14 November 2011

FN: Don't shoot the messenger, listen to the message

The unpalatable truth needs to be faced that some governments have been fiscally irresponsible and should not attempt to place the blame for the current crisis at the door of the CDS market. Such an effort is futile and dangerous. The EU’s motive for attempting to rein in speculative sovereign CDS buying is to prevent a vicious circle of fear developing. As the fear of default widens, so do CDS spreads, the wider the spreads, the higher the fear of default, and so it goes on.

The vast bulk of the sovereign bond market comprises traditional investors buying government bonds. Typically, these investors are rates investors, not credit investors – they do not naturally question the ability of the sovereign to repay its bonds, but are more focused on accessing future yield, having factored in inflation, economic growth, issuance plans and currency effects.

For developed country sovereigns, bond investors have typically focused for many years on tiny yield differentials between bonds of different maturity, and between governments. Often the performance of these investors is measured against an index of government bonds of roughly similar quality. Once a government starts to become fiscally irresponsible, the initial impact can be counterintuitive.

The CDS market is a fraction of the government bond market for most sovereigns. Data from The Depository Trust & Clearing Corporation shows that net notional CDS outstanding is a lowly 1.5 per cent of debt outstanding for Greece, and only 1.3 per cent for Italy. So governments should be grateful for the early warning of impending danger flagged by the sovereign CDS market, but focus their attention on their core backers – the pension funds, insurance companies and banks that buy the bonds.

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