Thursday, 14 July 2011 - 20:00

 

Charts

European Debt Crisis

The European sovereign debt crisis, which started in late 2009, has continued almost unabated as it moves from one European country to another.

The problems in Portugal, Spain, Ireland, Greece, and now also Italy weigh heavily on the European Union as a whole. At its most basic level, the issue is one of public debt levels that are not sustainable, with ongoing and rising budget deficits adding to the overall debt levels.

In May 2010, the European Financial Stability Facility was created, which is essentially a rescue package operation of around EUR 440 billion, with the aim to try and ensure a degree of stability across Europe.

Initial rescue packages aimed at providing states with the ability to roll over debt as it matures have been agreed with Greece, Ireland, and Portugal, but these negotiations are ongoing.

These European countries were able to borrow at low rates of interest after the introduction of the Euro. This in turn allowed their economies to perform well on the back of them taking on greater and greater levels of debt. But now it is payback time for the debtor nations.

The European Financial Stability Facility was put in place in May 2010, aimed at preserving financial stability through providing financial assistance to struggling Eurozone states. It is going to be replaced by the more permanent crisis mechanism, the European Stability Mechanism (ESM), which is expected to come into force in early to mid-2013.

Government bonds
A government bond is a bond issued by a national government denominated in the country's own currency. Bonds issued by national governments in foreign currencies are normally referred to as sovereign bonds. Bonds issued by governments are usually referred to as risk-free bonds, because the government can raise taxes to redeem the bond at maturity. For a foreign investor or indeed where a government issues a bond in a currency other than its own, there is the currency risk.

In addition to the currency risk is the risk of inflation. At a bond’s maturity, the purchasing power of the principal repaid is often likely to be less than the original investment. A bond is a debt instrument, where the issuer owes the holders the principal at a defined maturity date as well as interest or coupon payments on pre agreed dates, typically every 6 months.

In essence then a bond is nothing more than a loan, where the issuer – normally a government – is the debtor and the lenders are a variety of creditors.

Sovereign bond spreads
Sovereign-bond spreads is the extra interest rate of one bond compared with bonds issued by another country. In the case of the Eurozone, Germany is considered the safest credit.

The Eurozone debt problem:
The map below gives an indication of the problem countries. Greece has a debt to GDP ratio of 143% - some indications are that it’s close to 160%, Italy’s debt runs at 119%, Ireland at 96%, and Portugal at 93%.

Debt to GDP: Euro Map

Source: Economist

The chart below gives an indication of the debt of some of the major economies by way of comparison. Japan is by far the highest. It has however managed to continue to roll over debt as it matures because the bulk is yen denominated. By way of comparison, South Africa is running with a ratio of 40%.

Government debt to GDP: major economies

Greece
For over 10 years from 1998 to 2011 the yield on Greece’s 10 year government bond averaged 5,3%, reaching a record low of 3,2% in September 2005. But in 2011 it spiked up to 16,9% in June. It is currently trading at around 16,7%.

Source: tradingeconomics.com

The spike in yields is a clear reflection of the problems facing this economy. Politicians seem to be divided as to how to deal. Up until now it’s been a matter of kicking the problem down the road, extending some life-saving credit in return for some budgets austerity measures. But there is also growing dissatisfaction, especially from the camp that have to pay up for Greece’s profligate spending and low tax collections.

It is increasingly looking like holders of debt are going to have to realise a knock on their capital.

Italy
Italy's Government Bond Yield for 10 Year Notes rallied 122 basis points during the last 12 months. From 1993 until 2011 Italy's Government Bond Yield for 10 Year Notes averaged 5.9 percent reaching an historical high of 13.7 percent in March of 1995 and a record low of 3.2 percent in September of 2005.

Yesterday, however, Italy issued treasury bills for the first time since borrowing costs started blowing out – they came to the market looking for 6,75 billion euros. The spread above the German bonds moved up to 3,27% and the yields traded at over 6% for the first time since 1997.

The extent of the selloff can be clearly seen from the chart below, where yields had been trading around 5%. The 6% level has been highlighted.

Source: tradingeconomics.com

Portugal
From 1997 until 2011 Portugal's Government Bond Yield for 10 Year Notes averaged 4.7 percent reaching an historical high of 12.9 percent in July of 2011 and a record low of 3.2 percent in September of 2005.

The country saw the downgrade of its credit rating on government debt 4 notches to junk status by Moody rating agency last week. This had an immediate impact on the cost of funding for both government and corporates.

The chart below reflects the spike in the yields on 10 year bonds. These yields moved up to 14,4% or a massive 10,7% above German bond yields.

Source: tradingeconomics.com

Ireland
In a very similar way, yields traded at low levels throughout the decade, reaching a low of 3,1% in September 2005. However the crises saw yields jump up massively.

Source: tradingeconomics.com

Defaults
The spikes in the yields, the ongoing talks and wrangling about debt bailouts for these countries and the rating downgrades, all point to a high possibility of actual defaults on the debts.

Bonds as an investment
Traditional investment portfolio theory has advocated the inclusion of bonds in a portfolio. Bonds have different risk and return characteristics compared to other investors such as equities, which has made them attractive additions to a balanced portfolio. However as with all investments, the recent past can never be extrapolated into the future as a given. The charts above reflect the fact that for many years while yields remain fairly steady, bonds gave the appearance of a low risk investment. As the risks however materialised and yields spiked to a truer pricing level, so holders of these bonds have and continue to sustain massive losses.

With the yields at 12-16% there may now be an argument that these bonds represent value. This may well be the case, but we would not be advising an increase in exposure, because it is not that clear that there is true value. In general we continue to advocate a minimal exposure to global bonds.

Kind regards,

Ian de Lange
info@seedinvestments.co.za
www.seedinvestments.co.za
021 9144 966

Thu, 14 Jul 2011

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