Tuesday, July 15, 2014

Bonds - The Vanishing Risk Premium

Watching yields on sovereign debt these days is like a fantasy world, reality no longer exists.  While the debt is real, the yields are totally unrealistic.  This is particularly the case for the former Eurozone debt transgressors, Portugal, Ireland, Italy, Greece and Spain.

Here is a chart showing the debt levels in euros (except the United Kingdom) as supplied by Eurostat for the advanced European Member States for the end of 2013 and 2010 and the percent change in the nominal debt, debt-to-GDP levels for 2013 and 2010 and the percentage point change in debt-to-GDP levels from 2010 to 2013:

Let's look at a graph showing the change in actual debt levels in euros from 2010 (in red) to 2013 (in blue):

All nations except Greece saw their debt grow between 2010 and 2013.  Among the PIIGS nations, Portugal saw its debt grow by 31 percent, Ireland saw its debt grow by 41 percent, Italy saw its debt grow by a rather meagre 12 percent, Greece saw its debt shrink by 3 percent (thanks to massive intervention) and Spain saw its debt rise by a lofty 49 percent.

Here's a graph showing the percentage point change in the debt-to-GDP levels from 2010 to 2013:

Notice that the debt-to-GDP level for all advanced European nations grew with the exception of Germany.  In the cases of Greece, Ireland, Portugal and Spain, four of the main debt transgressors, debt-to-GDP ratios grew by between 26.8 and 35 percentage points over the three year period!

Now that we have that in mind, let's look at the current yield on ten year bonds for the PIIGS nations, starting with Portugal:

The yield on ten year Portuguese bonds is 3.81 percent, up from its 2014 low of 3.2 percent in June but well down from its high of 15.1 percent in January 2012.

Here's the yield on ten year bonds for Italy:

The yield for ten year Italian bonds is 2.88 percent, down from 7.1 percent in November 2011.

Here is the yield on ten year bonds for Ireland:

The yield on ten year Irish bonds is 2.299 percent, down from 14 percent in June 2011.

Here is the yield on ten year bonds for Greece:

The yield for ten year Greek bonds is 6.25 percent, down from 36 percent in early 2012.

Here is a chart showing the yield on ten year bonds for Spain:

The yield for ten year Spanish bonds is 2.77 percent, down from 7.6 percent in mid-2012.

Now that we've looked the bond yields for the less solvent Eurozone Members, here is the yield for Germany:

The yield on 10 year bunds is currently 1.21 percent, down from a peak of just under 3.5 percent in July 2011.

Let's summarize.  In general, German bunds are considered the benchmark Eurozone bond.  The risk premium to the 10 year bund has dropped to:

2.6 percent for Portugal
1.67 percent for Italy
1.089 percent for Ireland
5.04 percent for Greece
1.56 percent for Spain

Compared to the current yield of 2.55 percent on ten year United States Treasuries, the risk premium has dropped to:

1.26 percent for Portugal
0.33 percent for Italy
-0.25 percent for Ireland
3.7 percent for Greece
0.22 percent for Spain.

Given that the nominal debt and debt-to-GDP levels for all of the PIIGS nations, save Greece, have risen substantially over the past three years, it is quite clear that the risk premium associated with the bonds of Portugal, Italy, Ireland and Spain are terribly out of line with the investment risk involved.  While I'm not terribly comfortable with the debt level of either Germany or the United States, the debt of these two nations is the yardstick used to measure debt worthiness.  It's clear that in their haste to increase the yield or their investments, bond investors have exposed themselves to risks that they may otherwise not have been willing to take, particularly given the fact that Europe's debt crisis is obviously on a temporary hiatus.

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