| BUSINESSWEEK ONLINE : MARCH 1, 1999 ISSUE | ||||||||
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| INTERNATIONAL -- FINANCE
One Currency, Many Bond Markets (int'l edition) Some countries still pay a risk premium on their debt Europe may have achieved monetary union, but bond investors are still treating the Continent like a group of distinct countries. Many economists expected the 11 member nations to pay nearly the same rate for government borrowing after the euro's January launch and the European Central Bank's official opening. Instead, a familiar gap remains between countries that must pay a premium to issue sovereign bonds and those that can raise money more cheaply. Is the premium fair? It's too early to tell. Europe's fledgling capital markets are struggling to cope with the monumental implications of EMU. Since nothing like it has ever been tried before, investors have few tools with which to measure risk. In addition, pricing bonds is complicated by different tax rates and trading and settlement practices among the euro-zone members. As Europe's credit market matures, analysis will become easier. But in the euro's early days, figuring out a fair price for sovereign debt feels like ''running an experiment without a control,'' says Charlie Berman, head of European debt markets at Salomon Smith Barney. Spreads between European bonds have narrowed considerably over the past five years during the runup to the euro's launch. For example, on Feb. 24, the benchmark German 10-year bond, known as the Bund, yielded 3.90%, while Italy's 10-year bond paid 4.11%. That 21-basis-point spread is a far cry from 1995, when the gap between Italian and German sovereign debt was more than 600 basis points. But Italy still carries a public debt that amounts to 120% of gross domestic product. As a result, it's still considered a higher credit risk than Germany. Under the Maastricht Treaty's criteria for monetary union, neither the union nor any of its members is responsible for the debts of another. So any country that borrows too heavily or runs too big a budget deficit still owes investors a credit-risk premium to account for the possibility--however remote--of default. PIGGYBACKING? Indeed, the international debt-rating agencies assign Germany the top AAA rating, while Italy merits a mere AA3. In fact, says Cesar Molinas, senior Europe strategist at Merrill Lynch & Co. in London, Italy and other high-debt nations such as Belgium could be piggybacking on Germany's creditworthiness now that they're all in the euro club--even though Germany wouldn't be obligated to bail them out of a crisis. Other differentials are harder to explain. For instance, even though the core EMU countries--Germany, France, the Netherlands, and Austria--all boast AAA credit ratings, Austria pays 13 basis points more for its 10-year bonds than Germany (table). With many European governments running multibillion-dollar deficits, ''even a few basis points can be significant,'' says John Winter, head of debt markets for Deutsche Bank in London. France found that out in the first week of 1999, when Germany held an auction for a 10-year government bond due to mature January, 2009. Just a few days later, France auctioned a similar 10-year bond with an April, 2009, maturity--at 11 basis points higher than what the German Bund was yielding that day. That's odd, considering the French have lower levels of public debt. France is paying a price for liquidity risk. Investors always demand a premium for securities that aren't as easily traded as others. So international investors looking to diversify into European bonds prefer German paper, because it is perceived as more liquid. Ironically, thanks to the inefficiencies of the European debt market, the supply of Bunds is limited even though demand is strong. Still, Germany is likely to keep its benchmark status for a while. That's because the most actively traded futures contract in Europe is based on the Bund. It's therefore easier to hedge German bonds than any other European government debt. Between credit risk and liquidity risk, it makes more sense that the euro zone's $2.5 trillion government bond market isn't a monolith. ''There's a natural inclination to assume that now that Europe has one currency, its government bond market will develop along the same lines as the U.S. Treasury market,'' says Merrill Lynch's Molinas. A more accurate comparison, he says, would be the U.S. municipal bond market, where spreads between states and localities vary widely, depending on everything from tax rates to pollution to budgets. Some observers believe spreads between European sovereigns will narrow further as the euro zone's credit market evolves. The French hope that investors will take kindly to a new contract trading on the MATIF, France's over-the-counter derivatives exchange. The new product would combine French and German bonds in a synthetic debt instrument. Others think yields are as close to convergence as they'll ever get--at least until Europe achieves political union. Until then, investors will continue looking at Europe as a collection of different risk profiles, and charging the interest rates they see fit. By Kerry Capell in London _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ BACK TO TOP |
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