The Independent Market Observer

More of the Same?

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Jun 12, 2012 12:58:36 PM

and tagged Debt Crisis

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As promised two days ago, today we have more on Europe and China. The Spain situation continues to evolve, and the markets gave a resounding vote of no confidence on the bank rescue. After first rallying, equity markets either ended flat or down. Spain’s 10-year bond yields climbed to almost 6.5 percent and Italy’s to more than 6 percent.

The fallout went beyond the financial markets. Cyprus became the fifth European nation to seek a bailout, and China stepped up its stimulus by encouraging banks to lend more. The president of the European Commission called for all 27 countries to submit to common banking supervision and regulation. The front page of New York Times included an article titled “Worry for Italy Quickly Replaces Relief for Spain.”

The problem here, again, is unintended consequences. As I noted yesterday, the size of the rescue proposal is actually seen as large enough, and the timeliness was much better than usual. The problem is the terms.

Briefly, if this deal is senior to existing government debt, then the security of existing government bonds is significantly weakened. How secure is any bond issued by a government if it can simply be pushed down in seniority by supranational lenders at need? We have already seen this in the “voluntary” Greek default, but now the point may be made even more strongly.

Buyers of sovereign debt typically are not looking for a risk/reward calculation. The point of sovereign debt is that it is supposed to be risk-free. While that certainly has been disproven, adding another layer of seniority uncertainty to the mix does not help matters.

The rise in Spanish and Italian yields reflects the rising uncertainty about the security of the countries’ debt. Not only do investors need to watch the countries’ economics, but they also need to watch their capital structures. Small wonder many are deciding to exit the market.

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