Guest Post: It’s Only PIG: Fears About Spain Are Overblown

Submitted by JM

It’s only PIG:  Fears about Spain are Overblown

OTR bonds yields just don’t support the case that Spain is the “S” in the PIGS.  Spanish debt is higher than Bunds, but they are nothing like unserviceable. 

It makes more sense to think of EU sovereigns as junk grade: Greece, Ireland, and Portugal; middle tier credits with balance sheet stress that appreciably impact yields, like Belgium, Spain, and Italy; and credits like Germany and the Netherlands that benefit from derisking.

Q1 GDP grew .7% y-o-y.  Also, the CDS market shows an improvement in sentiment on Spain.

Spanish CDS, May 2010-tonight

Assuming 40% recovery, this spread is pricing in a 14% probability of a Spanish default in the next five years.  One shouldn't think of this probability of default as a classic probability derived from frequencies.  It is the view on default implied by aggregate buyers and sellers of Spanish government credit risk at the 5 year tenor.  This notion of implied probability “works” because it is the meeting place of willing buyer and seller at a given point in time.  It is nothing more than a market view of credit risk given the premium needed for a seller and the credit risk hedging needed for a buyer to both take the trade.  

There are other possible explanations that sentiment in this spread.  Possibly the CDS spreads reflect a certain large marginal buyers selling CDS to push down cash yields, acting to create a kind of fake-out.  CDS premium is cheap to OTR cash yields (see below).   Either way, the spread is an indicator of the the view of institutions with fast execution and informational advantage over most others. 

There are legitimate grips about the information content of these spreads, which I respect.  But CDS were created and function to address a basic business need that dealers have.  Dealers have an inventory of underlying securities on which they need to hedge credit risk.  The need became acute in the early 1990s because extremely low interest rate and liquidity policies from central banks altered the return distributions on bonds of all types.  These policies lower the first and second moments of the distributiion at the expense of much fatter tails that are best dealt with by hedging.

Politics Matters

The correlation between the Euro and Spanish credit risk shows that Spain is a domino too big to fail.  It is difficult to conceive of a situation where policymakers would say goodbye to their own jobs by permitting a default.  These are fundamentals that matter.     


It is doubtful that policy can actually stave off default, because liquidity provision is the limits of their arsenal.  However, liquidity policy can extend kicking the can down the road for a time.  The bottom line is cost of funding.  Once it reaches a threshold level, there is just too much pain and default becomes the politically acceptable option.  We are nowhere near funding costs that in Spanish government bonds.  If fact, the relative pricing of synthetic and cash makes for a compelling trade. 

Bottom line here is that one can use numbers and information to play the numbers, but the view you take is always speculative.

OTR Spanish 5Y Government Bonds, tonight’s quote