Credit-default swaps are a better gauge of euro region creditworthiness than bonds as the European Central Bank’s 74 billion euros ($98 billion) of debt purchases make investors skeptical about what is driving spreads narrower.
The cost of insuring Portuguese debt against default surged to a record on Jan. 10 on speculation that Germany and France would force the country to seek aid. By contrast, the yield spread between 10-year Portuguese debt and German bonds shrank by the most in a month. Credit-default swaps on Irish debt are almost 4 percent more expensive than before the nation accepted a bailout in November, while the yield premium investors demand to own its 10-year securities instead of similar-maturity German debt has declined by 18 percent.
“When yield spreads narrowed because of an intervention from the ECB while credit-default swaps blew out, our conclusion is that the worst is far from over,” said Stuart Thomson, who helps manage $110 billion at Ignis Asset Management in Glasgow. “The credit-default swaps have become increasingly important.”
The ECB began buying peripheral bonds on May 10 to stabilize markets rocked by the region’s sovereign-debt crisis. The central bank has so far bought Greek, Irish and Portuguese government securities, and nothing from Spain or Italy, according to traders with knowledge of the transactions who declined to be identified because the deals are confidential.
‘Better Proxy’
“The tightening of the spreads doesn’t change our view that this remains a risky market as long as there are no medium- or longer-term solutions to the debt problem,” said Richard Batty, a global strategist at Standard Life Investments in Edinburgh, which manages about $175 billion. “CDS is perhaps a better proxy. The problem with the cash market is that it can be so illiquid, especially during the crisis.”
Europe’s sovereign debt crisis came to a head in 2009 after Greece’s newly elected socialist government said the budget deficit was twice as big as the previous leadership had disclosed. The sell-off of euro peripheral bonds accelerated in November when Ireland joined Greece in seeking a bailout.
European finance chiefs started meeting yesterday to revamp their debt-crisis-fighting strategy, with Germany easing its opposition to an expanded rescue fund and Portugal insisting it will get by without an aid package. Policy makers may discuss cutting the interest rate charged for emergency funds.
‘Long-Term’ Support
Portugal raised 599 million euros from a sale of 10-year bonds on Jan. 12, with borrowing costs dropping to 6.72 percent from 6.81 percent. Ten-year yields dropped ahead of the auction after the ECB bought bonds during the two previous days, while People’s Bank of China Deputy Governor Yi Gang said his nation is a “long-term” investor in Europe. Deutsche Bank AG, Germany’s largest bank, recommends that investors refrain from betting that the gap between German yields and those of its more indebted euro neighbours will narrow further.
ECB council member Athanasios Orphanides said yesterday that the ECB may be able to stop buying government bonds if Europe’s rescue fund is empowered to purchase debt.
“That won’t change anything,” said David Schnautz, a fixed-income strategist at Commerzbank AG in London. “The underlying problem won’t go away as it only offers an artificial and short-term solution. The only benefit would be to allow the ECB to focus on its monetary policy mandate.”
The premium for holding 10-year Greek bonds instead of bunds declined 17 percent since the start of the year, while the cost investors pay to protect their bondholdings in the event of Greece defaulting dropped 11 percent during the same period.
Market Distortions
“Some people argue that the ECB’s bond purchases are effectively subsidising the cost of a country’s borrowing and, from that perspective, are distorting the market,” said Pavan Wadhwa, the head of global interest-rate strategy at JPMorgan Chase & Co. in London. “But, given the situation they are in, they don’t have much of a choice. The bottom line here is that these countries will need low and sustainable borrowing costs, whether through ECB buying in the secondary market or through the bailout facility.”
Wadhwa said policy makers could cut the rate on emergency loans that are provided by the European Financial Stability Facility to the equivalent of 100 basis points more than three- month money-market rates. Ireland, for example, is currently paying 5.8 percent for its aid, a premium of almost 480 basis points to money-market levels.
“Unless something is done on a longer-term basis to significantly reduce the cost of funding, these countries will have a difficult time achieving debt sustainability,” said Wadhwa.
To contact the writer of this story: Anchalee Worrachate in London at aworrachate@bloomberg.net
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