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Credit Insights

Are EU Periphery Debt Problems Spreading Inward?

Greek bonds are pricing in a near-term default, while French financials are in the hot seat.

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Get your game plan for the fireworks ready. The bond market is telling you loud and clear that it expects Greece will default in the near term. Greek one-year bonds have dropped precipitously during the past week, falling approximately 10 points (20 points since the end of July) to about 57 cents on the euro, which is only 10 cents higher than where the 6.25% notes 2020 are trading. At these levels, the bonds are trading toward an assumed recovery value. With the price level between short-dated and long-dated bonds collapsing toward one another, the credit market is rapidly pricing in an increasing probability of default within a year.

Credit spreads among sovereigns and European banks widened out across the board in sympathy. Of particular concern, Italian five-year credit default swaps widened out to new highs early in the week. The decline in the bonds came as the Italian government had been diluting the austerity measures it proposed in August, when the ECB had announced it would purchase Italian bonds in the secondary market and stabilize interest rates. Irish and Portuguese credit spreads also gapped out 50 to 100 basis points (although they are still tighter than their 52-week highs). Italian bonds did recover some of their losses by the end of the week after the government passed additional austerity measures.

David Sekera does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.