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By Jeremy Glaser and Dave Sekera, CFA | 07-25-2012 04:30 PM

Round and Round Go Europe's Debt Problems

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.

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