Can credit derivatives save European government bond portfolios?

By Margaret Elliott

Thinking with a sinking heart of how your portfolio of shaky European government bonds will suffer in the run-up to monetary union? And then, dreading the fact that no relief will be available once (if ever) EMU is in place?

The answer to both problems is the new and fast-growing market in credit derivatives. Though market participants point out that credit derivatives are used more often in emerging markets, they can and have been used successfully in the European context as well.

The focus in the EMU run-up will be on interest rates, not credit, but several developments are pushing European bond managers and banks to look at the credit issues associated with sovereign debt. One is the troublesome fiscal policies being pursued by some countries in an attempt to qualify for membership. Another is the imbalance in the debt levels of the European countries, which will become greater as all pursue the 60 percent of gross domestic product benchmark for EMU membership. And last, presumably once EMU is in place, credit issues will dominate interest rate volatility as convergence works its way into the fabric of the European bond markets.

Countries to watch

Within the last few years, two countries in particular have encountered fiscally heavy seas in Europe: Italy and Sweden. Both countries have faced recent banking crises, and fiscal mismanagement has put these countries' sovereign debt on the credit-watch list.

For Martin Kinnesinger at Daiwa Bank in London, these fiscal hiccups mean problems for his clients-banks and portfolio managers. "We prescribed default options and default swaps to manage the potential default risk on sovereign as well as corporates within these countries," he says. For banks in particular, it is easy for big issuers like Italy and Sweden to breach their counterparty credit limits. Even though the portfolio approach to managing bond exposures is universally used in banks, the sheer volume of debt from Italy and Sweden has made life difficult.

Yet, as Robert Reoch, director of special financial products at London-based Nomura Capital Int'l explains, the only problem with the use of specialized credit derivatives is the lack of liquidity. He expects that with the run-up to monetary union, the demand, and thus the consequent supply of these products will increase. "These products can be tailored quite specifically to manage a range of possible exposures."

For Italy and Sweden, the fiscal crises may have passed, yet neither is a shoe-in to EMU. Italy's sovereign debt is 120 percent of gross domestic product. And this doesn't include pension contributions, which, if included in Belgium's figures, would swell its debt to a whopping 150 percent of GDP. Yet it must be remembered that only Luxembourg would make the grade today. Sweden's debt stands at a more respectable, but nevertheless high, 80 percent of GDP.

Card tricks

Credit derivatives may come in handy as a way to get protection from increasingly uncertain financial information. In the run-up to monetary union, some countries are finding creative and controversial ways to reorganize their debt. Italy has recently been granted permission by Eurostat, the European Commission's statistical body, to include the receipts from its one-time "Eurotax" against this year's budget deficit in order to move its 6 percent budget deficit toward the 3 percent EMU deficit criteria.

A similar type of fiscal sleight-of-hand took place at the end of last year in Belgium, with Belgian Finance Minister Philippe Maystadt arranging a set of swaps with nongovernmental bodies that had the effect of showing that the country's debt was shrinking. Banks and portfolio managers can expect more of the same, with concurrent market effects. Understanding the credit issues is becoming more and more important, says Daiwa's Kannesinger.

Credit derivatives may also be used to pry returns from subtle differences in credit. When monetary union arrives, the likelihood is that some countries will be left out, and Italy, Belgium and Sweden come to mind. The divide between the included and excluded will provide arbitrage opportunities in both interest rate and credit terms on both a short-term and a long-term basis. After EMU, the European bond markets may not be the sleepy place many now expect.