Thursday, July 15, 2010

A Big Fat Greek Yield

The purpose of this article is to explain why Greece will not default and that there are still some amazing profits to be made from this diamond in the rough, including some wonderful high yield funds, which are mentioned at the end. Although she may look ugly on the outside, this ugly duckling is surely the place to be. We will start with yield on the current 10-year Greek issue. Basically market sentiment concerning Greece defaulting on their debt obligations is easing quite noticeably. Yields are showing this new sentiment as they have come off their highs. The 10-year yield on the active 10-year Greek note is around 10.3%.

The chart below depicts various yield spreads, which were calculated as the yield on the German Bund subtracted from the yield required on each country's respective 10-year issue. The larger the spread, the greater premium investors demand to hold that particular countries debt, over the so-called safe haven of the European Union, Germany. As the spread between these yields widens, the risk of holding that countries debt also increases. This increased risk can stem from numerous reasons but these particular spread explosions have resulted from fears that the countries below, especially Greece, will default on their debt obligations. Fear of default is derived from massive debt to GDP ratios burdening these countries, as mentioned above. It is clear that once reports caught wind of how bad things really were in Europe, these spreads exploded. It should also be noted that the huge decrease in spreads occurred on May 10, the day after the $1.0 trillion Eurozone bailout was passed. Once again, it appears contagion fears are waning quite a bit.

The chart below depicts 5-year credit default swap rates. As you can see, it is priced so that the owner of a CDS on Greek debt must pay a premium of about 8% to the counterparty in order to have the obligations of Greece "insured." This has come down quite a bit from rates over 11% back at the end of June.

The next chart shows how 5-year CDS rates have come down from the past couple of weeks.

Over the past month, rates on just about all Greek debt have come down.

Now you might be asking, what was the whole point of all that? Well it was to explain how market fears have waned and there is still time to get in on the free and virtually risk less debt of Greece. On Tuesday, Greece auctioned a $2.0 billion (1.625 billion Euro) 26-week bill. This auction finished with a 3.45 bid cover, down from 7.67 in the previous auction. The yield came in at 4.65%, which is up from 4.55% in the previous auction. The most recent US Treasury 6-month bill auction came in with a stopout yield of 20 basis points. The reason I note that is to show the tremendous spread between US 6-month bills and Greek bills. Now why would anyone in their right mind purchase a US T-Bill for 20 basis points when you can snag a perfectly good piece of Greek debt for 465 basis points? Yes, I understand the whole risk thing and such, but right now, there is economic data showing the economy is slowing and most likely heading for a double dip, which is smacking the S&P. If one were to purchase a piece of any European debt for that matter, their yield will greatly surpass the S&P returns for this year.

You might also note my use of the 10-year yield on Greek debt. The purpose of that graph was the following: Why would anyone lock up money for 10-years in a country with significant default risk, when they can do it for 6-months? Greece is not going to default, don’t get me wrong, but if you aren’t on the same page as I and have opposing feelings, then we can certainly agree default is not going to happen in the next 6 months. Greece currently borrows at a rate of 5% to pay down debts from the EU and just raised all new cash at 4.65%, clearly below the rate it can tap the Eurozone at.

So In regards to investments, I would recommend The Touchstone International Fixed Income Fund, TIFAX, which as about 5% exposure to Greek debt. The overall fund is also invested in debts from Germany, France, Belgium and the UK. One could also look at Blackrock International Bond Fund (BIIAX). Both offer perfect exposure to high yielding debt which is sure not to default.


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