Sovereign debt: the next bubble?

southsiderosie

On the heels of the recent thread about Ireland's downgrade and the reliability of the ratings agencies, I thought this blog post on the FT website makes a very interesting point about the 'safety' of investments over the last 25 years:

According to the report, between 1990 and 2006 — the year in which issuance of Asset-Backed Securities (ABS) peaked — assets with the highest credit rating rose from a little over 20 per cent of total rated fixed-income issues to almost 55 per cent. Think about it. More than half of the world’s debt securities were, for all intents and purposes, considered risk-free. In 2006, that was nearly $5,000bn of assets.

The financial crisis had a lot to do with triple-A ratings being slapped on to subprime securities which didn’t warrant them, we know that. The report says between 1990 and 2006 ABS accounted for 64 per cent of the total growth in the amount of AAA-rated fixed income, compared with 27 per cent attributable to the growth in public debt, 2 per cent to corporate and 8 per cent to other products.

But watch what starts happening from 2008 and 2009.

The AAA bubble re-inflates and suddenly sovereign debt becomes the major force driving the world’s triple-A supply. The turmoil of 2008 shunted some investors from ABS into safer sovereign debt, it’s true. But you also had a plethora of incoming bank regulation to purposefully herd investors towards holding more government bonds, plus a glut of central bank liquidity facilities accepting government IOUs as collateral. Where ABS dissipated, sovereign debt stood in to fill the gap. And more.

It’s one reason why the sovereign crisis is well and truly painful.

It’s a global repricing of risk, again, but one that has the potential for a much larger pop, so to speak.

Given that the wheels were already starting to come off the wagon, the fact that sovereign debt emerged as a 'safe haven' between 2008-2009 again calls into question the reliability of the ratings agencies. I also have to wonder where this will all go vis-a-vis the melodrama in the US over raising the debt ceiling.

beeftotheheels

http://www.ft.com/intl/cms/s/0/b13d5d56-b16a-11e0-9444-00144feab49a.html#axzz1S50lLvBv

southsiderosie

beeftotheheels wrote: »

http://www.ft.com/intl/cms/s/0/b13d5d56-b16a-11e0-9444-00144feab49a.html#axzz1S50lLvBv

Interesting...this isn't coming up on the WSJ or the NYT sites.

beeftotheheels

southsiderosie wrote: »

Interesting...this isn't coming up on the WSJ or the NYT sites.

I wonder though, what the distinction between delinquency and default is and whether it is a distinction understood by the Eurozone leaders

Reuters have it also

http://www.reuters.com/article/2011/07/18/rating-bonds-eganjones-idUSN1E76H0ZH20110718

so very interesting that it is not getting coverage in the US press!

Had I spotted Reuters first I'd have posted the link above since obviously not everyone can access the FT. I suppose I should have mentioned the content being that one of the smaller, investor funded, rating agencies has downgraded the US a notch which could up pressure on the larger agencies to follow suit.

Elba101

beeftotheheels wrote: »

I wonder though, what the distinction between delinquency and default is and whether it is a distinction understood by the Eurozone leaders

Reuters have it also

http://www.reuters.com/article/2011/07/18/rating-bonds-eganjones-idUSN1E76H0ZH20110718

so very interesting that it is not getting coverage in the US press!

Had I spotted Reuters first I'd have posted the link above since obviously not everyone can access the FT. I suppose I should have mentioned the content being that one of the smaller, investor funded, rating agencies has downgraded the US a notch which could up pressure on the larger agencies to follow suit.

And they most likely will follow suit and the same for Europe. Spain and Italy will be downgraded soon enough by Moody's then the rest. Greece will receive a second bailout package or default then Ireland will follow.

waster81

All the bailouts are ensuring are that finanicial institutions are been saved, bondholders been saved and soverign states been told to cripple their people with "savings" or social services depending on your outlook

later12

It's an interesting question, and one which like many prospective bubble candidates, doesn't attract enough attention until the pop.

Certainly sovereign debt issues have been increasing, and certainly prices have been rising:



First, however, is the question of whether the current activity represents a shift away from the fundamentals? The answer is generally no.

Given the weak inflationary outlook in many of the advanced economies, we have to say that rising bond prices are justified on those grounds. Low yielding bonds during a period of deflation or low inflation can deliver more genuinely nice returns relative to stocks. However, one danger is that while there might exist a sound fundamental reason for price appreciation in sovereign bonds of highly rated advanced economies at the moment, the reputation of such indentures for delivering appreciation may actually overtake the fundamentals at some point, i.e. the market will be fuelled by investors working on the basis of extrapolation of past returns instead of judging the fundamentals.

But I'm not convinced that this has yet occured. There are good reasons to be negative on inflation and to jump onto the sovereign bond bandwagon.

southsiderosie

waster81 wrote: »

All the bailouts are ensuring are that finanicial institutions are been saved, bondholders been saved and soverign states been told to cripple their people with "savings" or social services depending on your outlook

I'm not sure what this has to do with the issue in question?

later10 wrote: »

First, however, is the question of whether the current activity represents a shift away from the fundamentals? The answer is generally no.

Given the weak inflationary outlook in many of the advanced economies, we have to say that rising bond prices are justified on those grounds. Low yielding bonds during a period of deflation or low inflation can deliver more genuinely nice returns relative to stocks. However, one danger is that while there might exist a sound fundamental reason for price appreciation in sovereign bonds of highly rated advanced economies at the moment, the reputation of such indentures for delivering appreciation may actually overtake the fundamentals at some point, i.e. the market will be fuelled by investors working on the basis of extrapolation of past returns instead of judging the fundamentals.

But I'm not convinced that this has yet occured. There are good reasons to be negative on inflation and to jump onto the sovereign bond bandwagon.

But I think the question is not so much that the prices are rising, but rather the fact that the ratings agencies are being overly generous with what they consider to be essentially risk-free debt. Essentially there is grade inflation for securities; I guess the question then is, does this matter?

I think it may matter to the extent that there is a herd mentality among investors and everything is great...until it's not. So instead of a slow slide downwards, there are ratings 'shocks' and/or ill-timed downgrades (too quick; clashing with policy from the perspective of governments) that sends everyone into a panic, driving risk premiums upwards at an even faster rate...thus triggering more panicked government responses...thus continuing the cycle.

beeftotheheels

later10 wrote: »

It's an interesting question, and one which like many prospective bubble candidates, doesn't attract enough attention until the pop.

Certainly sovereign debt issues have been increasing, and certainly prices have been rising:



First, however, is the question of whether the current activity represents a shift away from the fundamentals? The answer is generally no.

Given the weak inflationary outlook in many of the advanced economies, we have to say that rising bond prices are justified on those grounds. Low yielding bonds during a period of deflation or low inflation can deliver more genuinely nice returns relative to stocks. However, one danger is that while there might exist a sound fundamental reason for price appreciation in sovereign bonds of highly rated advanced economies at the moment, the reputation of such indentures for delivering appreciation may actually overtake the fundamentals at some point, i.e. the market will be fuelled by investors working on the basis of extrapolation of past returns instead of judging the fundamentals.

But I'm not convinced that this has yet occured. There are good reasons to be negative on inflation and to jump onto the sovereign bond bandwagon.

Aaaah, now this comes down to a definition of fundamentals. In the private sector world the key issues would be ability to service the debt, and longer term, ability to rollover that debt. Not necessarily the inflation adjusted yield on that debt.

So, to my mind, you're looking at one fundamental, not all of the fundamentals. That one justifies the US triple A grading while a lot of the others do not. More upsetting (actually less so since I've actually explored the parameters of the ignore option which boards.ie affords me) is the fact that you're saying fundamentals suggest one thing when actually quite a few fundamentals suggest the polar opposite.

Not that you're on my ignore list, you'll never be on my ignore list, you're way too intellectually honest for that.

later12

southsiderosie wrote: »

But I think the question is not so much that the prices are rising, but rather the fact that the ratings agencies are being overly generous with what they consider to be essentially risk-free debt.

Perhaps, but increased numbers of AAA issues alone does not necessarily confirm a debasement of the rating. What about the effect of things like securitisation, for example?

And while it may not be on the same scale as increased AAA issue, the global issue of less attractively rated sovereigns has risen significantly in the last 20 years. Whereas more recently, AAA asset backed securities have fallen.



And in recent history, the advanced economies of the world have never been held in such poor regard by the ratings agencies collectively. The US on negative outlook? The UK eyeing its own rating with trepidation? Two of the world's three sovereign safe havens are under fire.
Also, in terms of riskier sovereigns, it would have been almost unthinkable 5 years ago that any mature sovereign would have to supply collateral for derivative trades that it cuts with banks. Yet that is now a reality for some.

Risk is changing, and not necessarily in sovereigns' favour. Investors clearly are questioning the privileges previously enjoyed by a significant number of sovereigns.

I think it may matter to the extent that there is a herd mentality among investors and everything is great...until it's not. So instead of a slow slide downwards, there are ratings 'shocks' and/or ill-timed downgrades (too quick; clashing with policy from the perspective of governments) that sends everyone into a panic, driving risk premiums upwards at an even faster rate...thus triggering more panicked government responses...thus continuing the cycle.

Yes the above certainly is a possibility, the bond rally may well end in tears. But is there too much herd mentality? Are CRAs being too generous? Have investors departed from the fundamentals? These are the fundamental questions, and I don't think there is a convincing argument to answer any of them in the affirmative. Yet.

Beeftotheheels wrote:

So, to my mind, you're looking at one fundamental, not all of the fundamentals. That one justifies the US triple A grading while a lot of the others do not.

Yes I think that's a fair criticism, but I would say it justifies increased investor confidence as opposed to justifying the triple A - which is not (just) a pedantic difference. If the rating is strong, i.e. the country specific risk is low, and the inflation outlook signals that current prices are worth the investment, then an investor should say, ok, this is something we can feel good about. We ought to get back our principal, at least. That's fundamental 1.

Fundamental 2 is the relationship that the current price has with inflation and interest rate expectations. Again taking the US as an example, going by current anticipations on growth and interest rates, the fundamentals still appear to be quite sound.

At some point investors have to go along with the CRAs on this, and if the CRAs judge a sovereign risk to be low, or negligible even, then the investor has to take that seriously into account as an assurance that the fundamentals - or fundamental 1, anyway - is indeed sound.
As highly as I think of Mulder and Scully's "Trust No One" credo (when it comes to finance & investments), investors actually cling to the other great X Files motto instead, "The Truth Is Out There". For them, the truth often transpires in the form of the CRA. God help us.

beeftotheheels

later10 wrote: »

If the rating is strong, i.e. the country specific risk is low, and the inflation outlook signals that current prices are worth the investment, then an investor should say, ok, this is something we can feel good about. We ought to get back our principal, at least. That's fundamental 1.

But that is potentially a self fulfilling prophecy, as are so many things in finance.

For our last downgrade what had happened to change the country specific risk? Nada, nothing, not a sausage. In fact the Troika report which closely followed it said we're doing okay. But Moodys decided that the risk of fallout from Greece was too strong and cut us. Why do Moodys get to decide what is relevant?

The data set you use can alter the fundamentals and there is a serious lack of clarity around the data being used by the CRAs such that the suspicion that they are looking for data to support the conclusions already reached by the markets remains. Does CRA stand for Credit Ratings Agencies or Credit Rationalization Agencies?

I'm not in favor of banning them, but I would make them publish, in detail, the reasons behind every sovereign rating, because I have to say that right now I struggle much more with the US's AAA than I do with most of the others. It looks to be practically untouchable absent an actual default by the US when AAA should be light years away from a default, not meters.

later12

Oh yes, I would agree with you on the CRAs (as per the rationalisation acronym), I don't think there can be many people in any walk of life who are enthusiastic about CRAs and who would not reform them.

Scarily enough, the CRAs actually are reasonably transparent compared to the time when they barely gave any explanation for some of their ratings, just plonked down a rating on the table and said nothing - how deliciously mysterious.

I wouldn't ban CRAs either, but would see you your ratings explanations, and raise you more frequent ratings. Ratings could be supplied on a more constant basis, none of this dramatic posturing of 'we are now in deliberation' as the markets scurry and melt in chaos.

While current grade ratings could remain, the rating could have a delta attached, whose value fluctuates with risk. Not only would a delta add-on allow the market to calm itself as both long and short term ratings moved more gradually, but a quick glance of say BBB+ Δ=+99 would look more appealing than A- Δ=-99

Having said all of that, even if the only service that CRAs provide is to have everybody singing off the same hymn sheet - then at least we are singing off the one hymn sheet, even if we're in the wrong key. It doesn't always necessarily matter if a reference entity is indeed logically a risk free crisis haven or not, but if we all believe that it is, then perhaps it will stay that way.

Well, I did say 'perhaps'...

View

There is a Chinese Credit Rating Agency called Dagong. Some of it's ratings - which are probably important for where China puts its money - are:

AAA - Norway, Denmark, Switzerland, Singapore, Australia and New Zealand
AA+ - China, Germany, the Netherlands and Canada
AA - The USA (recently cut)
AA- - UK, France (both recently cut)
A- - Belgium, Spain, Italy and Malaysia

Ireland is rated BBB by them.

beeftotheheels

http://uk.reuters.com/article/2011/07/21/uk-usa-ratings-sandp-idUKTRE76K5IY20110721

So, S&P now say that there is a 50:50 chance that they will downgrade the US to AA even if the US manages to avoid a technical default on the 2nd of August.

Where is the gobsmacked smilie?

later12

View wrote: »

There is a Chinese Credit Rating Agency called Dagong. Some of it's ratings - which are probably important for where China puts its money - are:

AAA - Norway, Denmark, Switzerland, Singapore, Australia and New Zealand
AA+ - China, Germany, the Netherlands and Canada
AA - The USA (recently cut)
AA- - UK, France (both recently cut)
A- - Belgium, Spain, Italy and Malaysia

Ireland is rated BBB by them.

Ah yes, they were furious when they were refused official SRO recognition by the Securities & Exchange Commission. The only thing their official response lacked were Little Miss Angry emoticons

http://www.dagongcredit.com/dagongweb/english/pr/show.php?id=78&table=web_e_zxzx

I would be wary of any ratings agency that takes an overtly nationalistic tone and has as much support (and apprent ties) as it enjoys from the Chinese state. Having said that, is Dagong any worse than those CRAs that are subject to meeting the demands of ratings shoppers, and even, perhaps suspiciously, downgrade one another? Not necessarily.

Scofflaw

later10 wrote: »

I would be wary of any ratings agency that takes an overtly nationalistic tone and has as much support (and apprent ties) as it enjoys from the Chinese state.

I would imagine that that's the main value of such an agency. True, it's not quite the same thing as the other ratings agencies, but it still has a certain value when the strings are as apparent as they are.

cordially,
Scofflaw

later12

Well you'd have to wonder whether the views of Dagong are the views actually held by the Chinese sovereign wealth funds, or the views that the Chinese authorities would rather be expressed.

I think we can tell a lot more about what the Chinese actually think by their actions, e.g. via their forex reserves, activity at sovereign debt auctions, or documents released to the SEC on their sovereign wealth investments. The Chinese and Japanese (why am I bunching them together?) are actually quite open on this stuff.

ArphaRima

I think we can tell a lot more about what the Chinese actually think by their actions

Always judge the Chinese (or any communist government) by what they do, not by what they say.
There is less accountability in a non-elected government to officials proclaiming policies or views and then reneging on them. All businesses (domestic and foreign) exist on the whim of the government.

rumour

View wrote: »

There is a Chinese Credit Rating Agency called Dagong. Some of it's ratings - which are probably important for where China puts its money - are:

AAA - Norway, Denmark, Switzerland, Singapore, Australia and New Zealand
AA+ - China, Germany, the Netherlands and Canada
AA - The USA (recently cut)
AA- - UK, France (both recently cut)
A- - Belgium, Spain, Italy and Malaysia

Ireland is rated BBB by them.

Thats interesting for some years i've followed weiss advice which has seemed pretty good. They are now providing their own ratings (bottom of page)which are pretty consistent with the ratings above.
There is also an equivalence with other ratings agencies provided.

In addition to being much more inline with Chinese thinking than the standard three they have been warning about a sovereign bond bubble for at least a year now. Things are pretty much unfolding as they have predicted.

Of course depending on how you choose to analyse information it could be disregarded in favour of our 'talk up the market' merchants. On the other hand if you want to make money i'd certainly take on board seriously what they say.

View

later10 wrote: »

I would be wary of any ratings agency that takes an overtly nationalistic tone and has as much support (and apprent ties) as it enjoys from the Chinese state.

I could well believe they are being a overly generous in rating China as I am sure there is an element of "home bias" if nothing else. Then again, the other agencies will all have their own home biases also depending on their global view.

It is interesting to see how they rate other states though if only to compare it with the other agencies.

View

Courtesy of The Guardian.

Finnbar01

later10 wrote: »

Ah yes, they were furious when they were refused official SRO recognition by the Securities & Exchange Commission. The only thing their official response lacked were Little Miss Angry emoticons

http://www.dagongcredit.com/dagongweb/english/pr/show.php?id=78&table=web_e_zxzx

I would be wary of any ratings agency that takes an overtly nationalistic tone and has as much support (and apprent ties) as it enjoys from the Chinese state. Having said that, is Dagong any worse than those CRAs that are subject to meeting the demands of ratings shoppers, and even, perhaps suspiciously, downgrade one another? Not necessarily.

I won't trust any rating agencies. Full. Stop.

beeftotheheels

Well, they did it http://www.ft.com/intl/cms/s/0/06999f9a-bf84-11e0-90d5-00144feabdc0.html

They made a complete hash of it and laid themselves open to all manner of criticism but they went and did it!

S&P 500 down over 3%, treasuries actually rose.

Where to now with the global economy, can we flog Croagh Patrick (there was talk of gold in dem der hills a while back was there not?)?

Scofflaw

beeftotheheels wrote: »

Well, they did it http://www.ft.com/intl/cms/s/0/06999f9a-bf84-11e0-90d5-00144feabdc0.html

They made a complete hash of it and laid themselves open to all manner of criticism but they went and did it!

S&P 500 down over 3%, treasuries actually rose.

Where to now with the global economy, can we flog Croagh Patrick (there was talk of gold in dem der hills a while back was there not?)?

You can't, it's private property - although I believe my mother is open to offers for her quarter of it.

cordially,
Scofflaw

beeftotheheels

Scofflaw wrote: »

You can't, it's private property - although I believe my mother is open to offers for her quarter of it.

cordially,
Scofflaw

I assume that it is commonage so you can't convince her to allow you set up a little mine on her quarter? I mean a drop of cyanide or two could really only benefit Clew bay, bound to kill algae or seaweed or some other undesirables (pilgrims walking barefoot up the Reek?).