A deepening crisis of confidence in sovereign debt within the euro zone is prompting institutional and retail investors to rethink their fixed-income allocation strategies.
There was temporary relief in the last few days of April, after the International Monetary Fund and the European Central Bank announced a $146 billion rescue package for Greece to prevent a default and restore confidence in the euro. Market turbulence resumed late last week amid violent protests in Greece, which raised serious doubts about the Greek government's willingness and ability to implement tough fiscal measures required under the terms of the aid package. Gloom turned to panic on May 6, as stock markets around the world plummeted. Equities sold off further on May 7.
The metric the market is using to gauge sovereign risk is the spreads on credit default swaps, which represent the number of basis points an investor must be willing to pay to protect bonds with a face value of $1 million against default. A basis point is 0.01 percentage point.
A resorting of sovereign risk spreads has been taking place within the euro zone, says Jim Carlen, who manages the RiverSource Emerging Markets Bond Fund (REBAX), which is now part of Columbia Management and which had $259 million in assets as of Mar. 31. Although each of the 16 countries in the European Union issues euro-denominated bonds, the risk varies by issuer. "There's a flight to quality, to the most creditworthy issuers in the euro zone, and that's Germany and France. So spreads on those have been stable, and spreads on the weakest members have been widening."
On May 6, the spread on 5-year credit default swaps for Greek debt spiked to 941, from 838 basis points the prior day. The spread for Portugal went to 461, from 422; for Spain to 275, from 227; for Ireland to 272, from 238; and for Italy to 232, from 187. In contrast, the spread on German bonds went up just 5 basis points, to 60, according to Bloomberg data.
Greece's five-year CDS spreads had narrowed to 400 basis points after the rescue package was announced late in April, but the spread widened again early last week as concerns about contagion to other debt markets escalated, says Carlen. He worries that the greater probability that Greece will default on its debt or have to restructure it may have a major averse impact on the overall appetite for risk, which could prompt a big drop in liquidity in all asset classes.
Questions about the ability of the European Central Bank and the International Monetary Fund to guarantee not only Greece's debt but also that of other heavily indebted countries such as Portugal and Spain have put the euro under extraordinary pressure in the last few weeks. That's good reason to stay away from all euro zone sovereign debt for now, says Mark Beischel, co-manager of Waddell & Reed's Ivy Global Bond Fund (IVSAX), which has $160 million in assets.
"Right now, there's absolutely no support for the euro. I don't think [ECB Chairman Jean-Claude] Trichet has any concern about the euro," he says. "We think Trichet and the ECB have been consistently behind the curve in their policies."
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