Sovereign bond crisis keeps on growing

Yields on Portuguese and Spanish debt have soared to new records as financial markets price in another bail-out

Sovereign debt continues to dominate the headlines. After Greece’s woes earlier in the year and Ireland’s reluctant acceptance of an €85bn European Union/IMF rescue package, the focus has now switched to Spain and Portugal.

Politicians in both Iberian peninsular countries insist that a bail-out along the lines of Ireland is not on the cards, but movements in bond markets suggest that could be wishful thinking on their part.

The two key measurements of the risk of holding debt issued by Spain and Portugal have deteriorated sharply since Ireland’s problems sparked the latest leg of the crisis.

Sovereign debt takes the form of bonds issued by a country, usually with a fixed rate of interest called a coupon. It is the coupon that gives rise to the inverse relationship between a bond and interest rates.

As interest rates fall, the value of a bond will rise - as the coupon becomes more valuable - and vice versa. Rising interest rates mean falling bond values.

A key determinant of the value of a bond is the possibility of the risk of default, or an investor not getting back their money.

The higher that risk, the higher the return, through a higher rate of interest demanded by investors to compensate. But above a certain point, the risks are considered too great, whatever the interest rate. At that point it becomes almost impossible for countries to refinance without a bail-out.

Right now, interest rates on Spanish and Portuguese debts are soaring as fears grow about their financial health.

Yields on 10-year Spanish bonds have risen to nearly 5.5%, giving a record spread of nearly three percentage points over the equivalent German bond yield of 2.68%. German bonds are viewed as the eurozone's benchmark.

The difference, or spread, between the yield on Portuguese bonds versus German bonds is even higher.

Portuguese bond yields have climbed above 7% following comments from the country’s central bank that its banks face an “intolerable risk” unless the debt issue is sorted out.

The nervousness of bond markets is illustrated even more starkly in the cost of insuring debt from both countries against the possibility of default.

The cost of this insurance premium, or credit default swaps (CDS) as they are known, has shot up over the past month.

Five-year CDS premiums for Spanish bonds have risen to 365 basis points (bp), while Portuguese CDS are up to 565bp.

A basis point on a credit-default swap contract costs €1,000 a year and protects €10m of debt from default for five years. So it now costs €365,000 to insure €10m of Spanish debt until 2015.

As a comparison, the current premium on €10m of Irish debt is nearly €600,000 while on Greek debt it is over €1m.

Spain’s economy is twice as big as that of Greece, Ireland and Portugal combined and the rise in sovereign debt insurance premiums generally also raises a potentially even bigger worry for the eurozone.

Ireland and Greece have already used up €200bn of the European Union’s €750bn bail-out fund. If Portugal and, more importantly, Spain ever did need to go cap in hand to the EU for a loan, where the money will come from could become a very pressing issue.