Rating agencies matter for issuers of international bonds as their credit rating assists investors to determine what a fair return on their investment should be. Sovereign states, just like any borrower, seek to maintain the highest rating possible as this helps lower their cost of borrowing. The institutions that buy these international bonds, such as pension schemes, insurance companies and banks are regulated entities, with their investments closely monitored.
Should the quality of these investments fall outside predetermined credit quality parameters the investments would need to be sold, since it would severely impact important financial ratios such as their solvency ratio. Moreover, banks use these credit ratings to calculate haircuts for inter-bank repo agreements. It is not surprising, therefore, to see institutions start to sell bonds in anticipation of a potential downgrade. While this may protect the quality of their investment portfolio it often exacerbates price falls of such bonds as is the case for Spanish and Italian debt.
Since the euro debut, 16 national central banks rely on the European Central Bank to determine the most appropriate monetary policy for the whole eurozone. In a European context therefore, it would be logical to expect any sovereign state that adopted the euro to be able to borrow at similar yields. This was true for many years between 2002 and 2008. German, Spanish, Italian and Irish yields were next to identical. Alas this is no longer the case.
The table below shows the yield and yield spread (the additional yield an issuer has to pay against a benchmark) for some five year European sovereign bonds.
All the above countries, except for Malta, regularly borrow from the international markets. Currently Spain has to pay a rate of interest more than twice what Germany pays to attract investors to purchase its bonds, while Greece has to pay nearly seven times that. The yield, or price a country has to pay, is determined by the market, which assesses the credit risk of investing in each country.
The first consideration an institutional investor would make is the probability that a country defaults on its debt. Additionally, investors also calculate the possibility of a country being downgraded below investment grade, possibly forcing the investor to sell at a substantial loss.
Currently this concern coupled with the risk of an outright default is forcing sovereign issuers in the periphery of the EU region to pay excessive spreads to German government bonds, which are, in percentage terms, wider today than when each country issued debt in its own currency. All this makes investors nervous, doubting the future of the European Union.
Interestingly, the stress tests carried out last summer indicated that the French and German financial institutions may be exposed to €1.3 trillion each in the combined debt issued by either Italian or Spanish states or their institutions. Cleary a multi notch downgrade to either country would be a severe blow to French and German institutions alike.
No wonder ECB president Jean Claude Trichet insists that the bank will continue to provide liquidity to the European banking system and purchase bonds to stabilise the markets. Sooner or later, this supply of printed money will have to end with whatever consequences that might bring to the European bond market.
The ECB need not be forced to continue to supply this money. While market participants only look at stability and a fair return on their investments, issuers are happy to pay a fair rate of interest but do not want to be penalised.
The ECB could issue a European Government Bond for all the additional borrowing requirement of the 16 EU states, conceivably trading at the same level as the German bunds. This would enable rating agencies to rate Europe as a state, and investors to assess sovereign risk in EU terms. In turn, each country could issue its international debt that is fully subscribed to by the ECB, effectively borrowing directly from the ECB. Politically it would be difficult to convince all members that each country should borrow at the same rate.
Each sovereign state can first issue debt for its domestic market. Additional borrowing requirement would be issued to the ECB. These issues would be floating rate notes, with the interest rate calculated as a function of required borrowing as a percentage of GDP, and of the country’s deficit.
But the interest rate need not be so punitive, as Ireland and Greece are paying. This brings additional income to the ECB, seems more passable for the Germans whose borrowing costs are very low, and reduces the risk of further financial crisis. Furthermore, investors would be quite happy to purchase ECB bonds guaranteed by the combined states of Europe, where country risk is reduced and the possibility of multi notch downgrades virtually eliminated. Surely the States of Europe bond would increase investors’ confidence and regain credibility.
This article has been prepared by Sandro Baluci of Curmi and Partners Ltd and is the objective and independent opinion of the author. The information contained in the article is based on public information. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.
www.curmiandpartners.com
Mr Baluci is portfolio manager with Curmi & Partners.