UK sovereign debt on red alert

Sovereign risk has been the story of the week.

The UK and Greece have attracted most of the headlines because in both countries the yields on their government debt rose sharply (in the UK after the pre-Budget report and in Greece after the country’s debt was downgraded by a ratings agency).

But there were also signs of investors in the US and Japan becoming more wary about those countries’ massive budget deficits.

Sovereign risk can broadly be defined as the danger of a government bond market collapsing – meaning yields on its debt rising – and at worst entails a leading developed world country defaulting on its debt.

There are particular sensitivities about government debt at the moment as bond issuance in many countries has reached record levels because of economic stimulus programmes, reduced tax revenues and bank bail-outs.

Both Greece and the UK are a warning sign to any government that fails to show sufficient determination to alleviate its debt burden in the eyes of bond market investors.

The Greek bond market saw an unprecedented rise in yields after Fitch downgraded its credit ratings and Standard & Poor’s threatened to do the same in the coming weeks.

Greek two-year bond yields, which have an inverse relationship with prices, rose 117 basis points to 3.04 per cent.

In the UK, the bond markets were rocked after ministers failed to convince investors that they were prepared to tackle the country’s debt mountain in their annual pre-Budget report (PBR). UK 10-year bond yields jumped 15bp on Thursday – one of the biggest daily moves of the year – and rose further to hit 3.84 per cent on Thursday.

Elsewhere, the US saw three poorly bid government bond auctions, while Japanese bond yields rose as the prime minister sparked concerns that he would not stick to his commitment to cap debt issuance next year.

Some analysts say the bond markets are in a liquidity-fuelled bubble, brought about by exceptionally low interest rates and central bank support measures such as quantitative easing.

Once the central banks take away this support and rates start to rise, bond yields will inevitably rise, they say.

How far and fast depends on government willingness to take the necessary tough fiscal measures.

On this point, the UK’s PBR could prove a watershed moment..

Tim Bond, head of asset allocation at Barclays Capital, says: “The PBR has opened up a can of worms. Before the PBR there was an expectation that most governments would follow the path to fiscal tightening with a stress on cuts on public spending over tax hikes.

“You can no longer apply that logic after the PBR as it created the illusion that there is a painless way out of the fiscal mess with tax hikes on a small group of rich people. The lack of detail on spending cuts is a big concern for investors.

“If we start to have policy drift in the UK, then people will start asking questions about the process in the US.”

Michael Saunders, UK economist at Citigroup, adds: “There are growing concerns across a range of governments that fiscal positions are not sustainable. In the UK and in many other countries, these fiscal positions will get worse next year. This will put pressure on the government bond markets.”

However, this week’s sell-off was different to the one earlier in the year when nearly every bond market fell sharply. The exceptions were Germany and the US, seen as havens amid fears of a financial meltdown.

This time investors have been more selective, as shown by Ireland.

Like the UK, it unveiled a budget on Wednesday. But, unlike the UK, it was one of the toughest in the country’s history with severe cutbacks on public spending.

Irish 10-year bonds fell 17bp afterwards, stabilising at 4.86 per cent by the end of the week.

Steven Major, head of fixed income research at HSBC, says: “This week showed that investors are looking more closely at fundamentals. Ireland produced a tough budget and the market rose, while the UK produced one with little detail and the market fell. This was very different to the sell-off we saw at the start of the year, when it looked like we faced a systemic crisis.”

The Greek sell-off had an impact on the euro, as it raised question marks over the health of the single currency. The euro fell 1.6 per cent against the dollar and 2.3 per cent against the yen this week.

Worries centre on the possibility of a Greek default and whether the Germans will bail Greece out if necessary. In February, they promised financial assistance to any eurozone member that needed it. Investors are not sure whether that promise still stands.

Most bankers think the Greeks would be offered help, if not by Germany and the European Union, then by the International Monetary Fund, which could force Greece to carry out tough reforms.

Laurent Fransolet, head of fixed income research at Barclays Capital, says: “If the Greek situation really gets out of hand, there will be some sort of help.”

This view was reflected in the markets on Friday as Greek bond yields fell for the first time this week, with investors buying the bonds because they had become so cheap.

However, this week is not the end of the story. More bond market meltdowns are on the cards for the coming year.

In fact, the outlook over the coming months looks highly uncertain.

It means 2010 will be a rocky ride as sovereign risk threatens to become one of the big issues of the year.