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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.
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
The Eurozone debt problem:
Debt to GDP: Euro Map
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
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.
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.
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.
Bonds as an investment
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.
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