Friday, November 26, 2010

European Sovereign Debt Probabilities of Default

It would be remiss not to comment on European Sovereign Debt fears at the moment. Not least because Spain's 10 year bond yield chart appears to be signalling that it could be next in line. This is significant because Spain is seen as one of those economies 'that really matter'...

One-Year Chart for Spain 10 Year (GSPG10YR:IND)

Indeed, what is remarkable about all of this is, how quickly sentiment has shifted. It is worth remembering that in the last crisis in the Spring, Ireland was left relatively unscathed. At the time, the Irish Government were lauded for having taken quick and decisive action in reducing public spending.

The markets aren't taking any prisoners now with Ireland's 10 year bond chart yield rising dramatically...

One-Year Chart for Ireland 10 Year (GIGB10YR:IND)

With this in mind I decided to take a look at the Cumulative Probabilities of Default (CPD) of European Sovereign Debt as calculated by CMA Datavision.

Country            Yield             CPD   Risked % 

Source: FT,CMA Datavision, Markets & Culture

This table is telling you that the CPD for Spain is 23%  The 'risked' yield calculations are a 'back of envelope' calculation to see if there is any value discrepancy out there. What strikes me immediately here is the speed of the sentiment shift against Ireland. It is now less 'value' than Greece on a risked basis. In addition the 'risked' spread between Portugal and Spain doesn't appear to be large enough,given that should Spain fall into serious difficulties, most commentators feel the rest of Europe would be hard pressed to bail them out.

Similarly, I note that CDS pricing  for iTraxx SovX Western Europe spread (the cost of insuring against default) is trading at close to all time highs of 180+

However, this isn't just a European problem. Not only are the knock on effects likely to hit US banks but also the markets (for now) appear to be ignoring the potential issue of US municipal bond difficulties. I note that CMA Datavision has the CPD for California at 23.2% That is higher than Spain, and Spain has the EU.

California has a Federal Government to deal with and, it is unclear whether they will be willing to 'bail' them out should difficulties occur. My main worry with California is related to the foreclosure debacle. If this slows the housing market significantly than States like California and Florida will feel a hit to their incomes.

I think it is time to be cautious on risk assets.

In addition, two further points strike me. The first is that the global economy is so correlated now that a change in sentiment over Irish Government Debt can cause significant knock on effects. The second is a deeper thought, which I am going to develop in a future blog post. It is something that has been troubling me for a while. Namely, that modern portfolio theory is predicated on a set of relative evaluations for asset classes, which have Government Debt as a 'risk-free' benchmark. What happens when the 'risk-free' asset is no longer risk free?


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