The real action in fixed income last week was in the sovereign debt markets as opposed to the domestic corporate bond market. For the week, the Morningstar Corporate Bond Index and the Morningstar Eurozone Bond Index were unchanged to slightly tighter. The corporate bond market sold off slightly at the beginning of the week, but recovered those losses by the end of the week.
The initial round of optimism following the announcement of the Spanish bank bailout quickly turned around after Italy successfully auctioned bonds and rumours surfaced that the G20 central banks were planning coordinated action if the situation in the eurozone deteriorated. Some investors still worried that the situation in Europe could spiral out of control; they flocked to the safety of US Treasuries, driving the yield on the 10-year down to 1.58%, only about 10 basis points off its all-time lows.
Contrary to the relative calm in the corporate bond market, Spanish and Italian bonds swung wildly. Watching the price action on these bonds reminded me more of trading junk bonds as opposed to (supposedly) investment-grade sovereign bonds. For example, on Tuesday the 10-year bonds of Spain and Italy gapped up more than 30 basis points wider intraday and then rallied back 10 basis points. Spanish bonds continued to widen the rest of the week and, after a slight tightening Friday afternoon, ended the week at 6.87%. Italian bonds recouped a significant amount of their losses after a successful bond auction Thursday and ended the week at 5.93%. Compared with the yields before the Spanish bank bailout, the yield on Spain's 10-year bond has risen 65 basis points and Italy's 10-year has risen 16 basis points.
Why Should Investors Care About Spanish Finances?
Many investors may ask, why do we care about Spain or that Spanish banks need to be bailed out?
In a nutshell, we believe that if Spain or its banking system defaults, the result will be a liquidity crisis in Europe. Depositors in Spain would realize losses, which would probably cause a run on the banks in other heavily indebted countries. The interbank system would seize up; European banks would not lend money to other European banks, as the bank run and losses would increase counterparty risk. This would lead to even greater economic deterioration than the eurozone is facing now. As liquidity freezes and the recessions deepen across the Continent, default risk would rise and credit spreads on corporate bonds would widen. This would inevitably have an impact on the UK and British markets.
Italian Bond Actions and Rumours of Coordinated Monetary Easing Soothe Markets' Nerves
Italy returned to the public markets Thursday and issued EUR 4.5 billion in bonds, consisting of EUR 3 billion of 3-year, EUR 627 million of 7-year, and EUR 873 million of 8-year debt. The market's focus was mainly on the strength of the 8-year auction. Italy sold the new 8-year bonds at a yield of 6.13%, which was slightly tighter than where the existing bonds were trading. Contrary to the Spanish bond auction, in which the bonds immediately fell out of the gate and never looked backed, the Italian 8-year bonds traded up in the secondary, resulting in a 1.8% gain for investors. The market is differentiating between the maladies affecting Spain and the prospects for Italy. Investors who bought Spanish bonds continued to take a pounding last week as those notes fell as low as 92 7/8, resulting in a loss of 5.8% since their auction.
Based on our calculation, we think the spread on Spanish bonds indicates a 30% probability of default over the next five years. However, the price of the bonds is not indicative of where a typical distressed debt bond would trade. For example, the 5.85% notes due 2022 are trading around 93. Based on the low recovery values that bondholders realized in the Greek bond exchange, we think the Spanish bonds have as much as 70 points of downside in a default scenario, whereas the upside is limited. At 6.87%, these bonds are trading at a spread of +544 basis points over German bonds. But considering the low yield on German bonds caused by investors seeking safety, we think the yield on German bonds would rise if the situation in Spain were to improve; investors would sell the safer German bonds to buy riskier assets. As the yield on the German bond rises, it could dampen any price appreciation in Spanish bonds. For example, if the spread were to compress to +300, but 100 basis points of that came from the German 10-year yield rising, the yield on the Spanish bonds would be 5.50%. A 5.50% yield would only represent a 10-point increase in the value of the bonds, nowhere near enough upside potential to offset the probability-weighted downside loss.
On Thursday morning after the Italian bond auction, several news outlets reported that the G20 was preparing for a global coordinated action following the Greek elections if needed. While some investors are keeping their fingers crossed that the rumour that the G20 nations are coordinating an easing plan is true, the UK announced a "funding for lending program." The intent is to support the British economy by providing £100 billion to cut bank funding costs in exchange for lending commitments that will in turn provide cheaper loans to retail and corporate customers. The program also activates an emergency six-month liquidity program to banks in the event that liquidity seizes up across the European continent in the wake of a Greek departure from the eurozone or a rapid deterioration in the Spanish situation.
Headlines on the Horizon
Now that the Greeks have gone back to the polls, the political parties will once again attempt to form a ruling coalition. We suspect there will be a lot of noise this week as the political parties use the media to frame their positions. It's also quite possible that this election will once again fail to reach a coalition and call into question the government's ability to negotiate further bailout financing with the European Union and force the country into default as the country's cash reserves are quickly dwindling.
Other near-term events that have the ability to significantly move the markets include the G20 meeting, which is wrapping up today in Mexico. The meeting is reportedly focusing on the EU's ability to recapitalize failing European banks. The Federal Open Market Committee is also meeting June 19-20. This meeting could prove to be a contentious debate between the hawks and doves. Economic metrics in the US have been weakening, but may not have deteriorated enough to warrant additional monetary policy adjustments.
