High PIIGS sovereign spreads – opportunity?

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The sovereign risk of Greece as measured by the yield spread between the yield on 10-year government bonds between Greece and Germany sky-rocketed from 200 basis points to the current 584 basis points as the debt crisis in Greece unfolded.

The Greek government on Sunday approved an economic and financial adjustment plan in terms of which it would receive 110 billion euros from the European Union and the IMF. Yesterday, the European Central Bank (ECB) suspended until further notice the application of the minimum credit rating threshold of all outstanding and new marketable debt instruments by the Greek government.

The current situation is reminiscent of the situation in Ireland last year when a serious deterioration in public finances came to the fore with the budget deficit rising from a predicted 2% to 6%. Even worse, debt amounting to more than 100% of the Irish GDP needs to be refinanced by 2012, with the bulk of it in 2011. The Irish government had no other choice than to impose draconian austerity measures along similar lines to those included in the approved economic and financial adjustment plan for Greece.

The suspension of minimum credit rating thresholds must be good news for the Greek bond market as further issuance of debt instruments by the Greek government is likely to be absorbed by other countries in the eurozone. Let us take our cue from what happened with the yield on Irish government notes.

After reaching a high of 264 basis points above German 10-year government notes, the spread between Irish and German bonds declined by 165 basis points in the first two months after the austerity measures had been announced. Thereafter it declined gradually and settled in the 160 basis point range.

Yes, the situation in Greece is more severe but the question is whether it warrants a spread of more than three times that of Ireland. I do not think so. While it is unlikely that the gap between Greek bonds and Irish bonds will summarily close, I am of the opinion that we may retrace to a 300 basis point spread against German bonds.

Source: Plexus Asset Management (based on data from I-Net Bridge)

Other bond markets in troubled countries in the eurozone such as Ireland and Portugal may also find comfort in the ECB’s action. However, be wary of Belgian bonds. According to the CIA Belgium’s public debt to GDP  ratio is the second worst after Greece in the eurozone, while Standard & Poor shows the country has the eurozone’s highest 2010 debt rollover ratio. Does that warrant a bond yield spread of only 45 basis points above German 10-year bonds? I think not.

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3 comments to High PIIGS sovereign spreads – opportunity?

  • I hope that international investors don’t find out this Wikipedia page
    When will S&P lower rating for the USA and especially the UK?

    Ecotretas

  • jmh

    Yes- but what happens if constitutional challenges and/or German voters derail Germany’s (essential) contribution to the ‘bailout’?
    In my view the interest differential might shrink somewhat, but the proposed trade looks very risky to me.

  • Frank W

    I could be wrong, but your estimate of a contraction to a 300 point differential may well turn out to be conservative. Financial markets are wonderful at exaggerating crises.

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