Friday, November 25, 2011

Inverted Italian yield curve spells trouble

A distressed credit tends to exhibit the so-called "inverted yield curve".  The reason is that in a bankruptcy the bond maturity generally does not matter - all pari passu (same seniority) paper tends to have the same recovery (thus the same discount).  If you apply the same discount to shorter maturity paper, it will generally have higher yield (depending on the coupon) than the longer term bond from that issuer.  Distressed bonds are said to "trade on price" rather than yield.  For example a 10-year bond with a 5% coupon trading at 80 cents on the dollar would yield 8% (you can check this using the YIELD function in Excel).  A 2-year bond with the same coupon also trading at 80 would yield 18%. Thus we have an inverted yield curve.  This also holds true for inverted CDS curves.

So why did we start this beautiful Black Friday morning with a discussion of inverted yield curves?  Because Italian government bonds are now trading in that fashion. Of course one can get an inverted curve, as was the case in the US in 07, due to expectations of falling short-term rates.  That's why a traditional inverted yield curve tends to forecast a recession.  But for the first time we get an inverted yield curve in a major sovereign nation (not counting Greece) due to credit risk - with significant probability of default priced in.  This morning's auction of short-term Italian bonds was a disaster.
Bloomberg: The Italian Treasury paid 6.504 percent to auction 8 billion euros ($10.6 billion) of the six-month debt, almost twice the 3.535 percent a month ago and the highest since August 1997. Italy’s two-year bonds yielded a euro-era record 7.82 percent, almost 50 basis points more than 10-year notes.
 We now have over 100 basis "inversion" between the 1-year and the 10-year Italian bonds.

Italian government yield curve - now and a month ago (Bloomberg)

This is a dangerous development because as discussed before it will put further pressure on European financial institutions (including French and German banks) who hold a great deal of Italian debt.  Deutsche Bank is the one to watch in particular, given its size and leverage.   It will also completely "crowd out" Italian corporations from rolling or obtaining new loans.

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