September 4th, 2011
Econontersect: Friday (September 2, 2011) saw a surge in Greek government bond yields as doubts continued to gather that the country could meet its debt obligations. According to The Wall Street Journal, the two-year Greek bond yield rose to 45.92%, the five-year rate reached 28.56% and the 10-year climbed to 17.54%. That is an astounding yield curve inversion generally considered to be a forecast of an impending draconian economic depression in Greece over the next several years. These astounding interest rates also indicated bond investors placed a high probability on partial or complete default by Greece on their debt instruments. Follow up:
Follow up:The Wall Street Journal also reported that at the same time Greek interest rates soared, the corresponding German two-year maturity was paying 0.43% interest.
The New York Times had the following on the efforts by Greece and the European Union to settle the uncertainty and doubt that has arisen over the sovereign debt situation:
An initial loan package, agreed to last year, has since been supplemented by a second bailout deal that was hammered out in Brussels in July, but which now hangs in the balance amid demands by some euro zone countries for guarantees from Greece in the form of collateral. Without that fresh aid, Athens could default on its obligations.
The Greek Finance Minister Evangelos Venizelos denied that there was a rift with the auditors over the country’s ability to meet deficit reduction targets set by the foreign creditors.
The minister said at a news conference that talks were continuing with auditors in “a very friendly and constructive climate,” and that he expected the team back on Sept. 14 for a second phase once Athens had finalized a draft of the national budget for 2012.
Simple calculations can estimate the bond market opinion of the probability of Greek default. The simplest approximation is obtained with the assumption that return of principal is the reference point (not principal plus interest). It can also be assumed that the German bund is risk free for the purposes of making the estimate. Then the yield spread of Greek over the corresponding German debt is related to the probability of Greek default. The two-year spread stands at 45.39%.
The following rough estimates can be made:
- There is currently a 10% probability of getting full principal repayment on a two-year Greek bond at maturity. Calculation: 45% a year times two years is 90% of principal. 10% principal repayment gives 100% repayment. This is the same as saying the market is predicting the most probable principal recovery is around 10%.
- The inversion of the above logic is that there is about a 90% probability that full default will occur at maturity.
- By linear interpolation it can be estimated that there is about 50% probability that only 50% of principal will be repaid at maturity.
Editor’s note: The above estimates were made by Global Economic Intersection staff. The probabilities can be shifted by assuming various low rate of return in addition to return of principal.
The estimates above indicate that the bond market is now saying that there is almost certainly going to be some level of haircut (or partial default) on Greek two-year debt by maturity and that full default is very likely (maybe approaching 90% probable).
Since the interest on five and ten year debt totals far more than 100% of face value, the bond market is saying that not only is the probability of subsatntial or complete default on those instruments a virtual certainty, there is also a high probabilty that the full term of interest payments will not be made.
Of course, these odds can be changed if the ECB (European Central Bank) and the European Commission, along with the dominant core countries of the EU (European Union), agree to find additional capital to apply to the Greek collapse. And they are still talking.