In this article, we will talk about how issues concerning sovereign debt can affect an investor’s portfolio. Sovereign debt is a term that was probably unknown a decade or two ago, and many of today’s younger investors have probably never come across the term until two years ago when Greece, Spain, Ireland and Portugal gave us a reason to get to know what the concept was all about.
Sovereign debt is all about debt instruments that have been issued by national governments to raise money to fulfil their budgetary obligations. Another name for sovereign debt is national debt or public debt. Almost every country of the world owes money in the form of debt instruments/bonds. Governments are responsible for most of the spending on infrastructure, salaries and other sectors of the economy on which the citizenry and private sector can function. These expenses are huge and unless a government has enough resources from its natural and human capital, there is really no way to foot the bills. As such, the money available to governments to fund their projects and expenditure for the fiscal year has to come from borrowed funds. Governments can decide to borrow from financial institutions such as the International Monetary Fund (IMF) and World Bank, or can decide to access cheaper and more flexible financing in the form of issuance of debt instruments. A common debt instrument issued by national governments is bonds. Under this arrangement, a government is leveraging on its ability to make money from sale of its natural resources (if any), increase in taxation, reduction in public spending, or by its ability to print more money using the instrumentality of the central bank, to tell investors to lend it money in return for an interest to be paid along with the principal in years to come. The maturity of the bonds (i.e. date at which the bond money is to be paid back to investors) is set at anything between three months to 30 years.
Governments are regarded as being too credit-worthy to default on bond payments, but the global financial crisis and the effect that this has had on several countries, especially the members of the European Union, has begun to challenge this long-held belief. The national governments of Greece, Spain, Ireland, Iceland and Portugal have been hit by financial crises that have challenged their ability to repay the sovereign debt that they acquired over the years. Part of the problem has been that some of these debts were acquired before the adoption of the Euro in 1999, and now having to pay off these debts in Europs have made it more expensive for these countries to pay off these debts (currency mismatch).
What happened after these problems developed? Let us see the impact of these crises on the stock markets across Europe and on the currency of the Eurozone countries, the Euro.
Impact of Sovereign Debt
Three well recognised phenomena follow a declaration by a national government on its inability or outright refusal to pay off its bond obligations as a result of cash flow problems.
1) There is a currency crisis.
2) There is also an economic crisis
3) The banking sector of the country will also suffer.
The balance of payment deficits that occur after a sovereign debt crisis will usually lead to an attack on the nation’s currency by speculators, leading to sharp falls in the foreign exchange market. As the currency starts to drop, citizens will dump the currency for more stable foreign currencies, leading to even steeper falls in the value of that currency. Let us look at what happened to the Euro when the sovereign debt crisis began to unravel.
Early 2010: Greece is hit by sovereign debt crisis: The exchange rate of the Euro versus the Swiss Franc drops from 1.4586 to just below 1.2770 between late May and September 2010. The Euro also dropped close to 1800 pips against the US Dollar from 1.3693 in March 2010 to about 1.1850 in June 2010.
November 2010: The full extent of Ireland’s sovereign debt crisis became apparent to the markets. It soon became clear that Ireland would require a huge bailout. The currency used in Ireland is the Euro, which took another massive hit in the forex market, selling off from just above 1.4133 to the US Dollar to 1.2970 in three weeks! The Euro also sold off against the Swiss Franc from 1.3743 to a low of 1.2399 in the same month. The Swiss National Bank was forced to introduce a minimum exchange rate peg on the EURCHF to stop the slide.
April/May 2012: The Euro once again experienced a drop from levels above 1.3300 to just above 1.2040 as it became apparent that the Spanish banking system was in dire need of a bailout in order to prevent a total collapse.
These three modern-day instances show clearly the bearish attacks on the Euro as a result of sovereign debt crisis.
Invariably, the credit rating of affected countries drop and leads to widening spreads on their treasury yields.
With a systemic collapse of the financial system, a run on the banks is inevitable unless there is a timely intervention by the central bank or international financial institutions like the IMF or World Bank.
Impact on Investor Portfolio
Problems create opportunities. Anytime there is a speculative attack on the currency of a debt defaulting nation, investors can make a lot of money from shorting that currency. The total loss sustained by the Euro in the various speculative attacks it suffered was more than 6,000 pips, which would have made standard lot traders shorting the Euro very rich indeed.
If an investor is holding the stocks of banks in a nation close to bond repayment default, that investor could be wiped out. However, professional investors can hedge those trades in the options market and cover losses on long positions in the affected stocks. This requires professional investment advice and is not suitable for everyone.
The final take on this is that a bond default situation could create losses for investors in some asset categories while creating money-making opportunities in other markets. If an investor knows how to play the markets at this time, their portfolios will actually come out healthier.