by Rom Badilla, CFA – Bondsquawk.com
June 4, 2010
The European Central Bank released a 225 page Financial Stability Review several days ago covering the situation across the Atlantic. In its review, the ECB mentions various channels that have the potential for a “spillover” of sovereign credit risk to the corporate bond markets which in turn would lead to higher borrowing costs. Here I summarized the review as well as added some noteworthy charts that may raise some eyebrows.
The first channel is that deteriorating credit amid rising public debt by sovereign countries will result in higher sovereign bond yields which will pressure and “crowd-out” addressing financing needs for the private sector.
The second channel is excessive fiscal deficits could lead to higher actual inflation and/or inflation expectations. This would again lead to higher interest rates, in particular yields on the long end of the curve. Furthermore, the review states that some models of credit risk, predict wider credit spreads after periods of lower interest rates. In any event and whether its inflation or credit risk, the absolute level of borrowing costs will rise for companies.
The third channel is the direct link between higher government bond yields and “potentially higher risk premia embedded in corporate funding costs” due to the way corporate bonds and CDS are priced. In other words, if government yields increase, corporate spreads increase with it which implies worsening credit. This is evident as the review, through the use of regression analysis, mentions that a 100 basis point rise in government yields, corporate bond yields as a whole increase an additional 10-20 basis points.
The fourth channel which in my opinion is one of the most significant since it can send ripples across the system, is the fact that financial companies and banks whose residence is in a country with large amounts of debt, are “typically large holders of government debt”. So if sovereign bond yields rise, banks would be impaired in their activity due to declines in the market value of their portfolio.
Furthermore, the review states:
To put this into perspective, around 50% of the stock of long-term debt securities issued by euro area governments is held by euro area banks, some of which also have sizeable lending exposures to governments.
Worsening sovereign financial problems would thus have a potentially large adverse impact on the euro area banking sector, and would thereby also imply further adverse consequences for the real economy.
According to the Merrill Lynch family of bond indices, the total tally of long-term debt claims (maturity greater than 10 years) of the peripheral countries of Portugal, Ireland, Italy, Greece, and Spain is around 400 billion euros. All are experiencing higher yields and declining prices as of late despite the announcement of ECB intervention on May 9.
The yield on 30-Year Greece bonds has increased 73 basis points to 8.30 from recent lows.
30-Year Greece Bond Yields Historical Chart
Spanish 30-Year bonds have surpassed their pre-intervention highs due to Fitch’s recent downgrade. The yield on Spain’s Long Bond is at 5.52 percent, a spike of 54 basis points from post intervention lows.
30-Year Spain Bond Yields Historical Chart
Portugal 30-Year is higher by 44 basis points from the recent lows to currently yield 5.57 percent.
30-Year Portugal Bond Yields Historical Chart
The fifth and final is the “credit rating spillover channel.” Since credit rating agencies use CDS spread data to back into and arrive at an “implied default rate”, wider CDS spreads in relation to its corporate bond counterpart is a major red flag for some credit agencies. Meaning if market participants are buying default protection via CDS on a company which leads to wider spreads while bond holders of that same company are not selling, something may be wrong with the credit. Furthermore, corporate CDS spreads could spike as sovereign CDS spreads widen since many banks were bailed out by euro area governments which in turn increased the interdependency between the two. As a result, this divergence between CDS and their bond counterparts may lead to a credit review. Regardless of the review leading to an actual change in the credit rating, the uncertainty will ultimately lead to less support and higher borrowing costs.
Basis Point Differential between Spain 5-Year CDS & 5-Year Bonds
After all that is said and done, these channels could lead to higher bond yields due to escalating fiscal deficits. Higher public debt negatively affects corporations which could undermine economic growth and stability in the financial system. An unwanted and negative “feedback loop” would be created as the response would most likely be more fiscal spending.
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Spillover in Europe
by Rom Badilla, CFA – Bondsquawk.com
June 4, 2010
The European Central Bank released a 225 page Financial Stability Review several days ago covering the situation across the Atlantic. In its review, the ECB mentions various channels that have the potential for a “spillover” of sovereign credit risk to the corporate bond markets which in turn would lead to higher borrowing costs. Here I summarized the review as well as added some noteworthy charts that may raise some eyebrows.
The first channel is that deteriorating credit amid rising public debt by sovereign countries will result in higher sovereign bond yields which will pressure and “crowd-out” addressing financing needs for the private sector.
The second channel is excessive fiscal deficits could lead to higher actual inflation and/or inflation expectations. This would again lead to higher interest rates, in particular yields on the long end of the curve. Furthermore, the review states that some models of credit risk, predict wider credit spreads after periods of lower interest rates. In any event and whether its inflation or credit risk, the absolute level of borrowing costs will rise for companies.
The third channel is the direct link between higher government bond yields and “potentially higher risk premia embedded in corporate funding costs” due to the way corporate bonds and CDS are priced. In other words, if government yields increase, corporate spreads increase with it which implies worsening credit. This is evident as the review, through the use of regression analysis, mentions that a 100 basis point rise in government yields, corporate bond yields as a whole increase an additional 10-20 basis points.
The fourth channel which in my opinion is one of the most significant since it can send ripples across the system, is the fact that financial companies and banks whose residence is in a country with large amounts of debt, are “typically large holders of government debt”. So if sovereign bond yields rise, banks would be impaired in their activity due to declines in the market value of their portfolio.
Furthermore, the review states:
According to the Merrill Lynch family of bond indices, the total tally of long-term debt claims (maturity greater than 10 years) of the peripheral countries of Portugal, Ireland, Italy, Greece, and Spain is around 400 billion euros. All are experiencing higher yields and declining prices as of late despite the announcement of ECB intervention on May 9.
The yield on 30-Year Greece bonds has increased 73 basis points to 8.30 from recent lows.
30-Year Greece Bond Yields Historical Chart
Spanish 30-Year bonds have surpassed their pre-intervention highs due to Fitch’s recent downgrade. The yield on Spain’s Long Bond is at 5.52 percent, a spike of 54 basis points from post intervention lows.
30-Year Spain Bond Yields Historical Chart
Portugal 30-Year is higher by 44 basis points from the recent lows to currently yield 5.57 percent.
30-Year Portugal Bond Yields Historical Chart
The fifth and final is the “credit rating spillover channel.” Since credit rating agencies use CDS spread data to back into and arrive at an “implied default rate”, wider CDS spreads in relation to its corporate bond counterpart is a major red flag for some credit agencies. Meaning if market participants are buying default protection via CDS on a company which leads to wider spreads while bond holders of that same company are not selling, something may be wrong with the credit. Furthermore, corporate CDS spreads could spike as sovereign CDS spreads widen since many banks were bailed out by euro area governments which in turn increased the interdependency between the two. As a result, this divergence between CDS and their bond counterparts may lead to a credit review. Regardless of the review leading to an actual change in the credit rating, the uncertainty will ultimately lead to less support and higher borrowing costs.
Basis Point Differential between Spain 5-Year CDS & 5-Year Bonds
After all that is said and done, these channels could lead to higher bond yields due to escalating fiscal deficits. Higher public debt negatively affects corporations which could undermine economic growth and stability in the financial system. An unwanted and negative “feedback loop” would be created as the response would most likely be more fiscal spending.