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Report on the European Bond Market – March 2010 to August 2011

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ABSTRACT

This report evaluates the European bond market’s performance over the last 18 months, and explains some of the underlying causes and events that have affected it, including the perception of risk related to sovereign debt levels in the Eurozone. The report goes on to discuss the outlook for the bond market over the next 12 months, and possible mechanisms that may be used to bring debt to more sustainable levels not only for the benefit of struggling economies, but also for the future of the Eurozone and global economy as a whole.

Introduction

A bond is a fixed income security, issued by Governments and corporations to raise long term capital.

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Governments sell bonds to finance the shortfall between their spending and revenue. Investors are interested in bond returns, which are determined by the initial bond price, coupon value and the maturity date (Buckle and Thomas, 2009).

Although there is no formal single European bond market, bonds by countries in the Eurozone are viewed as a single market, as these economies share a single European currency (excluding the UK), and are heavily exposed to each others’ economies. As the majority of bonds are held by Governments, global banks and institutional investors, even perceived risk of one Government defaulting on bonds can have severe consequences for the European and global economy.

European Bond Market Performance

Bond markets increased in importance post 2008 as investors shifted exposure from equity to debt instruments, and from private to public sector securities (Forster et al. 2011), in a flight to safety.

The European bond market has experienced volatility over the last 18 months, due to a number of concerns regarding sovereign debt and growth prospects of European and global economies, leading to a decline in investor confidence. Greece’s default risk (see Appendix 1.3) resulted in sharp increases in yields (Appendix 1.4) on Government bonds. This also resulted in bond yields of other European countries including Ireland, Portugal and Spain to rise due to fears of contagion (Bank of England, 2010a). In Greece’s case, already high sovereign debt levels meant that higher yields made servicing debts more expensive.

Due to this and to stop contagion spreading, in May 2010 the European Union (EU) and International Monetary Fund (IMF) agreed a bailout package for Greece of 110bn Euros, to provide certainty to the market and prevent Greece defaulting on its debt.

Chart A plots the spread of ten-year Government bond yields for European countries (benchmark – German Bonds/Bunds). Greece’s bond yields began to rise sharply from late 2009, peaking in May 2010 as the bailout package was announced. For risk neutral investors, higher yields meant increased returns, however this had to be balanced against the risk of default by the issuer.

Irish, Portuguese and Spanish bond yields also increased with their spreads diverging away from other European countries. Concerns now started to build for these countries as the Euro continued to fall, decreasing Europe’s buying power in the global economy.

From June 2010, bond yields began to fall as economies experienced a redistribution of capital into safe assets, causing economies to struggle to attract investors to finance spending. In November, the EU and IMF were forced to agree a bailout package for the Republic of Ireland of 85bn Euros, due to the re-emergence of sovereign and banking system concerns.

Bond yields hit historically low levels (Bank of England, 2010b), as sovereign debt crises triggered a search for safe assets (Chart B). However, it was also deemed that such extended periods of low bond yields could trigger a search for yield in riskier assets, resulting in overheating in emerging markets.

Then between March and May 2011, Greece, Ireland, and Portugal experienced sharp rises in yield spreads due to uncertainty about how they will resolve their economic challenges (Chart C). In May 2011, the EU and IMF were forced to bailout Portugal, as it struggled to finance its sovereign debt. In August 2011, the European Central Bank indicated that it will buy Spanish and Italian Government bonds, in a bid to bring down those countries’ borrowing costs, and prevent concerns growing of a Europe-wide sovereign debt crisis.

Future of the European Bond Market

Over the next 12 months, movements in the global economy, including the downgrade of the US bond market from its AAA rating may slow growth and return the country, and global economy, into recession. This will have a significant impact as investor confidence falls and global growth expectations are downgraded.

In terms of debt sustainability, there will be further efforts by EU Governments to implement more severe austerity measures, in a bid to bring sovereign debt to manageable levels. However, as we have seen over the past 18 months, this has come at a cost to growth. Without growth, it is evident that countries cannot afford to service their current debt levels, let alone reduce them. In the EU, this leaves Governments with a lack of fiscal policy levers to manage the economy. Apart from the UK which has not joined the Euro, other Eurozone countries are unable to use mechanisms such as currency devaluation in an attempt to control economic fluctuations.

In addition, as the budgets of larger European countries come under scrutiny, if fears of default or a downgrade of their debt arise, the fallout will be massive. For these economies, a bailout may prove impossible, causing the disintegration of the Euro and Eurozone.

Conclusion

The European bond market has experienced volatility over the last 18 months, due to fears of default by European economies such as Greece, Ireland and Portugal, and deteriorating economic conditions globally. The pursuance of austerity plans have meant that growth has stunted and with the recent downgrade of US debt, fears of a double dip recession have returned.

The financial crisis that began in 2008 has now evolved into a sovereign debt crisis in 2011, making it difficult for countries to service their debt, and difficult for institutions such as the European Central Bank and IMF to prevent the contagion spreading. Although the new Basel regulations have supported banking systems by ensuring Banks are retaining profits to improve their capital to lending ratios, their level of exposure to sovereign debt means that default by any advanced economy may trigger another, deeper, financial crisis, as Governments will not have the funds to bail Banks out.

However, there are some mechanisms that are being explored to return normality to the bond markets. Short selling is currently banned, reducing volatility in the equity and bond markets. In addition, other solutions are being explored such as the automatic extension of bond maturities, allowing Governments more time to pay back lenders, and the potential for a common Euro area bond. This would potentially bring down the cost of borrowing for Greece and other troubled countries, however may increase costs for countries with healthy balance sheets such as Germany, meaning this proposal has faced substantial opposition.

Finally, there is renewed debate that credit ratings agencies such as Moody’s, Fitch and Standard & Poor’s cause volatility in markets by prematurely downgrading Government and corporate debt, and subsequently causing weak investor confidence and market jitters that affect all economies. Their role in the financial crisis of 2008 and the current sovereign crisis is coming under intense scrutiny and we may see Governments coming together to reign in their power, reducing volatility in both bond and equity markets.

APPENDIX

1.1Bond Definition

A bond is a fixed income security, or debt instrument, issued globally by Governments and corporations to raise long term capital. Governments sell bonds to finance the shortfall between government spending and government revenue. In the UK, this is referred to as the Public Sector Net Cash Requirement. Bonds represent a promise by the issuer (borrower) to pay the holder (lender) a fixed single payment or stream of payments, called coupons, at specified dates over the term of the bond. Once the bond matures, the issuer must return to the holder the par value of the security plus any outstanding payments. Importantly, bond returns are determined by the initial bond price, coupon value (dependant on percentage of yield) and the maturity date (CFA UK, 2009).

1.2Bond Calculation

The Present Value of a bond can be calculated using the following basic formula:



C = coupon payment
n = number of payments
i = interest rate, or required yield
M = value at maturity, or par value

1.3The Beginnings of the European Sovereign Debt Crisis

Bond markets have increased in importance following the global financial crisis in 2008. Investors shifted exposure from equity to debt instruments, and from private to public sector securities (Forster et al. 2011), in a flight to safety. However at this time, government borrowing also rose substantially, partly due to the banking crisis, but also to provide a stimulus to ailing economies.

In 2009, the EU ordered France, Spain, Ireland and Greece to implement austerity measures to reduce their burgeoning budget deficits. Following this, in December 2009, Greece admitted that its debt had reached 300bn Euros, equivalent to 113% of its Gross Domestic Product (GDP). Ratings agencies swiftly downgraded Greece’s credit rating due to fears that it may not be able to repay its lenders on the bond market. This led to concerns about the debt sustainability of other European countries such as Portugal, Ireland and Spain, and fears of contagion, where other countries’ national banks were exposed to Greece’s default risk. If Greece did default on its debt, this would have severe consequences for other European economies and the European single currency, and this led to bailouts for Greece and other economies.

1.4Explanation of Yield

The yield determines the value of the coupon payment that the issuer must pay to the lender on the bond. An increased yield can indicate that there is a greater risk associated with holding that bond for the lender, and therefore the lender requires a greater return.

1.5Growing Sovereign Debt Levels as a Proportion of Gross Domestic Product (GDP)

As bond markets finance Government debt, and this debt can only be serviced by economic growth in the domestic economy, it is important to consider the growing levels of Eurozone debt as a backdrop to the volatility in the bond markets. Table A shows the consolidated gross debt of European countries since 2004 as a percentage of GDP (Source: Eurostat).

GEO/TIME2010200920082007200620052004
Belgium96.896.289.684.288.192.194.2
Germany83.273.566.364.967.668.065.8
Estonia6.67.24.63.74.44.65.0
Ireland96.265.644.425.024.827.429.7
Greece142.8127.1110.7105.4106.1100.098.6
Spain60.153.339.836.139.643.046.2
France81.778.367.763.963.766.464.9
Italy119.0116.1106.3103.6106.6105.9103.9
Cyprus60.858.048.358.364.669.170.2
Luxembourg18.414.613.66.76.76.16.3
Malta68.067.661.562.063.469.972.2
Netherlands62.760.858.245.347.451.852.4
Austria72.369.663.860.762.163.964.8
Portugal93.083.071.668.363.962.857.6
Slovenia38.035.221.923.126.727.027.2
Slovakia41.035.427.829.630.534.241.5
Finland48.443.834.135.239.741.744.4
United Kingdom80.069.654.444.543.442.540.9

REFERENCE LIST

BANK OF ENGLAND (2010a) Financial Stability Report, Issue no 27 (June). London.

BANK OF ENGLAND (2010b) Financial Stability Report, Issue no 28 (December). London.

BANK OF ENGLAND (2011) Financial Stability Report, Issue no 29 (June). London.

BUCKLE, M. and THOMAS, S. (2009) Official Training Manual, Volume 2: Investment Practice, 7th ed. London: CFA Society of the UK.

FORSTER, K. et al (2011) European Cross-Border Financial Flows and the Global Financial Crisis. Occasional Paper Series, European Central Bank, No 126 (July).

BIBLIOGRAPHY

BANK OF ENGLAND (2010) Financial Stability Report, Issue no 27 (June). London.

BANK OF ENGLAND (2010) Financial Stability Report, Issue no 28 (December). London.

BANK OF ENGLAND (2011) Financial Stability Report, Issue no 29 (June). London.

BBC NEWS (2010) Greece Crisis: Fears Grow that it could Spread. www.news.bbc.co.uk, 28th April.

BUCKLE, M. and THOMAS, S. (2009) Official Training Manual, Volume 1: UK Regulations & Markets, 7th ed. London: CFA Society of the UK.

BUCKLE, M. and THOMAS, S. (2009) Official Training Manual, Volume 2: Investment Practice, 7th ed. London: CFA Society of the UK.

DE GRAUWE, P. and MOESEN, W. (2009) Gains for All: A Proposal for a Common Euro Bond. Intereconomics (May / June), pp 132-135.

EUROPEAN CENTRAL BANK (2011) Financial Integration in Europe (May) Germany.

EUROPEAN CENTRAL BANK (2011) Financial Stability Review (June) Germany.

EWING, J and HEALY, J (2010) Cuts to Debt Rating Stir Anxiety in Europe. The New York Times, 27th April.

FORSTER, K. et al (2011) European Cross-Border Financial Flows and the Global Financial Crisis. Occasional Paper Series, European Central Bank, No 126 (July).

NASH, M. (2011) Debt Report: Sovereign Issuers Dominate the Debt Agenda. FTSE Global Markets, Issue 53, pp 32-34 (July / August).

ZANDSTRA, D. (2011) The European Sovereign Debt Crisis and its Evolving Resolution, Capital Markets Law Journal, Volume 6, No. 3, pp 285-316 (May).

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