with such poor economic fundamentals and a history of political instability. Although Pakistan has not yet defaulted, their bonds trade at about 40 cents on the dollar, suggesting that the likelihood of Pakistan defaulting is now imminent.
Other sovereign entities have already defaulted. The Seychelles defaulted in August 2008. On December 13, 2008; Rafael Correa, Ecuador’s president, said his nation intended to default on its foreign debt.
Fears have also mounted recently that Argentina will struggle to meet its 2009 debt servicing payments of $21 billion, but economists believe it will avoid defaulting, in view of the fact that the state went so far as to nationalise private pension funds just to meet its obligations.
As massive de-leveraging takes place, it leads to increased market volatility and absence of players from the credit markets. This is turn leads to various bond market dislocations.
For instance, over the past few years Russia (rated BBB) has been running large deficits and has substantially more government debt as a percentage of Gross Domestic Product. On the other hand, Turkey has been running large fiscal deficits and has relatively more government debt as a percentage of Gross Domestic Product. Yet, on account of the anomalies mentioned above, Turkish dollar bonds yield a little over 8 per cent, whereas Russian sovereign debt yields more than 11 per cent.
Emerging market debt spreads have yet to adjust fully to the realities of weaker global growth, falling commodity prices and higher defaults. Historically, emerging market debt has traded on similar spreads to high yield as both have similar underlying credit quality. Yet, currently spreads on high yield are about 1,400 basis points wider than emerging market spreads.
Many emerging market countries have weak fundamentals with several countries like Hungary, Ukraine and Pakistan are at the beck and call of the IMF. At current spreads, investors are not being fully compensated for the risks in many of these countries.
High-yield spreads are above 2,000 basis points and still widening. This provides a premonition of how much emerging market spreads might widen, particularly the sub-investment-grade issuers.
The author is CEO, Global Capital Advisors
