Home > Finance, macro, politics > Do the prices of European bonds reflect default chances?

Do the prices of European bonds reflect default chances?

I have a tendency to reject the conventional wisdom without thinking.   So much so that I more than half suspect that this knee-jerk skepticism of mine works on the level of what Kahneman would call “System 1”–effortless thinking– rather than on “System 2” which is supposed to be the skeptical part of your mind.   One reason I say this, is that I come across essays like this from Krugman or this from Yglesias both of which reflect my thinking right back at me.   Both have argued in the past that Greece was the “exception” in the Euro-mess, while I see no important differences on the macro-level (as opposed to the, largely irrelevent, micro-level inefficiencies of the Greek system).    I would almost think that Yglesias/Krugman read me, except that, to a good approximation, no one reads me (hi mom!–j/k… she doesn’t read me, either).

Well, let’s see if we really are on the same page after all.   I have another anti-CW thought rolling around my brain.   It seems to be taken as given that bond spreads in the Euro-periphery reflect the risk of sovereign default.   I call BS.   There’s a much bigger effect on bond yields: Euro-breakup.

So what do you think is more likely: the periphery nations stay on the Euro, but default on debts, or the periphery nations drop the Euro?   If you think the latter, than we are on the same page.   Consider: If the periphery drops the Euro, what happens to the real value of bonds?   What happens to default probability?

On the second question, the answer is easy.   Once the Euro is dropped, all domestic debts would be re-denominated in the local currency–this includes bonds.   Debtors in these countries will demand the option to repay in the new currency (drachmas).  Creditors will demand repayment in their new currency (marks).   It is debtors who hold the purse-strings.   It will be messy, but debts will be inflated away.   The chances of default would fall dramatically–although perhaps Greece might still find it be in its interests to default anyway.

The first question is more interesting.   Exit for the peripheral nations means large devaluations of their currencies.   Breakup for Germany means a revaluation of its currency.

Suppose that you are an investor in Europe right now.   You can buy a Greek bond or a German bond.  It will be practically impossible to pay only Greek citizens drachmas and German citizens marks.   You know this, so you would want to purchase the bond with the highest real value after a Euro-breakup.   In particular, a German bond will be worth more than its face value if it is converted one for one from Euro-denominated to mark-denominated.   On the other hand, the Greek bond will be worth less if it is converted one for one to drachmas.

Then, you as a bond investor will buy the Greek bond only if there is a discount roughly equal to the probability of exit times the expected exchange rate of drachmas in terms of marks, since the mark would be expected to rise considerably and the drachma to fall even more dramatically.   Let’s put some numbers to this.   If the new exchange rate is expected to be 2-1 and the probability of exit is about 50-50, than a Greek bond is worth (in PDV) about 25% less than the equivalent German bond.   That’s huge.   I’m too lazy to turn that into a yield for the sole purpose of this post, but that could easily explain the majority of the German/Greek spread.

None of this is to say that default isn’t reflected in the price of bonds, rather my point is that exit/devaluation likely dominate the German/periphery spread.   This means that a simple (yet binding) commitment to keep these nations in the Eurozone  would in itself bring down spreads considerably.   On the other hand, a small increase in the probability of exit increases refinancing costs and hence the probability of exit, and hence refi costs, etc.

Categories: Finance, macro, politics
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