Bets rise on rich country bond defaults


By David Oakley
Financial Times, London
Sunday, November 22, 2009

LONDON -- The mounting level of debt in the industrialised world is prompting a growing number of investors to use the derivatives market to bet on the chance of rich governments defaulting on bonds.

The volume of activity in sovereign credit default swaps -- which measure the cost to insure against bond defaults -- linked to the US, UK, and Japan have doubled in the past year because of concerns about their public finances.

CDS volumes for Italy, which has one of the highest debt burdens of the developed economies, are now the highest for an individual country, according to the Depository Trust & Clearing Corp.

In contrast, the outstanding volume of CDS linked to emerging nations such as Russia, Brazil, Ukraine, and Indonesia have been flat or fallen in the past 12 months as investors have become less interested in trading the risks of those countries.

In the past, the CDS market for developed countries was sluggish, because few investors saw the need to buy or sell protection against a risk of default that seemed exceedingly remote.

However, rising debt levels and growing political and economic uncertainty has created a more active market, with more investors now seeking insurance. Meanwhile, many banks are prepared to offer protection in exchange for a fee.

This fee has recently jumped, since the cost to insure the debt of developed countries has increased since the summer of last year, while the cost of insuring emerging market debt has fallen.

Gary Jenkins, head of fixed income research at Evolution, said: "The biggest single risk hanging over the bond markets is the rapid rise in public debt in the industrialised world. If we get to a point where the market thinks the levels of debt are unsustainable, then we will see an almighty selloff in the government bond markets, with yields soaring. Governments need to take action to cut deficits and debt."

Fitch Solutions, the data arm of the Fitch Group, said that there is almost as much uncertainty in the CDS market about the outlook for the developed economies and their bond markets as there is for emerging economies.

Comparisons between Italy and Brazil are often used by strategists as an example of the contrasting fortunes of the developed and emerging world.

Italy's debt to gross domestic product ratio is forecast to rise to 127.3 per cent in 2010.

On the other hand, Brazil's debt to GDP ratio is forecast to stabilise at 65.4 per cent in 2010.

Nigel Rendell, senior emerging markets strategist at RBC Capital Markets, said: "It is not surprising that investors are increasingly worried about debt in the industrialised world. Debt to GDP of more than 100 per cent is difficult to sustain."

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