Greek Bailout Isn't a Bond Cure-All

Debt Yields Seen Rising for Other Struggling European Nations; Markets Acting 'More Rationally'

By TOM LAURICELLA
The deal to bail out Greece reached over the weekend might undo some of the recent damage done to other European bond markets, but some investors expect government bond yields to keep rising for many heavily indebted countries.

They argue that yields on bonds issued by countries such as Portugal, Spain and the U.K. were too low in the first place, given the risks posed by their big budget deficits.

At the beginning of April, even as the crisis in Greece was escalating and contagion fears were growing, Portugal's 10-year notes were yielding 4.11% and Italian 10-years were yielding 3.85%; U.S. Treasurys were yielding 3.95%, according to Tradeweb data.

While the U.S. has its own deficit problems, that yield gap meant investors believed it was only a touch more risky to lend money to Portugal than to the U.S., which has a significantly more diverse and productive economy.

As the selloff accelerated over the month, the yield on Portugal's 10-year notes rose to 5% Friday, 1.34 percentage points more than the 3.66% yield on 10-year U.S. Treasurys. Italy's 10-year debt yield stood 0.34 percentage point above the 10-year Treasury. (As prices drop, yields rise.)

"In many ways the markets are behaving more rationally now," says Scott Mather, head of global portfolio management at Pacific Investment Management Co., where many of the firm's funds have avoided government debt from heavily indebted, developed countries.

Only recently have investors begun to differentiate between European countries based on their economic and fiscal outlooks. They are "not relying on the political rhetoric and ratings agencies alone to dictate" bond yields, Mr. Mather says.

Investors accepted low yields from countries like Greece and Portugal because they believed that once they had adopted the euro, the European Union's strict monetary policy and tough fiscal rules would make such countries less risky.

Michael Cirami, a portfolio manager on Eaton Vance's global fixed-income team, says the recent jumps in yield were justified and will likely continue, even if investors stop worrying about a possible government default.

Mr. Cirami, whose firm is betting yields will rise, says yields on five-year debt issued by countries such as Italy and Portugal should be somewhere between four and seven percentage points above those in Germany. Even now, Portugal's yield is less than three percentage points above Germany's, and Italy's five-year yields are less than one percentage point above. "Spreads should be materially higher at this point," Mr. Cirami says.

The situation has strong echoes of the underpricing of risk by financial institutions even after the housing crisis began to unfold.

Another parallel: the assumption by holders of Fannie Mae and Freddie Mac preferred shares that their investment was backed by the U.S. government. That turned out not to be the case, and those debtholders were wiped out.

Over the weekend, the EU prepared a package of direct loans from the International Monetary Fund and euro-zone countries—the largest share will come from Germany. The deal is expected to total more than €100 billion ($133 billion) over three years.

Before the deal started to come together last week, European bond yields had risen sharply—particularly on shorter-term debt—as the prospects for approval of a backstop program seemed to be in doubt.

That was magnified by credit-rating downgrades of Portugal and Greece. Yields on Spanish two-year notes jumped to more than 2% from around 1.5% a week earlier.

Yields on two-year notes issued by Italy, Belgium and the U.K. each rose roughly 0.2 percentage point. Even Ireland, which is widely seen as having aggressively tackled its debt problems, saw two-year note yields spike by well more than one percentage point.

This move elicited complaints from European officials that the markets were behaving irrationally and sparked a flight out of riskier investments such as stocks and commodities.

But the European markets were behaving exactly as they should, says Carmen Reinhart, an economics professor at the University of Maryland.

"Once a country such as Greece comes to foreground…everybody in the financial community looks around and says, 'Aha, these others have similar characteristics,' " Ms. Reinhart says. "You could call it contagion, but…the fact is that they have common fundamentals that are troublesome."

Mark Schofield, global head of interest-rate strategy at Citigroup in London, says investors trying to value government debt tend to put much greater weight on the impact of short-term changes in monetary policy and economic cycles, often leading them to underprice sovereign risk.

But Mr. Schofield says there is a measurable relationship between bond yields and changes in the deficit, and historically, the lower the credit quality of a country, the stronger that relationship.

In the case of a country rated triple-A, such as the U.S., an increase of a budget deficit by 1% of gross domestic product should increase 10-year note yields by about 0.07 percentage point, Mr. Schofield says. For a country rated triple-B, such as Greece, a similar change in deficits should move yields by roughly 0.2 percentage point.

Mr. Schofield thinks the rise in Portuguese yields may have overshot a bit, but in the U.K., where the budget deficit has worsened to 12% of GDP, yields could rise further. Current U.K. 10-year gilts are yielding around 3.8%, which is about 0.8 percentage point over German bonds. Should the country be downgraded to double-A from triple-A, a 1.4-percentage-point spread would be warranted, he says.

Pimco's Mr. Mather says that at some point there is a good chance the markets will overshoot, but that stage hasn't been reached.

In fact, "over the next several years you're going to have a series of rolling debt crises," he says. Against that backdrop, the markets are "undergoing a major regime shift in terms of people recognizing that sovereign risk is underpriced."