January 16, 2010

Switch in view on ‘risk-free’ nations

Filed under: Uncategorized — ktetaichinh @ 5:27 pm
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By David Oakley

Published: January 12 2010 19:21 | Last updated: January 12 2010 19:21

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// ]]>Before the old market rules were torn up by the financial crisis, investors regarded government debt as risk-free.

But that does not seem to be the case any longer: for the first time, the market has started to price in a bigger probability of default among industrialised countries than among investment grade companies.

More specifically, it now costs more to insure the combined risk of default of Europe’s developed nations, including Germany, France and the UK, than it does the combined risk of Europe’s top 125 investment-grade companies, according to the Markit indices.

Markit’s iTraxx Europe index of 125 companies was on Tuesday trading at 63 basis points, or $63,000 to insure $10m of debt over five years. This compares with 71.5bp, or $71,500, for Markit’s SovX index of 15 European industrialised nations.

This development reflects the market’s current obsession with sovereign risk. The same thing applies in the bond markets where investors are no longer willing to regard the debt of an increasing number of developed world governments as risk free. These countries have taken on huge private sector debts in their efforts to reverse the economic downturn and bail out the financial sector.

pop-up: CDS spreadsJohn Wraith, fixed income strategist at BofA Merrill Lynch Global Research, says: “The concept of what is risk free has certainly changed in as much as government bond yields of the UK and other countries are higher than some corporates.”

The UK, a Group of Seven nation, has seen the cost to insure its debt rise to double that of some of its leading companies. The UK CDS has jumped by 40bp to 83bp since September, which compares with Unilever at 29bp and BP which is 38bp.

The public debt mountain in the UK has even prompted concerns that the UK could lose its prized top-notch triple A status, with all three main ratings agencies warning that its budget deficit must be reduced to avoid a downgrade.

Critics warn that Markit’s SovX index is not that liquid, which means that small movements can exaggerate moves. Investors should, therefore, avoid reading too much into its 20bp rise since its launch in September.

It is also important to distinguish between countries such as Greece, which has seen a sharp deterioration in its public finances, and Germany, which is still the European benchmark. German CDS has remained stable over the past few months at 27bp.

However, in the highly liquid government bond markets, the story is more nuanced.

Greek government bond yields are trading much higher than many investment grade corporates, but yields on UK government bonds are lower than yields of company bonds of the same maturity.

UK five-year government bond yields closed at 2.75 per cent on Tuesday, much lower than Greece, which closed at 4.75 per cent. Meanwhile, the yield on five-year bonds of Deutsche Post was 3.174 per cent, 3.178 per cent at BP and 3.312 per cent at Unilever.

Huw Worthington, fixed income strategist at Barclays Capital, says: “We live in a different world since the financial crisis. Clearly, Greek bond yields are much higher relatively than Germany and are even trading above some companies.

“But, in terms of what is risk free, Germany remains the benchmark. There is more divergence between the different economies with German yields much lower than Greek yields today than they were three years ago.”

Mr Wraith says: “There has been a big change in perceptions as to what risk free really means, as although governments can print money and should therefore never technically be forced to default, the act of doing so could damage the currency so much that investors are left nursing big losses.”

He believes it is now up to heavily indebted governments to get their finances in order. If they fail to act, there could be a sell-off in the bond markets as investors cut their government exposure .

The plight of Greece, which saw its bond markets implode last month because of concerns over the credibility of its public finances (they sold off furtheron Tuesday for the same reason), is a salutary reminder to other governments of the price of failing to act.


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