Global Investing

The (CDS) cost of being in the euro

What’s the damage from being a member of the euro? German credit default swaps, used to insure risk, have spiralled to record highs over 130 basis points, three times the level of a year ago amid the escalating brouhaha over Spain’s banks and Greek elections. U.S. CDS meanwhile remain around 45 bps. That means it costs 45,000 to insure $10 million worth of U.S. investments for five years, compared to $135,000 for Germany. (click the graphics to enlarge)

A smaller but similarly interesting anomaly can be found in central Europe. Take close neighbours, the Czech and Slovak Republics who are so similar they were once the same country. Both have small open  economies, reliant on producing goods for export to Germany.

The difference is that Slovakia joined the euro in 2009.

Back then, with the world grappling with the fallout from the Lehman crisis, Slovakia appeared at a distinct advantage versus the Czech Republic. At the height of the crisis in February 2009, Czech 5-year CDS exploded to 300 bps, well above Slovakia’s levels. But slowly that premium has eroded. A year ago CDS for both countries were quoted at similar levels of around 70 bps.  Now the Czech CDS are quoted at 125 bps, having risen along with everything else, but Slovak CDS have jumped to 250 bps, data from Markit shows. (bonds have not reacted in the same manner — Slovak 1-year debt still yields around 0.8 percent versus 1.4 percent for the Czech Republic; similarly German yields have fallen to zero; for an explanation see here).

According to Benoit Anne, head of emerging markets research at Societe Generale:

These days being outside the euro zone is better than being in it and being outside the European Union is better than being inside it. The Slovak market has suffered a huge cost from a market perspective because of its membership of the euro.

Argentine CDS spiral on “peso-fication” fear

Investors with exposure to Argentina will have been dismayed in recent weeks by the surging cost of insuring that investment — Argentine 5-year credit default swaps have risen more than 300 basis points since mid-May to the highest levels since 2009. That means one must stump up close to $1.5 million to insure $10 million worth of Argentine debt against default for a five year period, data from Markit shows.

The rise coincides with growing fears that President Cristina Fernandez Kirchner is getting ready to crack down on people’s dollar holdings. Fears of forcible de-dollarisation have sent Argentine savers scurrying to the banks to withdraw their hard currency and stash it under mattresses. That has widened the gap between the official and the “black market” exchange rate. (see the graphic below from Capital Economics)

While government officials have denied there is such a move afoot, Fernandez has not helped matters by exhorting people to “think in pesos”.  That will be hard for Argentines, most of whom have vivid memories of hyperinflation, default and devaluation. Unsurprisingly, most prefer to save in dollars. 

Three snapshots for Wednesday

On Friday 283 companies in the S&P 500 had a dividend yield higher than the 10-year Treasury yield, at yesterday’s close this had fallen to 266 but remains very high compared to the last 5-years.

Italian consumer morale plunged to its lowest level on record in May as Italians’ pessimism over the state of the economy plumbed new depths.

Germany set a zero coupon on its new Schatz, the first time it has done so on debt of such maturity. The bid to cover ratio for the new bond at the auction was 1.7, compared with 1.8 at a sale of two-year debt on April 18.

Three snapshots for Thursday

Fears that Athens is on the brink of crashing out of the euro zone and igniting a renewed financial crisis have rattled global markets and alarmed world leaders, with Greece set to figure high on the agenda at a G8 summit later this week. This chart shows the impact on assets since the Greek election:

Euro zone banks now account for only 8% of total euro zone market value – they were over over 20% of the market in 2007:

Japan’s economy rebounded in January-March from a lull in the previous quarter, shaking off the pain of a strong yen and Europe’s debt crisis on solid consumer spending and rebuilding from last year’s earthquake.

Three snapshots for Monday

The yield on 10-year  U.S. Treasuries, fell to their lowest levels since early October today, breaking decisively below 1.80 percent. That compares to the dividend yield on the S&P 500 of 2.28%.

The European Central Bank kept its government bond-buy programme in hibernation for the ninth week in a row last week. The ECB may come under pressure to act as  yields on Spanish 10-year government bonds rose further above 6% today.

Output at factories in the euro zone unexpectedly fell in March, the latest in a series of disappointing numbers signalling that the bloc’s recession may not be as mild as policymakers hope. On an annual basis, factory output dived 2.2 percent in March, the fourth consecutive monthly slide, Eurostat said, and only Germany, Slovenia and Slovakia were able to post growth in the month.

Research Radar: Greek gloom

Greek gloom dominates the start of the week as new elections there look inevitable and talk of Greek euro exit, or a Grexit” as common market parlance now has it, mounts. All risk assets and securities hinged on global growth have been hit, with China’s weekend reserve ratio easing doing little to offset gloomy data from world’s second biggest economy at the end of last week. World stocks are down heavily and emerging markets are underperforming; the euro has fallen to near 4-month lows below $1.29; safe haven core government debt is bid as euro peripheral debt yields in Italy and Spain push higher; and global growth bellwethers such as crude oil and the Australian dollar are down – the latter below parity against the US dollar for the first time in 5 months.

Financial research reports on Monday and over the weekend were just as gloomy, but plenty of interesting takes:

Bank of New York Mellon’s Simon Derrick’s view of the Greek political impasse concluded “there is at least an evens chance that the latter part of this summer will see what had officially been seen up until last November as an impossibility: a nation leaving the EUR.”

Not everyone is “risk off”

Who would have thought it. As fears over the euro zone’s fate, Chinese economic growth and Middle Eastern politics drive investors toward safe-haven U.S. and German bonds, some have apparently been going the other way.  According to JPMorgan, bonds from so-called frontier economies such as Pakistan, Belarus and Jordan (usually considered high-risk assets) have performed exceptionally well, doing far better in fact than their peers from mainstream emerging markets.  The following graphic from JPM which runs the NEXGEM sub-index of frontier debt, shows that returns on many of these bonds are running well into the double digits.

NEXGEM returns of 8.4 percent  are on par with the S&P 500, writes JPMorgan and outstrip all other emerging bond categories. Clearly one reason is the lack of correlation with the mainstream asset classes, many of which have been selling off for weeks amid growth fears and in the run up to French and Greek elections.  Second, investors who tend to buy these bonds usually have a pretty high risk-tolerance anyway as they keep their eyes on the double-digit yields they offer.

So year-to-date returns on Ivory Coast’s defaulted debt are running at over 40 percent on hopes that the country will resume payments on its $2.3 billion bond after June. The underperformer is Belize whose bonds suffered from a default scare at the start of the year.

South African bond rush

It’s been a great year so far for South African bonds. But can it get better?

Ever since Citi announced on April 16 that South African government bonds would join its World Government Bond Index (WGBI),  almost 20 billion rand (over $2.5 billion ) in foreign cash has flooded to the local debt markets in Johannesburg, bringing year-to-date inflows to over 37 billion rand. Last year’s total was 48 billion. Michael Grobler, bond analyst at Johannesburg-based brokerage Afrifocus Securities predicts total 2012 inflows at over 60 billion rand, surpassing the previous 56 billion rand record set in 2o1o:

The assumption..is based on the fact that South Africa will have a much larger and diversified investor base following inclusion in the WGBI expanding beyond the EM debt asset class

Emerging bond defaults on the rise, no surprise

As may be expected, the crisis has increased the risk of default by emerging market borrowers. According to estimates by ING Bank’s emerging bond guru David Spegel, the default rate on EM bonds is running at over $6 billion in the first four months of 2012, already surpassing the 2011 total of $4.3 billion. He  predicts another $1.3 billion of emerging defaults to come this year.

Spegel expects the default rate for speculative grade emerging corporates to rise to 3.25 percent by September, up from 3 percent at present.  That doesn’t look too bad, given defaults ran at 13 percent after the 2008 crisis and hit a record of over 30 percent in the 2001-2003 period. But ING data shows some $120 billion worth of corporate bonds trading at “distressed” or “stressed” levels, i.e. at spreads upwards of 700 basis points. The longer such wide spreads persist, the higher the probability of default. A worst case scenario  would see a 12.9 percent default rate by end-2012, Spegel says.

Many companies are having trouble rolling over maturing bonds (selling debt to pay off existing creditors). One reason might be the explosion in bond issuance this year. Data from Bank of America/Merrill Lynch shows bond sales by emerging borrowers, sovereign and corporate, totalled 14 billion in the first three months of the year, a quarter more than the same 2011 period.  Clearly everyone is rushing to raise cash before U.S. Treasury yields rise further. (see what we wrote on this a few months ago)

Three snapshots for Thursday

Weaker than expected economic data has pushed Citigroup’s G10 surprise indicator into negative territory. The indicator has tracked closely with the relative performance of equities vs bonds:

Italian business confidence fell unexpectedly to its lowest level in two and a half years on Thursday. Business confidence has historically given a good lead on GDP growth suggesting further weakness to come.

An update on currency moves against the dollar this year. Hungary tops the list, the EU opened the way to talks with Hungary on financial aid on Wednesday, ending a five-month dispute over the independence of its central bank. The UK pound and the euro remain positive for the year despite the UK falling back into recession and the continued euro zone crisis.