RX for Shaky Sovereign Debt
Can credit derivatives save European government bond portfolios?
By Margaret Elliott
Thinking with a sinking heart of how your portfolio of shaky European
government bonds will suffer in the run-up to monetary union? And then,
dreading the fact that no relief will be available once (if ever) EMU is
The answer to both problems is the new and fast-growing market in credit derivatives. Though market participants point out that credit derivatives
are used more often in emerging markets, they can and have been used successfully
in the European context as well.
The focus in the EMU run-up will be on interest rates, not credit, but
several developments are pushing European bond managers and banks to look
at the credit issues associated with sovereign debt. One is the troublesome
fiscal policies being pursued by some countries in an attempt to qualify
for membership. Another is the imbalance in the debt levels of the European
countries, which will become greater as all pursue the 60 percent of gross
domestic product benchmark for EMU membership. And last, presumably once
EMU is in place, credit issues will dominate interest rate volatility as
convergence works its way into the fabric of the European bond markets.
Countries to watch
Within the last few years, two countries in particular have encountered
fiscally heavy seas in Europe: Italy and Sweden. Both countries have faced
recent banking crises, and fiscal mismanagement has put these countries'
sovereign debt on the credit-watch list.
For Martin Kinnesinger at Daiwa Bank in London, these fiscal hiccups
mean problems for his clients-banks and portfolio managers. "We prescribed
default options and default swaps to manage the potential default risk on
sovereign as well as corporates within these countries," he says. For
banks in particular, it is easy for big issuers like Italy and Sweden to
breach their counterparty credit limits. Even though the portfolio approach
to managing bond exposures is universally used in banks, the sheer volume
of debt from Italy and Sweden has made life difficult.
Yet, as Robert Reoch, director of special financial products at London-based Nomura Capital Int'l explains, the only problem with the use of specialized
credit derivatives is the lack of liquidity. He expects that with the run-up
to monetary union, the demand, and thus the consequent supply of these products
will increase. "These products can be tailored quite specifically to
manage a range of possible exposures."
For Italy and Sweden, the fiscal crises may have passed, yet neither
is a shoe-in to EMU. Italy's sovereign debt is 120 percent of gross domestic
product. And this doesn't include pension contributions, which, if included
in Belgium's figures, would swell its debt to a whopping 150 percent of
GDP. Yet it must be remembered that only Luxembourg would make the grade
today. Sweden's debt stands at a more respectable, but nevertheless high,
80 percent of GDP.
Credit derivatives may come in handy as a way to get protection from
increasingly uncertain financial information. In the run-up to monetary
union, some countries are finding creative and controversial ways to reorganize
their debt. Italy has recently been granted permission by Eurostat, the
European Commission's statistical body, to include the receipts from its
one-time "Eurotax" against this year's budget deficit in order
to move its 6 percent budget deficit toward the 3 percent EMU deficit criteria.
A similar type of fiscal sleight-of-hand took place at the end of last
year in Belgium, with Belgian Finance Minister Philippe Maystadt arranging
a set of swaps with nongovernmental bodies that had the effect of showing
that the country's debt was shrinking. Banks and portfolio managers can
expect more of the same, with concurrent market effects. Understanding the
credit issues is becoming more and more important, says Daiwa's Kannesinger.
Credit derivatives may also be used to pry returns from subtle differences in credit. When monetary union arrives, the likelihood is that some countries
will be left out, and Italy, Belgium and Sweden come to mind. The divide
between the included and excluded will provide arbitrage opportunities in
both interest rate and credit terms on both a short-term and a long-term
basis. After EMU, the European bond markets may not be the sleepy place
many now expect.