Friday, 17 September 2010

Thoughts on sovereign bonds #2

The yield to maturity on sovereign bonds has generally represented the "risk free rate" for financial markets. No other financial asset could provide for less risk that a fixed stream of cash flows emanating from the government of a sovereign country.

What is the risk free rate in the Eurozone now, say from an Irish perspective.

It can't be Irish government bonds. In the past the domestic sovereign bond issuer was seen as "risk free" because in the event of difficulty in making repayments the government could either levy higher taxes or print some more money. Not so any more on either count.

It can't be a market basket Eurozone bonds - generally weighted by amounts on issue. You could hold German government bonds alone at a lower yield, but presumably lower risk than a basket that includes Greek, Irish and Portuguese bonds for example.

Can it be German bonds? They are issued in the same currency. Within the Euro is Germany able to meet all potential fiscal demands on it via taxes or money supply? Probably not, as the German people clearly fear - Germans look obliged to help bail out the financial troubles of other and again, they no longer have their own currency to print. Outside the Euro, a different story might apply perhaps - a renewed German fiscal and monetary autonomy, which could allow it an increased capacity and backstops to repay any debt it occurs (and to accrue less debt int he first place). Unfortunately, new bond issues in Euro would be forsaken for NeuDeutschmark. The amount of German issued "risk free" Euro bonds would wain.

Is that it then? While the Euro remains in its status quo there is no traditional "risk free haven"? Is a German departure from the Euro the event that would bring a return of a proper risk free rate, but in doing so kill the Euro risk free rate off?

Sounds bizarre, but no different really to US, Australian or Canadian state or provincially issued debt. In those countries we see a Federal issuer with fiscal and monetary primacy fill the role of "risk free" lending. Should the Euro survive, do you doubt where the constitutional structure of the EU is headed?

1 comment:

Justin Collery said...

Geckko,

Nice post. I am surprised at how few people realise what the logical outcome of this crises is -

Euro disintegration
or
Fiscal union

DMcW talks of Ireland leaving the Euro. Much more likely the sugar daddy leaves, Germany.
More likely however is fiscal union. EU budgets, EU tax, EU bonds. Question then arises as to accountability, again with a logical conclusion of an EU state. Of course, this may not be politically acceptable, which may kick us back to option 1.