It’s an old story but who doesn’t think the debt issues with Greece aren’t going to continue? Even the casual observer has caught on that Greece, amongst other countries, isn’t going to solve their financial issues any time soon because they essentially aren’t committed. Meanwhile, Greece was rescued again in a bail out of nearly $130 billion U.S. So why would any organization, such as a large bank, pension fund or investor put any money into high risk sovereign debt?
Surely, the world’s smartest money managers haven’t lost their minds and forgotten about what happened in the credit crisis. It’s not that there aren’t other opportunities either because there are plenty. With governments buried in debt and weak economic growth, the business sector has never had such a strong relative advantage. The truth is nothing has changed in the world of finance. Smart money isn’t going to invest a nickel in anything unless they expect a high return, an easy return or both.
Retail investors and bond fund managers need to be aware that the investors who put hundreds of billions of dollars into Greece, Italy, etc. aren’t going to do so without a clear plan to make money. That implies they have an exit plan to realize the profit on their investment. That exit plan can be identified, and targeted, by declines in interest rates in the bond market. Like any market there are cycles and in the bond market a decline in interest rates means bond prices have gone higher.
In a relatively low interest rate environment, it doesn’t take a large change in interest rates to make a reasonable profit. If, for example, rates fall from 3.5% to 3.00%, a decline of 50 basis points, rates have fallen 14.2%. Since the beginning of the year, the yield or rate on Italy’s 10 year government bonds has fallen from 7 to 5% (see the chart below). The U.S. traded Powershares Db Italian E.T.F. (ITLY) have appreciated 21% in that time (second chart below). That is a healthy return in a market that many people have likely believed could only lead to a large loss. To provide perspective, for every $10 billion invested in high risk European debt a 10% return is $1 billion in profit. Given that financial markets have always had their cycles, up and down, it would seem investing in Greece or Italy has a better than expected return than some imagined. Meanwhile, the investment industry and the banks are taking their usual fees on every transaction.
The naive investor needs to be made aware that big investors who are loaded up on European sovereign debt are going to cash in their profits and cut their risk when the opportunity develops. The cycle may repeat itself numerous times, as it has already in the past three years, but one of these days, a significant rise in rates, i.e. a down turn in the bond market, may be punctuated with gruesome headlines. If bond prices plummet thanks to heavy selling and an absence of buyers, retail investors may hit the panic button and manage to unload their bond funds right at the bottom.