How Safe Is Government Debt?

Monday, October 04, 2010 » posts.tags:

Looking for safe investments? Government bonds!

But is that really so? And if not, what tools do we have to assess and compare the risks? Is there an issue with Greece, Ireland, Italy, Portugal and Spain (the “GIIPS countries”)?

First of all there are the rating agencies. They assign classifications represented by letters to all debtors. For example Standard and Poor’s uses letters A, B, C and D. AAA is the best, then AA+, AA, AA-, BBB+ etc. all the way down to D for companies that have defaulted. Anything from and above BBB- is called “Investment grade” and anything below BB+ is a “Junk bond”. Each rating agency uses different symbols and has its own methodology. There are two ratings per debtor: one on short term and one on long term. The rules to assign the letters are different for countries and companies and even depend on the sector in which the company is active. The rating gives a good indication of the probability of default.

Looking at the ratings we see that Greece is in troubles, but that most probably the rest of the GIIPS countries will be fine. So no reason to panic it seems.

Entity Standard & Poors Spread (in %) CDS (in %)
Greece BB+ 7.93 6.84
Ireland AA- 3.30 4.21
Italy A+ 1.06 1.73
Portugal A- 2.74 3.46
Spain AA 1.30 2.05
Poland A- 3.56 1.19
Germany AAA 0.00 0.32
USA AAA -0.53 0.38
Indonesia BB+ 4.76 1.29

Another way to judge the risk of a certain country is to study the “Spread”, the difference in interest rate that the debtor has to pay compared to a chosen reference. For European countries one generally compares to Germany, one of the world’s most creditworthy countries and a dominant debtor in Europe. The spread is hence a measure for the risk premium that investors demand in order to buy certain bonds.

Therefore the spread reflects the common opinion of all investors; it is a consequence of the trading going on between all players. Where rating agencies very seldom adapt their views, the spread changes intraday just as interest rates or stock prices.

In order to asses the risk of a bond it makes more sense to study the spread than the interest rate itself in order to eliminate the overall interest climate.

The spreads in the table already give us more reason to worry. Greece has a higher spread than Indonesia that defaulted a few years ago. Further we see that actually Ireland is assessed to be more risky than Italy and Portugal, whereas the Ratings gave us the opposite image. This can still be consistent, because a buyer of a bond will not only be interested in the probability of default, he will also be interested in how much he still can recuperate in case of default.

Also a Credit Default Swap (CDS) is an ideal instrument to assess the credit risk of a certain bond. If you have a bond, you can cover its default risk by buying a CDS, the seller will then pay you the face value of the bond in case it defaults (and you give him the paper, so he can recuperate whatever is left). The joint probability of default and amount to recuperate is most explicitly present. But there is another aspect that plays a key role.

You have your bond and CDS, but you still have a credit risk on the seller of the CDS. So, this operation only makes sense if the creditworthiness of the seller is better than that of your bond. In other words, the market of CDS providers is small. And those who do will have a portfolio of contracts. Hence a third element of the risk of the bond comes to the foreground: the systemic risk: when it goes wrong, how strong are the bonds correlated?

The CDS values in the table learn us that there is more matter of concern for Greece, Ireland, Portugal, and Spain than there is for Indonesia for example. And that is a reason to take precautions!

Indeed things can go wrong: companies can default, even Lehman Brothers or Enron were not immune. Also governments can stop paying or pay only part. Take for example Argentina. After the two wars the country could not gain the confidence of investors and it ended up paying high interest rates and had hyperinflation. The situation exploded in December 2001: the country had its currency devaluated and paid back partly in the devaluated currency.

None of the Euro countries has the option to devaluate its currency, so the income from taxes minus current expenses determine the limits.

That reflection allows us to look via a different frame at the same reality. Greece has a debt of 116% of its GDP, but we must not forget that this is only 118% of its annual revenue (total income from tax). If we compare that to the USA who has 53% debt-to-GDP but a stunning 358% debt-to-revenue ratio, we must conclude that all is still relatively under control.

Buying GIIPS debt is like jumping into a driving train: hopefully it works out, but when it goes wrong then it really hurts. The first default will trigger panic among inventors and the IIPS countries will see their cost of funding soar. One domino will make the others tumble. In other words let’s hope for the best, but when it goes wrong it won’t be easy to hide.

NOTE: Another interesting observation while comparing CDS and spread is that the EU countries have an interest rate advantage compared to Poland for example, but more about this in another paper about the advantages of the Euro.