Currency Convertibility Is Back as a Risk in European Bonds

Besides default, perhaps the biggest risk to holders of euro-denominated bonds is currency convertibility. It isn't talked about all that often, but it hangs over the market like a black cloud. The fear is that some geopolitical event causes a member of the euro zone to decide to exit the union and investors holding sovereign bonds denominated in euros are suddenly left with securities denominated in some other currency.

This risk was on full display during the Greece debt crisis. The nation's bonds plunged not only because of its fiscal troubles, but also because of speculation the country might leave the euro zone and resurrect the drachma. If you lent money in euros, you surely don't want to be paid back in devalued drachmas. Now, investors are confronted with currency-convertibility risk again as Catalonia’s separatists in Spain have say nothing will stop their drive toward an independent state. Whether you believe Catalonia will successfully secede or not, the developments demonstrate the democratic power of local politicians to hold such referendums.

Although the Catalans say they want to stay in the euro zone, that's little solace to holders of Spanish bonds: The region accounts for 20 percent of the country's gross domestic product. Since the referendum issue heated up early September, weakness in Spanish bonds has even caused European peripheral yield spreads to widen in sympathy. That suggests markets see a risk that if Catalonia succeeds, populist movements in other European countries might seek to hold similar referendums, threatening the euro. Populism and currency-convertibility risk are closely related. Recall the market anxiety during the recent French presidential election when candidate Marine Le Pen ran on a campaign of leaving the euro.