Thursday, August 31, 2017

The Wacky World of Sovereign Bonds

Updated September 6, 2017

Remember back in September 2011 when Standard & Poors lowered the debt rating of Italy from A+ to A and again in December 2014 when it cut the rating further to BBB-, one notch above junk bonds after it looked like the high level of Italy's sovereign debt was becoming chronically  problematic?  While it may seem like a lifetime ago, the PIIGS debt crisis began only only seven and a half years ago and it seems that the bond market is doomed to repeat its mistakes of the past, only in a much more painful way for investors.

According to National Debt Clocks, here's what Italy's national debt looks like now (in USD):


Here is a graphic showing how Italy's sovereign debt has grown as a percentage of its GDP:


Since 2011 at the height of the Eurozone debt crisis, Italy's debt situation has worsened from 117.9 percent of GDP to 157.3 percent of GDP in 2015.
  
Over the past twenty years, Italy's general government spending as a percentage of GDP has varied from a low of 45.5 percent in 2000 to its most recent level of 50.31 percent in 2015.  Unfortunately, on the revenue side of the equation, general government revenue has varied from a low of 42.97 percent of GDP in 2005 to its 2015 level of 47.76 percent.  This has led to deficits which vary from a low of 1.32 percent in 2000 to its 2015 level of 2.44 percent.  Despite the wakeup call of 2010 - 2011,  Italy's federal deficits have ranged from 3.71 percent of GDP in 2011, 2.93 percent in 2012, 2.92 percent in 2013, 3.02 percent in 2014, 2.69 percent in 2015 and 2.44 percent in 2016.  This suggests that Italy has made very little progress in fixing its own fiscal problems.

To put Italy's sovereign debt issues into context, here is a graphic showing how the level of Italy's sovereign debt-to-GDP compares to other developed and less developed nations:


As you can see, at 157.3 percent, Italy's sovereign debt-to-GDP ratio is the third worst in the world after Japan (a nation with an ongoing and unique demographic problem) and Greece (a nation that is perpetually on the wrong side of fiscal prudence).

Now, let's look at how the bond markets have reacted to this ongoing and burgeoning Italian debt crisis.  Here is what has happened to the yields on Italy's two year bonds over the past ten years:


In case you think that there is something wrong with your vision, let's look at a closeup of the yields over the past year:


That's right, for the great honour of lending Italy, one of the world's most indebted economies, your hard-earned dollars for two years, you will actually lose money since the current yield on the two year Italian bond is negative 0.124 percent, down from 0.062 percent just one week earlier.  And just when you thought that negative yields were a thing of the past!  The current yield on two year Italian bonds is down from a peak of 7.9 percent back in November 2011 when it looked like Italy had the potential to follow in the footsteps of its PIIGS peers and have to renegotiate its debt, providing its debt holders with that painful "haircut" that no bond investor likes to face.

So, since 2011 when Italy's debt was "only" 117.9 percent of its economy and yields on its two year bonds were just south of 8 percent, the situation has worsened to the point where Italy's sovereign debt is now nearly 160 percent of its economy and yet, thanks to central banks flooding the economy with "cash" and lowering interest rates to all-time lows, investors in Italian two year bonds will lose 0.064 percent of their investment if they hold the bonds to maturity, meaning that they actually get to pay for the privilege of holding one of the higher risk sovereign bonds in the world.

And yet, central bankers would have us believe that all is well in the global economy while this data would strongly suggest otherwise.  Investors pay heed.

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