Concerns over Greek, and more recently, Portuguese government bonds once again dominated bond market headlines and led to underperformance of Investment-Grade Corporate, High-Yield, and Emerging Market Bonds. More broadly, worries of rising budget deficits among the peripheral European countries of Greece, Portugal, Spain, Ireland, and Italy led to additional fl ight-to-safety buying of US Treasuries and German Bonds.
credit: Dr John2005
Concern over rising budget deficits in several peripheral European countries have become an increasing focus for investors and cause for risk aversion trades. While Greece faces the largest budget deficit in Europe, amounting to 13% of Greek economic output as measured by Gross Domestic Product (GDP), concern has most recently spread to Portugal and Spain with government bonds from Ireland and Italy also showing weakness relative to stronger German and French counterparts. The risk aversion has had a domino effect causing more economically sensitive corporate bonds, Investment-Grade, High-Yield, and Emerging Market Bonds to underperform despite still improving fundamentals, as measured by the Barclays Corporate Index, Barclays High-Yield Index, and Barclays Global Emerging Market Index.
How bad could the situation in Greece get?
We view a Greek default as highly unlikely for two reasons. First, there is little incentive for Greece not to pay its government debt obligations. A decision to not pay would result in bankruptcy with the Greek government restructuring its debt.
However, attempting to borrow in the bond market following a restructuring would be highly punitive, with bond investors likely to demand double-digit interest rates, much higher than the current 6.7% yield on Greek 10-year government bonds. Second, although yields are higher, the Greek Ministry of Finance has been able to sell government bonds and access capital markets for funding. In late January, a 5-year note auction totaling 8 billion Euros received orders totaling 25 billion Euros as the higher yields drew in investors. The ability to access capital markets greatly reduces the risk the Greek government would default by not being able to pay off existing debt holders.
Sovereign risks create difficult trading conditions and are likely to remain with bond markets for some time. We see three potential solutions to Greek bond turmoil:
- A bailout by the European Central Bank (ECB)
- A loan package by the International Monetary Fund (IMF)
- Simply wait for defi cit reduction measures to take effect
Either of the first two solutions would likely result in a sharp snap back by lower rated segments of the bond market as investors perceive less risk.
The reaction would be swift and difficult for investors to position portfolios around. Ultimately, we believe the ECB would stand behind Greece, however, supporting Greece may set a dangerous precedent, and therefore we view a bailout as a low probability. An IMF loan package seems a slightly more plausible solution as it would share the burden more broadly but Greek finance authorities may not agree to the terms. We see the third option as the most likely. Unfortunately, this option will take time and with Greece now required to report concrete steps and progress more frequently to the ECB, market volatility could persist. We are respectful of recent market action and the potential risks but, over time, we believe that investors will realize Greece and Portugal do not pose broader contagion risk to nongovernment bond markets across the globe.
Fears of Contagion
Market action has been driven by fear, as peripheral European governments are, for the most part, small contributors to Eurozone GDP and bond markets (See table below). Both Greece and Portugal are relatively small contributors to Eurozone economic output as measured by GDP. Similarly, their respective bond markets are relatively small components of the Barclays Euro Government Bond Index. Although Greek bonds comprise roughly 5% of the Eurozone government bond market that percentage drops to 1.7% on a global basis after including the much larger bond markets of the U.K., U.S., and Japan. While Greece is a small participant in the global bond market, poor performance of lower rated segments of the bond market suggests investors have assumed not only further troubles in Greece and Portugal but that their challenges will spread to more financially sound economies across the globe.
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Potential for Contagion
Spain represents roughly 9% of European government debt and is the next potential threat to the global bond markets since its deficit, at 11% of GDP, is the third largest in the Eurozone. However, Spain’s debt-to-GDP ratio, a key credit metric which measures the level of debt as a potential burden to economic output, is among the lowest of Eurozone countries at 54% of GDP and a key reason why Spanish government bonds are rated AAA by Moody’s and AA+ by S&P. The greater the amount of debt relative to the size of the economy (GDP) the greater the debt burden is and the greater the risk of not
servicing that debt (see Bond Market Perspectives — The Deficit and Interest Rates from February 2). These ratings might be lowered in the future but one reason for the higher ratings was Spain’s ability to move from deficit to surplus in the past. From 1996 to 2006, Spain steadily reduced its deficit and eventually moved to a surplus that amounted to 2% of GDP. Spain has more credibility with investors limiting the effect of contagion from Greece’s troubles.
Italian government bonds have also come under scrutiny but the budget deficit, at 5.2% of GDP, is slightly more than half that of the U.S. We do not dismiss the financial challenges faced by Eurozone countries
overall, however, the financial challenges faced by Greece and Portugal are signifi cantly greater than larger bond issuers such as Spain and Italy. Spanish and Italian 10-year government bonds would not be yielding 4.13% and 4.08%, respectively, if the market perceived more serious long-term significant credit risks facing those countries. The challenges faced by Eurozone countries are a primary reason why we have no exposure to foreign bond funds in model portfolios. European government bonds comprise roughly 50% of the primary benchmarks that foreign bond funds are tied to.
We recommend avoiding the European bond market. Instead, we continue to recommend international bond exposure in Emerging Market Bonds, which have exhibited stronger fundamentals than developed Europe recent weakness notwithstanding. The five largest country issuers in the Barclays Global Emerging Market Debt (EMD) Index have shown steadily declining debt-to-GDP ratios [Chart 1]. These ratios, which are through the end of 2008, are expected to increase (a combination of weaker economic growth and debt issued to fund domestic stimulus) when 2009 data is finalized but the increase is expected to be small and amount to just a few percentage points. The smaller increase is a reflection of the stronger rebound in emerging market economies.
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