Sovereign credit risk to remain in the spotlight?
Mon, Mar 8 2010, 10:31 GMT
by Trevor Williams
The travails of Ireland and, more recently, Greece have turned the spotlight back on the sovereign credit markets. Since November last year, sovereign credit spreads in Greece have widened sharply amid growing fears that the country’s fiscal problems could precipitate a prolonged economic stagnation or a sovereign default. It is not only Greece, however, that has been affected. Fears of contagion have pushed the spreads of other countries higher, particularly those perceived to have weak fiscal positions. In this weekly we look at some of the main measures of sovereign credit risk and assess what they imply for country default in 2010.
Government bond spreads
For countries which share the same currency, such as members of the Euro-zone, the easiest way of measuring sovereign credit risk is to assess the cost of each country’s government borrowing in relation to a benchmark - namely Germany (widely seen as the anchor for inflation expectations). Chart a shows the evolution of 10- yr spreads over German bunds since 2005 for a select group of Euro-zone countries. Perhaps not surprisingly, the under-performance of Greece and Ireland has been marked. With 10-yr German bunds currently yielding 3.1%, the spread indicates that Greece is having to pay over twice as much as Germany for 10-year euro-denominated debt.
While comparisons of sovereign bond spreads provide an accurate assessment of credit risk within the Euro-zone, they cannot be accurately applied to countries that have their own currency. This is because the prevailing level of short-term interest rates also has a key bearing on the level of government bond yields. Abstracting from credit and liquidity issues, a 10-year government bond yield can, broadly speaking, be considered to be the market’s best guess of what the official shortterm policy rate is likely to average over the life of the bond. For countries that have independent currencies and so different inflation targets (either implicit or explicit), the expected evolution of the short-term policy rate is likely to be very different.
OIS-adjusted spreads
In order to adjust for this, a better way of looking at sovereign credit spreads is on a swap-adjusted basis. This gives an indication of the credit risk relative to either three-month Libor or, more appropriately, the overnight index swap rate (OIS)
Chart b shows the OIS-adjusted sovereign credit spreads for a selection of countries. Although OIS rates fluctuate in response to changes in liquidity conditions in the wholesale market, the OISadjusted spread is, we believe, the cleanest measure of sovereign credit risk available. As the chart shows, spreads for all these countries have widened since early 2008. Since the start of the year, however, the sovereign credit premia of Greece and the UK have risen the most. Nevertheless, UK spreads are not out of line with Germany or the US, despite popular belief. On this measure, the real risk is, indeed, Greece and Ireland.
CDS spreads
There is another measure of sovereign credit risk which has received a high degree of publicity in the recent past - namely, sovereign credit default swaps (CDS). Sovereign CDS spreads measure the annual premium payable to protect against a sovereign default. For example, a spread of 100bp value of $10m would cost $100k per annum - implying a probability of default over 5 years of 5%. Chart c shows how various sovereign CDS spreads have moved since September 2008. Not surprisingly, those countries that have experienced a widening in their bond spreads have also seen their CDS spreads move higher.
While useful as a gauge, CDS data should be treated with caution. Firstly, because they are relatively illiquid, they can easily be distorted by sudden bouts of speculative pressure (as has already been the case in a number of markets). Second, CDS are used for purposes other than default protection. For example, an asset manager that has an overweight position in a region can rebalance a portfolio by buying the region’s sovereign CDS, without needing to sell the underlying assets. Thus, market activity may have little to do with the underlying perception of default, but still move the price significantly.
Investment-grade bonds outperform
While sovereign credit premia have risen, interestingly this has not been reflected in nonsovereign credit spreads: AAA investment-grade spreads have narrowed sharply (see chart d). In the sterling markets, the reduction in investment grade spreads has been accentuated by corporate bond purchases by the BoE as part of its asset purchase programme. Taken at face value, the reduction in the spreads of blue-chip companies like Unilever, 3i and Tesco suggests the market now views these names to be nearly as safe as the sovereign credit that underpins them. This calls into question whether the widening in sovereign spreads is really justified.
What is the outlook for sovereign risk?
Over the coming months, ongoing uncertainty about the economic and fiscal outlook risks putting further upward pressure on sovereign credit spreads, particularly those countries where public sector indebtedness is under the microscope. While there is a possibility that Greece could default if its fiscal austerity programme is unsuccessful, good demand for last week’s 10-yr bond offering suggests the market still has an appetite for Greek debt, albeit at a price.
In the UK, credit spreads have widened but they remain well below the peripheral highly indebted countries of Europe. Indeed, the probability of a UK sovereign default remains negligible. Firstly, the size and dynamics of the UK are very different to Greece. Secondly, although the UK’s budget deficit is at record high ( close to 13% of GDP), the level of public sector debt is no worse than in many of the other major economies. Third, the average duration of UK government debt is far longer than most other countries; thus the UK is not exposed to significant roll-over risk.
Lastly, and perhaps more importantly, in contrast to Greece, the UK can, in theory, in a worse case scenario resort to eroding the real value of its debt through debasing its currency. Given the long-term cost to economic stability, we suspect this would only ever be considered as a last resort. Nevertheless, it underscores the point that sovereign credit spreads on countries with independent monetary policies are more a reflection of their perceived volatility than they are about the sovereign’s true probability of default. to Greece, the UK can, in theory, in a worse case scenario resort to eroding the real value of its debt through debasing its currency. Given the long-term cost to economic stability, we suspect this would only ever be considered as a last resort. Nevertheless, it underscores the point that sovereign credit spreads on countries with independent monetary policies are more a reflection of their perceived volatility than they are about the sovereign’s true probability of default.
