Wed, 25 Jul 2012
Germany is hitting negative sovereign yields, while Spanish regions and banks seek financial assistance from their parent country, which needs a bailout of its own.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Volatility has remained the name of the game in Europe during the last couple of days, with Spain's bonds trading like junk bonds and with Germany seeing negative yields. I'm here with Dave Sekera, our corporate bond strategist, to see what's happening and if it will have any impact on the U.S.
Dave, thanks for talking with me today.
David Sekera: It's good to be here, Jeremy.
Glaser: So let's start with Spain, I think that's been kind of the center, at least recently, of the European debt crisis. What's happening there? Why are people all of a sudden worried about those yields continuing to spike? What's happening in Spain?
Sekera: Well unfortunately the bond yields in Spain especially on the 10-year bonds have been rising again pretty strongly. The bonds have been trading kind of in that 6.5% to 7% type area for a little bit of time now. Unfortunately over the course of the last week it's really spiked up. Over the past three or four trading days it's moved up about 60 basis points over 7.5%, I think it topped out around 7.60%.
Glaser: What about Spain's short-term debt? Is the country still able to have the liquidity to kind of keep itself going for a while?
Sekera: Well, that is really the most concerning part to me. I've been watching the Spanish two-year bond. I've been looking at the curve between the two-year and the 10-year bonds, and two-year bond really has been backing off. I think that backed off, quickly 140 to 160 basis points over three or four trading days, as well. And what that's really telling me is that, as that credit curve, essentially the difference between the two-year and 10-year, starts to come in--usually it's about 200 basis points from two-year bonds to 10-year bonds--that's inside a 100 basis points. I think, it got as tight as about 90. What that does, is that indicates to me that the market is pricing in a much higher probability of default in the short term as opposed to long term. That's what we call jump-to-default risk.
Glaser: So what's driving that? What do we know about Spain now, or what is the market worrying about Spain now, that it wasn't two or three weeks ago?
Sekera: Well, there are a couple of different things going on. One, we do have the bank bailout, and it's still very unclear exactly how that program is going to work out or where that money is going to come in at the end of the day. Is it coming in as equity? Is it coming in as loans? Does the government of Spain have to back it up or not? So we still have to get clarity exactly how that's going to work.
Now, in addition to that we've also seen several regions within Spain now have to say that they can't get financing themselves so they've been going to the kingdom of Spain, looking for their own mini-bailouts from the country that needs a bailout in and of itself. So it's really been kind of the circular problem that's been getting worse and worse, and we're waiting to try and find out what can the eurozone really do to try and quantify the risk and really be able to end it here in the near term.
Glaser: Whenever there's a discussion of Spanish debt, Italy is never far behind. Is Italy getting dragged into this, as well, or is that country in better shape?
Sekera: It's not that Italy is in better shape, but I think the problems in Italy are different than what we're seeing in Spain. Spain's debt/gross domestic product ratio is probably around 72% right now, I believe. It's probably going to 82% by the end of the year, whereas Italy's debt/GDP is significantly higher around 122%. However, with Spain, what we are really concerned about is whether or not the government has to back up the banks. If [the government does] that, the GDP then starts to skyrocket. Instead of being 72% going to 80%, that 80% goes to 90%-plus.
Plus then, as analysts, we can't really look at and understand, well, where is it going to top out. At least with Italy, while its debt/GDP is way too high right now, we are not seeing these huge jumps where it has the same kind of deficits, has the same kind of problems in its banking system that we are seeing in Spain.
Glaser: So, it sounds like Italy might be a little better off there. In terms of policy of trying to stop these yields from going ever higher, in particular in Spain, you mentioned the bank bailout, there's been talk of creating a closer fiscal union. Can any of these be successful? Is there any way to really bring this crisis in, or has that train already left the station?
Sekera: Well, there are three things that I see that's really going on in Europe, and all of them are very interrelated to one another. So the first problem is the liquidity. So for example in Spain we are seeing a lot of depositors take their money out of the Spanish banks, and they are moving them into the core banks, such as in Germany and so forth. So you have these liquidity issues where the banks are losing their deposits, yet the banks don't have the access to the capital markets in order to be able to raise the cash to pay off those deposits. So therefore they are having to go and use collateral, and pledge that to the central bank in order to get those loans.
Now, we also have imbalances between the Spanish central bank and the German central bank as all of that money is coming out of one country, Spain, and going into Germany. So we have these liquidity issues that are going on and know that the Spanish banks need this money to pay off those deposits, but yet they are running out of the collateral to be able to do so.
Second, we just have the overindebted nature of the sovereigns themselves. Plus, it's getting worse because those sovereigns now are having to back up these banks.
The third problem is that the banks themselves appear to be or many of them are insolvent, which is why we had to have this banking bailout in the first place.
So, in the short term, we need to be able to solve these liquidity issues and be able to make sure that the depositors are able to get their money out when they want to get it out and make sure that they're comfortable keeping the money in the banks in order to stop the run on the banks.
Then, you need to figure out well, how do we make sure that these banks remain solvent? How much capital do we have to put into these banks? And I think if [the governments] were able to maybe kind of try and cut off the problem with the banks, then we wouldn't be worried so much about the over indebted nature of the country and whether or not the country would be able to support the banking system.
At the end of the day, nothing is really going to get solved until someone has to take losses and fund those losses. That's really the crux of the issue to me as, who is going to take those losses, how are they going to run through the system, and how quickly are they going to be taken?
Glaser: So investors seem somewhat fearful of Spain and Italy. What's happening in the core countries like Germany?
Sekera: Well, we've seen some interesting things going on there. In fact, it's stuff I hadn't even seen in my experience, and I started off in the business, in 1991. In Germany we're seeing a negative yield curve out through the two-year bond. So essentially right now if you buy a two-year German bund you are locking in a negative 6-basis-point rate of return, and I've never seen that before. Maybe it was in some Treasury bills in the credit crisis here in the U.S., but not anywhere through that part of the curve. In fact, in Switzerland, the negative yields go all the way out until the five-year part of its curve.
There are a couple of things going on I think that investors are looking at. One, it is just definitely the safety and the flight to quality; people who are just afraid of taking any kind of loss of principal are going to the core countries where they know they are going to end up getting repaid at the end of the day.
Now Switzerland has pegged the Swiss franc to the euro, and the country has been defending that. I think a lot of people are buying the Swiss bonds, not necessarily, because they are willing to take the negative yield, but they're making the speculation or making the bet that Switzerland will end up relaxing that peg and let it appreciate. So they will be able to make money back through the difference in the foreign exchange movement.
I think you're also looking at kind of a disaster scenario with the German bunds, where some investors are betting that maybe Germany is the one that ends up leaving the eurozone. If it were to leave the eurozone and go back to the deutschemark, then if those bonds are redenominated in deutschemark, they would appreciate significantly versus the euro.
Glaser: Certainly sitting here in United States we worry about how what's going on in Europe is going to affect, let's say, corporate bond investors or other fixed-income investors in the U.S. What transmission mechanism is there between Europe and the United States, and would you expect to see any dislocations in the U.S. market?
Sekera: Well, right now what we are seeing is that, it appears that we're going into a recession over in Europe and whether or not that's going to then impact here in the United States, our own economy. It will to some degree. But Bob Johnson, our director of economic research, has talked about that the amount of exports to Europe from the United States is a relatively minor part of our entire GDP.
Will there be an impact to it? Yes, there will. But it won't be as bad as many people think it might be. Now on the corporate credit side, what we are seeing is that corporate credit spreads are starting to widen out in Europe. Now, I've always had a preference at least since May 2010, kind of when this really started, to stick with the U.S. corporate bonds over European corporate bonds because what's going to happen--and we kind of saw this during the credit crisis--is there's going to be contagion.
So within Europe, as people are starting to get more and more concerned about the recession, they then get more concerned that the probability of default risk will increase over in Europe. Then bonds over there--rated BBB, single A, and so forth--will widen in order to capture that heightened probability of default risk. Well then investors who can look at both U.S. and European bonds will start seeing the wider spreads that they can get for a single-A bond in Europe versus a single-A bond in the U.S. and at some point there will be a natural arbitrage where they can then sell the U.S. bonds and pick up the spread in the European bonds.
Then that would technically end up pushing some of the spreads wider in the U.S. So while spreads in the U.S. would go wider with the European spreads, I don't think that they would go as wide as quickly and as far as we would see in Europe.
Glaser: Dave, it sounds like this is something that will not be solved quickly. Thanks for your update.
Sekera: You're quite welcome.
Glaser: For Morningstar, I'm Jeremy Glaser.