Thursday, June 21, 2012

Spain's Bond Offering: What Are Investors Thinking?

Spain is in its second recession since 2009 with the highest unemployment rate in Europe. The world may find out later today that the condition of the Spanish banking system is worse than projected by the Spanish government.  Against this background, Spain sold three year bonds at a yield of 5.457 percent.  Why didn't the investors go on strike until after the banking results, when they would have information for pricing their bids?

I heard a comment that some of the big buyers of the issue were the Spanish banks themselves.  The offering is described in the press as being oversubscribed.  It just feels as if these interest rates and this kind of investor behavior border on the same irrationality shown at the peak leading up to the last global crisis. 

I go back to Charles Prince's immortal quote: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing,”

Investors must believe that there is a meaningful liquidity backstop to this euro crisis.  I don't think the backstop can be the ECB or any of the current European credit facilities with the funny acronyms. Surely investors won't be so foolish as to inject cash directly into the Spanish banks.  Therefore, the bailout of the Spanish government must be assured, and so investors buy this deal. 

Going back to a point I've made before: credit default swap spreads were a failed leading indicator of the last crisis. Applying the CDS to sovereign paper seems far worse than applying them to high quality corporate paper, where the spreads seem rational.  Why should they be believed in the case of Spanish sovereign debt now?  Academic researchers, e.g. Takeyama et al. from the University of Essex, have shown that interpreting the information contained in credit default spreads is problematic at best.   I hope these investors get their risk-adjusted rate of return.

To quote Mister T, "I pity the fool!"

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