By JACK HOUGH
World stocks plunged Wednesday after Italy's 10-year government bond yield jumped to 7.4%. Ordinary savers might wonder what one has to do with the other.
Heavily indebted countries depend mightily on fresh sources of cheap loans to tap as old debts come due. A sudden rise in rates does more than reflect a drop in creditworthiness; it helps cause it. Greek 10-year yields have soared to more than 30% from 11% a year ago as investors who once viewed a bond default there as likely have come to see it as certain. But that crisis was set off by a spike in rates from less than 5% to 11% during the prior year.
For Italy, the difference between summer's sub-5% bond yields and today's 7%-plus one could determine whether it goes the way of Greece. The two countries aren't nearly alike in terms of potential for broader damage. "There's not enough backstop in the world to protect savers if Italy defaults," says John Canally, an economic strategist with LPL Financial in Boston. And an Italian default would drag down bigger economies like those of France, Germany and the U.K.
Much will be decided in the next two weeks. Europe's central bank is buying Italian bonds to try to contain yields. At the same time, says Mr. Canally, "a lot of speculators are trying to do what Soros did to the pound in 1992." In that episode, hedge fund manager George Soros made a massive bet against the British pound, profiting from its eventual fall, and, some believe, contributing to it. European policy makers will have to ward off even higher yields on Italian bonds for long enough for Italy to stabilize its government and introduce bold economic reforms, says Mr. Canally.
But there's another threat to Italy's bonds -- and those of its heavily indebted peers. Confidence in bond insurance is waning, and that's making the bonds themselves less palatable.
Insurance companies can sell protection against any event, and several made a brisk trade until recently in insurance against default on the part of municipal bond issuers in the U.S. The insurance turned risky bonds into AAA-rated ones, and in doing so, reduced the cost of borrowing for issuers -- a seeming win-win solution. But common sense suggests otherwise. The risk of a borrower is reflected in the interest rate that borrower must pay. An insurer can't magically make that risk disappear for less than the cost of the interest. At best it can carry too much risk on its own shoulders while collecting meager premiums. But that's not a sound business model, and so municipal bond insurance is already in sharp decline.
But bond insurance is still plentiful in the form of credit default swaps (CDSs), highly liquid instruments that pay off when a bond issuer doesn't. Buy an Italian bond with the right CDS wrapper and the result is risk-free, right? Maybe not. Last month Greece proposed a clever debt restructuring that would have reduced some of what it owes by half while labelling the markdown voluntary so as not to trigger CDS payoffs. That has some CDS owners questioning their protection. At the same time, CDS protection on sovereign issuers flirts with the absurd to begin with, because the nations that owe the money are much larger than the firms that protect against nonpayment. Recall that insurer American International Group (AIG) was brought down by insuring against something much larger than itself -- widespread mortgage default.
For a look at where Italy's 10-year rate might be headed, add the cost of CDS protection to the yield, wrote Carl Weinberg, chief economist with High Frequency Economics, in a Monday note to clients. The result at the time was a yield of about 10%. If investors are losing confidence in artificial bond protection and beginning to demand that issuers pay rates commensurate with their creditworthiness, Italy, along with Portugal, Spain and Ireland, could soon find their debt much more costly, according to Mr. Weinberg.
For now, savers are rushing into U.S. Treasury bonds, reducing yields and driving the dollar sharply higher against the euro. Kathy Jones, a fixed income strategist for Charles Schwab, wrote last week that the U.S. might be bucking for another credit downgrade, this one from Moody's, to follow a similar move by Standard & Poor's in August, if it doesn't soon make progress in reducing its deficits. But for U.S. yields to rise on such a downgrade, savers would have to have somewhere else to go. At the moment, choices are few.