Is Germany Next? Investors Flee Madrid's CDS For Berlin

on May 24 2012 4:37 PM
Running of the Bulls 2011. Pamplona, Spain
Running of the Bulls 2011. Pamplona, Spain Reuters

Investors are making a flight to quality faster than a runner chased by a bull through the streets of Pamplona. Investors are increasingly looking for alternatives to credit-default swaps (CDS) on Spanish national debt and on Europe's primary CDS index and moving it to German CDs, a trend which indicates higher expectations that periphery nations will be unable to repay their debts and a lack of confidence in the political will of the economic union.

The cost of buying credit-default swaps, a kind of insurance to protect investors against the default of bond issuers, has been growing steadily in the last month for euro zone periphery nations like Spain. Similarly, investors are increasingly avoiding putting their money in broader CD indexes like Markit's iTraxx SovX Western Europe index because of a lack of confidence in the indexes' internal stability.

An increase in the spread on CDs, the cost to insure a bond, indicates that investors believe they are less likely to receive an eventual repayment of sovereign bond debt. In other words, the wider the spread, the more likely a default in the minds of investors.

The spread on Spain's five-year benchmark bond has increased 10.51 percent over the past month and 110.38 percent over the past year, according to data from Thomson Reuters. The cost to insure Spanish sovereign debt is now 543 basis points.

In comparison, the cost of insuring German sovereign debt, which investors see as being more stable, is substantially lower at just 100.5 basis points for the nation's five-year bond.

As the spread on sovereign CDS for countries like Spain increases, it indicates that investors are becoming increasingly less confident in the ability of that government to repay its debt, according to Jerry Tempelman, sovereign risk analyst for capital markets research at Moody's Analytics.

Investors may want to make a flight to quality and stop putting their money into CDS protection on the debt of Europe's periphery nations, according to Tempelman.

Investors are increasingly shying away from CDS on debt of European periphery nations like Spain, Portugal, Ireland and Italy. Markit's iTraxx SovX Western Europe index which encompasses CDS for 15 countries in Western Europe is being substantially avoided by traders because it includes the weaker periphery nations alongside countries like Germany, according to a recent report by the Wall Street Journal. The index has been left largely untouched, only trading an average of two days a week since the beginning of April.

The flight from the iTraxx SovX Western Europe index is driven by the same factors that are pushing investors away from CDS on individual periphery nations. The index is seen as having more risk from periphery nations than can effectively be offset by stronger nations, especially as a possible departure of Greece from the euro zone seems more likely.

Investors may want to put their money in safer places as the European financial system becomes more precarious, and they cannot do it using that index, Tempelman said. Instead, investors are looking to put their money directly into CDS on debt from stable nations like Germany.

Clearly spreads have widened out (for Spain), but they have for other countries. In general, the movement in the past year (of Spain's CDS spread), you'll see it in other European periphery nations, Tempelman said.

The uptick in CDS yields for Spain has been directly driven by policy factors at home.

Spain's fiscal condition has looked far more precarious than at the beginning of the year, said Dr. Viral Acharya, Professor of Economics at New York University's Stern School of Business' Department of Finance.

The fiscal risk of the Spanish government has only increased, Acharya said, following Spain's announcement on Wednesday of a €9 billion ($11 billion) bailout of its fourth largest bank, Bankia.

The greater the amount of debt taken on by the Spanish government, the less likely it is to be able to pay it all, a factor which drives the spread on CDS wider and sends investors scurrying to CDS for nations like Germany.

Such bailouts, however, are costly and run the risk of amounting to a 'Pyrrhic victory,' for the sovereigns. First, bailouts require immediate issuance of additional debt by the sovereign ... This leads to an immediate increase in the sovereign's credit risk, Acharya wrote in a paper titled A tale of two overhangs: the nexus of financial sector and sovereign credit risks.

Investors' perspective on Spain's stability is further hurt by the failure of the European Union to step in on behalf of the country.

This is almost an understatement of their problems. Relative to Greece, there was a much greater expectation that the euro zone will do something, but that expectation has begun to weaken as they have delayed issuing euro bonds, Acharya said.

As the spread widens on Spanish CDS and the nation is forced to begin bailing out its banks and the inclusive nature of the iTraxx SovX Western Europe index, investors are increasingly fleeing to safe havens like German CDS. The upshot?

The spread on German CDS has grown 14.2 percent in the last month and 148 percent in the last year. While the spread remains low in terms of cost, especially in comparison to Spain, the spread has steadily increased over the past year.

The perceived risk of German debt is still considerably lower than that of many other European nations, but investors are growing increasingly wary there as the gulf in the CDS spread slowly widens.

More News from IBT MEDIA