Feb 07

A little bit of Bond misinformation

I was just reading the latest riveting story on bonds in this month’s Asset magazine and I feel compelled to share an example of misinformation that tends to annoy me a little (I know its probably a little pathetic but anyway)…John O’Brien, van Eyk – Head of Research, apparently said that

many of the great developed nations are now in trouble…citing Standard and Poor’s recent downgrade of the US federal government from AAA to AA+ in August last year and the downgrade of Japan’s credit rating

mmm…whilst I agree that both Japan and the US have debt levels that are uncomfortably high, I believe some clarifying facts are appropriate.

Firstly, when Standard and Poor’s downgrades government debt from AAA to AA, statistically that means that the probability of default increases from 0.01% to 0.07%…that’s two decimal places and then a percent sign. So the chances of default according to S&P increase from around 10,000 to 1 to 1,400 to 1! oooohhh…scary. So from a pricing perspective that should result in a widening of the yield by 0.06% or 6bps…to be honest…woopee do.

Secondly, before the S&P downgrade US 10 year bonds were yielding around 3%…now they’re around 1.9%…how’s that for market confidence. Following the downgrade the market started buying up an enormous amount of US government bonds.

Finally, Japan’s S&P downgrade was in 2002 (2002 is not a misprint)…we’ve obviously forgotten about it because their 10 year bond yield is a frightening 0.97%!!! How awful…imagine paying that rate on your mortgage.

Bad example John…perhaps you should have used Germany, oh, hang on their 10year bond yield is 1.9%…or maybe the UK …oops, they have a 10 year bond yield of 2.1%.  The market sees little credit risk there too.

Bottom line, with the exception of the well-documented PIIGs, the major government bonds of the world are showing very low yields that, according to the market, are not in the slightest bit concerning in terms of default or credit risk. That’s not to say they don’t carry risk as there is certainly a reasonable chance of yields increasing, resulting in capital losses, on the back of improving economic sentiment. Certainly, in the US the latest unemployment figures are positive and markets are much more comfortable with Italy and Spain debt and this has flowed into positive equity markets and a sligt  turnaround in confidence.

Anyway,  in my opinion, John gave a bad example in explaining the main risk of bonds because at the end of the day an S&P downgrade is often a little late and more often than not, meaningless.


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