Bunds Lose to Treasuries as Swaps Count Costs of Rescue

German Chancellor Angela Merkel
German Chancellor Angela Merkel. Photographer: Jock Fistick/Bloomberg

For the first time, the U.S. is at risk of defaulting, and derivatives show that it’s riskier to hold German bunds than Treasuries.

Credit-default swaps tied to bunds jumped about 39 percent this month, pushing the cost of insuring against losses above that for U.S. debt. That hasn’t happened since April. All 20 strategists and economists surveyed by Bloomberg say yields on 10-year German securities will rise by year-end, after falling as investors sought a haven from the region’s debt turmoil.

While Germany’s economy is growing faster than the U.S. and the rest of the euro zone, bond traders are concerned about the spiraling costs the nation will face as Chancellor Angela Merkel leads the bailout of cash-strapped partners among the 17 nations that share the currency. Germany has failed to receive enough bids for all the bonds offered at auctions three times this year.

“The solution to the peripheral crisis is Germany pillaging its balance sheet by lending more and more money to troubled countries,” Stuart Thomson, a money manager in Glasgow at Ignis Asset Management, which oversees $120 billion, said in an interview last week. “That view is reflected in the CDS prices, but not bond yields. The idea of fiscal union will eventually undermine German sovereign credibility. We are more positive about Treasuries than bunds.”

Europe Bailouts

The European Union and International Monetary Fund have committed about 365 billion euros ($525 billion) to bail out Greece, Ireland and Portugal, including an additional 109 billion euros for Greece last week. The aid comes partly from a 440 billion-euro EU facility, which can buy bonds of debt-laden nations.

Germany is responsible for 27 percent of the rescue funds, according to a European Financial Stability Facility document.

The yield on the benchmark 10-year German bund jumped 13 basis points, or 0.13 percentage point, last week to 2.83 percent, according to data compiled by Bloomberg. Treasury 10-year yields rose 6 basis points to 2.96 percent. The spread has narrowed from as much as 53 basis points in January.

Treasury 10-year notes yielded 2.98 percent today as of 11:49 a.m. in New York, while bund yields were six basis points lower at 2.76 percent.

Bund yields will rise to 3.36 percent by year-end, while Treasury rates will increase to 3.5 percent, according to the median estimate of economists and strategists surveyed by Bloomberg.

Lagging Behind

Returns on bunds are already lagging behind Treasuries, gaining 1.4 percent this year, compared with 3.3 percent in the U.S., according to Bank of America Merrill Lynch indexes.

Treasuries rose this month even after Moody’s Investors Service and Standard & Poor’s said the U.S. may lose its top AAA credit rating if lawmakers don’t raise the nation’s $14.3 trillion debt ceiling and there is no credible plan to lower the $1.3 trillion budget deficit. Germany has the same ranking.

“Although Germany’s public finances have worsened as a result of the recession, the deterioration has been more contained than that of several ‘AAA’ rated peers, whose steep deficit increases have been more pronounced and may well persist for longer,” S&P said in a May 18 report.

Credit-default swaps suggest the forecasts for bund yields may be too conservative. The cost of hedging against losses in German debt for five years ended last week at 56.8 basis points, compared with 52.9 for the U.S., according to data provider CMA, which is owned by Chicago-based exchange owner CME Group Inc. German swaps rose above their U.S. counterparts on July 11 for the first time since April 26.

Contracts Outstanding

The contracts typically increase as investor confidence deteriorates and fall when it improves. Swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a swap protecting $10 million of debt.

“CDSs can lead or foreshadow a movement in the cash market,” Bradley Tank, the chief investment officer for fixed income in Chicago at Neuberger Berman Fixed Income LLC, which oversees about $83 billion, said in an interview last week. “What’s viewed as positive for bunds over the short term, to the extent that Germany shoulders a substantial portion of the restructuring responsibility, this could be construed as a negative.”

Banks and investors had bought or sold a net $16.6 billion of protection on German bunds as of July 15, compared with $4.8 billion on Treasuries, according to the Depository Trust & Clearing Corp., which runs a central registry for the market.

Smaller Deficit

While Germany, Europe’s largest economy, is bearing the brunt of the euro-area bailouts, its finances are in better shape than the U.S. and the nation is growing faster.

Germany’s budget deficit is 3.3 percent of its economy, compared with 9.1 percent for America, according to data compiled by Bloomberg. Gross domestic product will likely expand 3.4 percent in 2011, versus 2.5 percent for the U.S., based on the median estimate of at least 25 economists in separate Bloomberg surveys.

Republicans yesterday prepared to force action on a shorter-term extension of the U.S. debt limit than President Barack Obama has requested, defying a veto threat amid warnings that continued stalemate risks roiling financial markets. The president would veto a measure to raise the debt ceiling if it doesn’t extend the limit into 2013, White House Chief of Staff Bill Daley said in an interview on NBC’s “Meet the Press.”

Less Safe

“The risk to the U.S. credit rating may cause bunds to outperform,” John Canavan, a fixed-income strategist at Stone & McCarthy Research Associates in Princeton, New Jersey, said in an interview last week. “If we’re not able to pay the bills we’ve already amassed, then people will be less likely to see the U.S. as the historical safe haven.”

A default would be the first of its type in U.S. history, Steven Hess, the senior credit officer at Moody’s in New York, wrote in an e-mail last week. The government was late to make payments on about $122 million of bills in 1979, in part, because of “severe technical difficulties” that the Treasury said stemmed from a failure in word-processing equipment, Terry Zivney and Richard Marcus wrote in August 1989 in the “The Financial Review.”

Bunds to Rally

A deterioration in Europe to the point that Greece or another nation leaves the currency union would cause bunds to rally, said David Keeble, the head of interest-rate strategy at Credit Agricole Corporate & Investment Bank in New York.

“If there’s a hint of a breakup, everyone would flood out of peripheral countries and into the core,” Keeble said in an interview last week. “Countries would be a lot weaker. You would want to keep your money in bunds, so you would see a move downward in yields.”

Greece may be joined by Portugal and Ireland in asking for a second bailout, Moody’s said this month after cutting the nations’ credit ratings to junk. Italian and Spanish 10-year bond yields exceeded 6 percent in July, within 1 percentage point of the level that triggered rescues for Greece, Ireland and Portugal.

Merkel is committing more German money to ensure the EU holds together, though 61 percent of the nation’s citizens are opposed to granting Greece partial debt relief and 56 percent said the euro has mainly brought them disadvantages, N24 television reported July 21, citing a poll it commissioned from Emnid GmbH.

“Europe is unthinkable without the euro,” Merkel told reporters July 22 in Berlin.

‘Worst Case Scenario’

The euro has weakened 1.22 percent the past month, trimming its gain for the year to 0.78 percent, according to Bloomberg Correlation-Weighted Indexes, which track a currency’s performance against a basket of nine others, including the dollar and yen.

To deal with the “worst case scenario” of contagion spreading to Italy or Spain, European leaders should almost triple the size of the rescue fund under the European Stability Mechanism to 2 trillion euros, said Paolo Manasse, an economics professor at University of Bologna.

Under that scenario, Germany could be liable for as much as 540 billion euros of loans and guarantees, equivalent to about 22 percent of its 2010 gross domestic product.

The cost to Germany would be even greater under a proposal to issue common euro area bonds, according to Mohit Kumar, head of euro-region and U.K. interest-rate strategy at Deutsche Bank AG in London.

Declining Demand

“Common euro bonds would be an ideal solution, but it will definitely raise borrowing costs of AAA countries like Germany and France,” he said. Every extra 75 billion euros in AAA debt could push bond yields up by 30 basis points, he said.

Germany hasn’t received enough bids for all the bonds offered at auctions three times this year and six times in 2010. Unsold bonds are kept by the Bundesbank and released to the market in the following days and weeks.

Demand fell at a German auction of 10-year bunds on July 13, the day after Ireland was downgraded to below investment grade. Bids totaled 1.2 times the amount of securities offered, the lowest so-called bid-to-cover ratio this year. Speculative grade bonds are rated below BBB- by S&P and less than Baa3 by Moody’s.

Debt Sales

The U.S. Treasury attracted higher-than-average demand at three note and bond auctions totaling $66 billion in the week ended July 15.

Investors bid for 3.22 times the amount of securities offered at a sale of three-year notes on July 12, up from an average of 3.14 for the past 10 auctions. The bid-to-cover ratio was 3.17 at the 10-year note offering the following day, rising from an average of 3.11. The measure was 2.8 for the 30-year bond auction on July 14, higher than the 2.64 average.

“Treasuries will retain the safe-haven status even with a downgrade because it still remains the world’s lone superpower,” said Gary Pollack, a money manager who helps oversee $12 billion as head of fixed-income trading at Deutsche Bank Private Wealth Management in New York. “The dollar is still the world’s reserve currency. We’re still the wealthiest nation. Our bond market is still the largest and most liquid, and there’s no competition from a global point of view.”

The $9.3 trillion Treasury market may even rally in a U.S. default as stocks, mortgage debt and corporate bonds will likely be the first to decline as investors ditch risky assets, according to Thomson at Ignis.

“If anything, Treasuries will become even more of a safe haven in that situation,” said Thomson. “There aren’t that many alternatives for this market in terms of depth. Where else would China be able to park $1.2 trillion of its money?”

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