by Brad Houle, CFA
Executive Vice President
We have illustrated below the details of the convergence of government bond yields between the stronger credits of Germany and the United States versus the weaker credits of Italy and Spain. Germany and the United States are arguably two of the strongest sovereign bond insurers in the world. While not perfect, both Germany and the United States have dynamic economies with reasonable levels of inflation versus economic growth. Also, both countries have excellent ability to pay their debts and are viewed as "safe haven" credits by bond investors.
Italy and Spain are a different matter. While we do believe that these countries are starting to recover from the European debt crisis, there are still many structural economic issues that need to be addressed. For example, Italy has a 12 percent unemployment compared to the six percent unemployment in the United States. However, Italy's unemployment looks very favorable compared to the 25 percent unemployment currently in Spain. In addition, both of these countries have severe demographic issues with aging populations and strict labor market regulations that make the labor force less flexible.
What changed to cause interest rates to drop from around the seven percent for a 10-year bond for Spain and Italy in 2021 to the less than three percent rate of interest they now pay were the actions by the European Central Bank or ECB. Essentially, the ECB, which is akin to the Federal Reserve for Europe, announced they would do whatever it takes to backstop these countries. These words gave bond investors the confidence that Italy and Spain will have the ability to honor their debt obligations. Financial markets run on confidence, and this was enough to cut the borrowing costs of these countries by half.
Countries compete for capital from investors. Investors strive to get the best return for the risk that they are taking. Given this set of facts, buying United States treasury bonds versus European country debt seems like a much better investment from a risk versus reward standpoint. While the words of the ECB do merit more investor confidence, there is still underlying credit risk that does not seem to be properly priced into European government debt.
This week there was an event in Portugal that highlighted this risk. During the European debt crisis, Portugal was in a similar position to Italy and Spain. Portugal had a heavily indebted economy with structural economic issues and a high cost of borrowing based on perceived credit risk. Portugal fell under the ECB umbrella and their borrowing costs have declined in a similar fashion to Spain and Italy. However, this week Portugal's Banco Espirito Santo announced that they were having issues meeting debt payments on some short-term borrowing the bank had done to fund operations. This news was enough to cause a one day .30 percent increase in the yield of the Portuguese 10-year bond and a broader decline in European stock markets. While relatively minor, this incident demonstrates the market confidence in European sovereign debt markets is on the razor's edge and credit risk is probably not properly reflected in the possible risk of this debt.
Our Takeaways for the Week
- U.S. Treasury debt is more attractive than European sovereign debt
- While we do believe interest rates will rise in the U.S. as economic growth continues, there is a cap on how high interest rates will climb. Investors will favor U.S. Treasury bonds over European bonds which will help keep rising rates in check