How Super Mario turned a “PIGS” bond into a gilded sows ear…

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After hitting a high of more than 7% in 2012, the yield on Spanish sovereign debt then embarked upon a remarkable sustained downtrend that has now culminated with the current yield level of just 2.5%. If the inflation target of 2% the ECB follows is to be taken into consideration, then the yield on Spanish debt effectively allows almost nothing for credit risk. The same is true for Italian debt, which rose above 7% in 2011 but is now currently trading at 2.7%. Way to go Mr Draghi!

The implicit yield on a bond is made up of a few components that represent the compensation required by investors to bear a series of risks, with the most important being the inflation risk and the credit risk. In the case of the US government, where there is a central bank printing money with gusto, and which, crucially and usefully for them they still benefit from “reserve currency” status, the credit risk is deemed to be (crazily on our opinion) virtually zero. The scenario of US government bankruptcy is deemed impossible. Well, in the markets our motto is “think the impossible, it invariably happens much more frequently than you’d believe possible!”

In the US, the Central Bank is printing money and buying its countries government bonds. In effect the US is paying its debt with newly laundered paper. Forgive the comparison, but it is a kind of a Ponzi scheme, with the central bank printing money to pay for past debt, and then printing more money to pay for the newly created debt. Repeat the process ad infinitum and you are left with runaway inflation, nay hyperinflation and which is not all that different from bankruptcy (with the main exception being that inflation is immediately felt by the whole population while bankruptcy initially affects just the bondholders).

In the Euro area we have a different dynamic. Italy, Spain, Portugal and any other Euro area countries have no national central bank. Instead, there is one common central bank that represents the interests the whole lot. The ability for any of these countries to print money depends on their ability to seduce the ECB to do so. This is a serious drawback in a model where investors seem to ignore the credit risk. From what we can see, Germany opposes the monetisation of government finances and we are not really comfortable in assuming that the ECB will actually stop jawboning and will jump in and bailout any country in difficulties. Of course, if there were a high systemic risk of bringing the whole system near to collapse, a bailout would be more likely, but these correlated risks are now lower than they were in 2008-2009.

Looking at the current yield levels for Spain and Italy, one must assume that investors either think these countries are “too big to fail” and that the ECB would jump in to save them if need be; or bondholders don’t perceive any risks deriving from these countries. The first case is highly implausible, and even if it were to happen, we would say that bondholders would lose at least part of their investment, and so the risk is significant. The second case is more plausible but shows irrationality, as the debt-to-GDP levels in the PIGS is still very high. Did we say still? What I meant was even higher than before.

Central banks are continuing to generate severe distortions in asset markets by inducing an artificial decrease in perceived risks for investors. A low interest rate should seduce investors to apply their funds into the real economy, but instead what we have is financial institutions using the “free” money to invest in sovereigns. The austerity measures and suppressed euro land inflation has brought about reduced bond yields that is true. If this were the measure of success then all well and good, however, it cost the jobs of millions of Europeans. To us we believe that the credit risk premium in European bonds is in fact negative and if Monsieur Draghi does hit the print button then the complete absence of an inflation premium being embedded in bond yields at present will result in severe bond losses for current investors as the seeds of inflation get sown…

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