An Update on Yesterday's Spanish Bond Sale

(Globe and Mail Business)
Spain can still sell bonds. That’s the good news from the Iberian front. The bad news is that it had to pay a hefty premium to push its new debt out the door, reinforcing the fear that European debt crisis will not politely excuse itself for the holidays.

The Spanish treasury sold €2.4-billion of 10-year and 15-years bonds, substantially less than the €3-billion it had hoped for. Investors demanded a yield of 5.45 per cent on the 10-year bonds, up from 4.62 per cent yield on a similar sale only last month. The treasury had to pay 5.95 per cent to unload the smaller 15-year bond issue, up from 4.54 per cent in October.

The fat premium paid by Spain will not be lost on the leaders attending the European Union summit in Brussels, the seventh this year, on how to design a permanent bailout mechanism for countries that cannot roll over their debt. While Spain is no Greece or Ireland, the two countries that sought bailouts from the EU and the International Monetary Fund this year, its ailing economy -- the unemployment rate is 20 per cent -- and plump budget deficit mean a bailout is not unthinkable. Spain is the euro zone’s fourth-largest economy, after Germany, France and Italy. In other words, a Spanish rescue mission might be unaffordable.

Higher yields on the Spanish bonds was expected, because earlier this week Moody’s said it may lower the country’s rating only three months after the previous downgrade. Moody’s said Spain’s central and regional governments, and banks will collectively require €290-billion in financing in 2011, leaving the country “susceptible to further episodes of funding stress.”

The currency markets took Spain’s expensive new debt in stride. The euro rose modestly Thursday morning, bolstered by stronger euro area manufacturing data, driven by Germany, and an inflation report that met expectations.

One of the big questions overhanging the future intensity of Spain’s debt pain is the Spanish banks' appetite for Madrid’s bonds. The banks so far have been fairly reliable buyers of Spanish debt. But between June and October, they lowered their holdings of Spanish government debt by 15 per cent, to €132-billion. That puts their share of Spain’s debt at 26 per cent, down from 33 per cent.

How to interpret this news? The charitable explanation is that the banks’ lower rate of bond purchases constitutes an unexceptional portfolio tweaking while giving them more room to load up on government bonds in the future. The ominous interpretation is that the banks think the bonds are getting too risky. If they go on a buyers’ strike, Spanish bond yields could keep rising next year.