Can the UK escape the ‘silly risk premium’?

aone month later After being excited for all the wrong reasons, the UK bond market has finally calmed down. All it took was an emergency bond-buying program from the central bank, the removal of the prime minister, the installation of a thoughtful successor, the humiliation of the prime minister, and the crushing of the massive, unfunded tax-cut package that caused the debacle. motion.

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Amid the turmoil, the UK’s five-year borrowing costs were higher than Italy and Greece, two countries with difficult lender relationships. Markets are calm now, but the country’s sovereign bonds, or ‘gold coins’, are trading at much higher yields than before the self-destruction.Dario Perkins TS Lombard, an investment research firm, calls this the “silly risk premium.” What does the premium mean for new Prime Minister Jeremy Hunt as he seeks to restore order to the country’s finances?

It is important to remember that a country is not a corporation. Familiar measures in the corporate bond market do not mean the same thing when applied to sovereign bonds. In the United States, if two companies borrowed dollars at different interest rates, the company with the lower interest rate would have higher creditworthiness. In some cases, this also works for government debt. For example, countries like Argentina and Colombia that borrow heavily in foreign currencies (US dollars), and countries like Germany and Italy that share a currency and central bank. But most of the time it doesn’t. US 10-year yields are higher than Slovakia. That doesn’t mean the American government is a more dangerous prospect. Similarly, the UK has not suddenly transformed into one of the more problematic members of the Eurozone.

Instead, government bond yields reflect a wealth of interrelated factors. Chief among these is the expected future path of interest rates set by the central bank from which the currency is borrowed. information about inflation (which could force banks to raise interest rates), gdp Growth (which may be more optimistic about doing so) and unemployment (which may be more reluctant). There is judgment about whether the central banks themselves are hawks or doves.

Then there are other risks. If the currency is likely to depreciate, foreign investors should demand higher yields to compensate. If inflation remains unchecked, the value of both interest payments and principal will be eroded, requiring higher yields. There is no doubt that the UK government’s actions have pushed gold coin yields higher. But those yields tell as much about the country’s economic trajectory as the government’s credibility with investors.

One way to clarify the situation is to subtract from the government bond yield for a given maturity the average central bank rate that the market expects for that period. Known as an “asset swap spread,” this is similar to a corporate borrower’s credit spread. For the long-term gold coins that caused the UK meltdown, the Bank of England stepped in and the reading actually ballooned in the last week of September before returning to lower levels. , is also tainted by other factors, such as the demand for government bonds to use as collateral and debt matching.

A better option is to look at the costs of insuring government debt. A credit default swap is a bilateral agreement in which one counterparty agrees to insure the other counterparty against losses due to the default of a particular bond in exchange for a fixed stream of payments. A fixed stream is quoted as a percentage of the sum insured or “spread” and represents the probability of default of the issuer of the underlying bond. UK credit default swaps trade at much lower spreads than Italian spreads. This means the market perceives a much lower risk of default in the UK.

If yields are a bad guide to risk, volatility is a better one. Daily movement is measured in “basis points”, or hundredths of a percentage point. This shows that the daytime range of his 30-year-old heifers in the UK on 28 September spanned 127, greater than the annual range of all but his four of the last 27 years. increase. The largest daily increase before the blast was just 29 basis points. Since then, movements of similar size have become routine. UK sovereign debt is not in the red at risk of bankruptcy. But the Prime Minister and his successors face a long and painstaking effort to convince investors that solid gold is once again a safe bet.

Read more from financial markets columnist Buttonwood:
Credit default swaps are unfairly defamatory derivatives (October 13th)
The world’s most important financial market is fit for purpose (October 6)
Investment banks are sharpening their axes (September 29)

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