Why Hasn’t Refinancing Risk Disappeared?

Germany’s debt management office yesterday failed to sell all the five year bonds it was auctioning. But why hasn’t refinancing risk disappeared?

After all, it’s less than three weeks since the announcement of a €720 billion rescue package from the European Union and the IMF, together with a commitment from the European Central Bank to intervene in the government bond markets to support prices.

According to Gary Jenkins, fixed income strategist at Evolution Securities in London, the lack of investor demand at yesterday’s BOBL auction was primarily a reflection of the miserly 1.47% yield on offer. With the euro down by 9% against the US dollar over the last month, that’s not much compensation for currency risk if you’re a non-European investor, for example.

But Germany has now suffered a number of government bond auctions in the last 18 months where investor bids have failed to cover the total securities offered for sale. Similar events have occurred in the UK, Spain and the Netherlands, while bond auctions in Italy have come close to failing and Belgium has on occasion been forced to cancel bond sales.

Shouldn’t such events be a thing of the past now that governments have committed to backstop investors’ bond purchases?

Part of the problem, according to Jenkins, is the sheer volume of debt to be sold. Italy alone has something like €400 billion of maturing bonds and interest payments to refinance in the next year and a half. If you’re an investor, why hurry to buy? Perhaps yields will rise further to compensate you for the volume on offer, ECB or no ECB in the background as buyer of last resort.

For reference, here’s a chart from Standard and Poor’s showing the amounts to be refinanced by European governments this year as a percentage of GDP, and a table from Morgan Stanley showing the refinancing totals month by month this year (in euros).

An additional concern, says Jenkins, is that the IMF/EU agreement has been set for three years, so there’s lingering doubt about buying any securities with a longer maturity date, even if the betting would have to be on an extension of the bond-buying programme if market conditions don’t improve.

Finally, he adds, there’s still a residual risk that one of the debtor nations might unilaterally tear up its agreements with the IMF and EU and go it alone, defaulting along the way. Greece’s attempt, reported yesterday on Reuters, to renegotiate the terms of the pension reform it had only just agreed to, reminds us that political risk can’t be ignored. General strikes are possible in both Italy and Spain for the summer months in protest against planned government austerity measures.

With credit default swap spreads for the weakest European sovereign borrowers still a good percent above the levels reached on May 10, the day after the EU/IMF rescue package was announced, there’s still clear concern amongst fixed income investors.

Unprecedented sales volumes, currency turmoil, legal uncertainties, threats of social unrest…perhaps it’s unsurprising that refinancing risk in the European government bond markets hasn’t gone away.

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