Bond math

Here's an extract from an article in today's Guardian:

The European Commission president, Jose Manuel Barroso, also expressed "deep concern" at the rise in Italian and Spanish borrowing costs, with investors continuing to demand interest rates of more than 6 per cent to lend money to either country. Although off earlier highs, at 6.1 per cent for Italy and 6.27 per cent for Spain, the rates remain within striking distance of the 7 per cent level seen as unsustainable by investors.

And here's something from Ian King, business editor of The Times:

The yields on Italian and Spanish bonds are now well above 6 per cent, edging ever closer to 7 per cent, the danger level at which the debt burden of a country starts to become unmanageable.

And now a question for you: based on these statements, do you think that Italy and Spain are now having to pay out almost 7% in interest on their entire outstanding stock of debt? Because they're not.

A talking head on CNBC this lunchtime, US fund manager Jim McCaughan, was closer to the truth when he said that neither Italy nor Spain could afford to refinance their debts at current interest rates. Maybe that's true, although it's not that long ago that yields of 6-7% for long-term (say, 10-year) debt were nothing unusual for most countries. But here's the really important point: neither Italy nor Spain actually has to refinance their debt at today's rates. They only have to refinance it when it becomes due. Until that happens, they only have to pay the rates that applied when the bonds were originally sold.

As far as I can tell -- most of the media reports are vague on this, probably because the authors don't really understand what they are talking about -- the 6-7% figure is supposed to represent the current yield to maturity on Italy or Spain's outstanding 10 year bonds. It's true that any new 10-year issuance would probably require these countries to cough up something like that yield in order to get a deal away, but that's a whole lot different from arguing that the burden of the existing debt is becoming unaffordable.

Let's look at something that actually happened in the market this week. Spain issued a new tranche of bonds at a yield of....4.84%. Now, it has to be borne in mind that these are 3-year bonds (2014 maturity), and that the yield was 50 bp higher than the last time Spain made a comparable offering, just a month ago. Still, that's a portion of Spain's debt now locked in for 3 years at a cost far below the supposedly fatal 7%.

There's another interesting feature of the latest Spanish bond issue too, if you can bear a bit more bondspeak. The bid-to-cover at the bond auction was 2.4, which means that for every 1000 euros of bonds offered, there were bids to buy 2400 euros. That doesn't seem like evidence of investor panic. The hedgies and other short sellers may be getting all the headlines, but it looks as if for now, there are plenty of other investors looking to take on Spanish risk at current levels.

These facts suggest that the ECB doesn't need to panic in response to the current market turmoil. Rather, it needs to work closely with Italy and Spain to assess their need for new funding over the near term, and if necessary work with creditor countries (Germany,for the most part) to see if a "backstop bid" can be put in place when those countries next come to the bond market.

In that context, some of the ECB's actions over the past day have been perplexing. It has reportedly been buying up Portuguese and Irish bonds in the secondary market, in order to support prices. A City of London type on the news last evening described this as "a misguided missile", which seems a fair description. Both Portugal and Ireland are fully funded for the next year and more: they won't have to come to public markets any time soon. If private investors want to take lumps out of each other by shorting Irish and Portuguese bonds right now, that's of very little consequence for the countries themselves, and would not seem to warrant ECB involvement when there are more pressing issues to be addressed.

Note however that the shorting is of "very little" rather than "no" consequence. If the bonds are held by banks, short selling in combination with mark-to-market accounting means that bank balance sheets may be impaired, which creates a whole new set of issues. Those issues become much more serious when we are talking of Italian or Spanish bonds being shorted, rather than Irish or Portuguese. This explains why European bank shares fell sharply in response to the latest bond market declines. A second round of taxpayer-led bank recapitalisations is not a realistic option, so the ECB's primary goal should be to ensure that Italy and Spain's borrowing and refinancing needs can be met until such time as markets calm down. Both countries have robust budget-balancing plans already in place; there is no reason to allow the short sellers to have their way at the taxpayer's expense yet again.