Wednesday, 20 July 2011

The bond markets are rarely wrong - is Italy next?

Working on the principle that rich investors become rich by knowing where to invest their money, taking a look at the performance of bonds issued by eurozone countries gives a valuable insight into their economies.

Government bonds are like loans - investors effectively loan governments money by buying bonds which can be turned back into cash with a guaranteed amount of interest (the "yield") after a certain amount of time.  There is, of course, the ever-present risk that said government might find itself in dire financial straits and will default on the repayment of bonds when they mature.

Generally speaking, the risk of a government defaulting on bonds is tiny because if they need money they raise taxes or print more money (quantative easing).  But there is only so much money you can print before your currency becomes worthless and it costs a month's wages to buy a toilet roll like has happened in Zimbabwe and there is only so much people will pay in taxes before they start wondering what their leader's head would look like on a spike on the walls of that lovely big palace they live in.

Sometimes countries have no choice but to default on bond repayments because there simply isn't enough money to pay them - a situation Greece finds itself in now.  And it's because of these occasional defaults that investors expect a higher or lower yield on the bonds they are buying to reflect the higher or lower risk of not getting their money back.  This is no different to what happens in high street banks and just as there are credit reference agencies deciding on the credit worthiness of you and I, so there are credit reference agencies that decide the credit worthiness of countries and their bleak outlook on the economies of eurozone countries has lead to an EU proposal to censor them.

Using the information that the likes of Moody's and Standard & Poor produce and their own gut instincts, institutional investors offer to buy a certain amount of bonds at government bond auctions with a specific yield (interest rate).  The higher the yield, the higher the risk these people think there is of the country not being able to pay their bills and defaulting or of having to print so much money that they will devalue their currency so much that the bonds are worth less than they paid for them.  In the eurozone, countries can't just print their own money or devalue their currency because they're locked into the Franco-German controlled monetary union so a higher yield on a eurozone country's bonds is mostly based on their perceived ability to pay.

Ok, lesson over.  How are things looking on the European bond market?  Let's kick Greece while it's down: Angela Merkel is trying to play down hopes of a miraculous cure for Greece's financial problems and investors clearly agree - investors are asking for an average of 28% yields on 10 year bonds according to Trading Economics.  That means that for every million pounds the Greek government raises selling 10 year bonds, in 10 years' time they will have to pay back the original millon pounds plus £280,000.  Greece raised about €20bn by selling bonds at the start of last year - if it tried to raise that amount of money again at current prices, they'd be faced with a bill for €5.6bn in interest alone as well as the original €20bn sale price of the bond.

But it's not just Greece.  If you take a look at the big increases in yields over the last year, Ireland, Greece, Portugal, Italy and Spain top the list.  The UK and Norway have seen small decreases in the cost of borrowing and Switzerland has seen a very small increase - the UK is of course outside of the eurozone and Norway and Switzerland are outside of the EU altogether.  In fact, other than Austria, Sweden, Poland and the Czech Republic, the cost of borrowing has gone up across the eurozone while costs have decreased outside of it.  Belgium is high on the list of countries seeing the cost of borrowing increase by almost a third over the year and apparently presenting a higher risk to investors than, amongst others, serial bankrupt Japan and Thailand which is rumoured to be on the brink of another military coup.

If the bond markets are anything to go by, Italy is going to leapfrog Spain and be the next eurozone economy to fail.  That's certainly the fear the EU has at the moment - they held a meeting a few days ago to talk about a possible default in Italy.  Unfortunately for the people living in eurozone countries, there is no way out of the downward spiral into bankruptcy while they are tied into the EU's single currency.