Wednesday, November 09, 2011

Italy: Illiquid-but-Solvent

Evidence for the argument that Italy is having a liquidity crisis, not a solvency crisis:
Italian Yields Top 7%

Italian bonds slumped, driving two- five-, 10- and 30-year yields to euro-era records, after LCH Clearnet SA raised the deposit it demands for trading the nation’s securities.

Two-year note yields rose above 10-year rates, with five- year debt climbing above 7.5 percent as Prime Minister Silvio Berlusconi’s offer to resign left his weakened government struggling to implement austerity measures to reduce borrowing costs.

...The yield on Italy’s five-year notes jumped 82 basis points, or 0.82 percentage point, to 7.70 percent at 11:56 a.m. London time.
The rate on Italy's ten-year bonds are currently at about 7.25%, creating a fairly sharp inversion over the 2-to-10 year portion of the yield curve. In other words, while investors are demanding a risk premium on all maturities of Italian bonds, they are now demanding a higher risk premium on shorter maturity bonds than on longer maturity bonds. This implies that market participants believe that Italy's potential difficulties in repaying its bonds are concentrated in the next couple of years, and that if Italy can get through that stretch then the risk of default diminishes.

This is not to say that there couldn't also be some concerns about Italy's long-term solvency; but those concerns are clearly being overshadowed by worries that Italy may not make it through its current liquidity crisis. Which means that no matter what steps are taken to change Italy's long-term budget picture, if Italy isn't provided with the liquidity it needs to get through the next couple of years, then long-run solutions are really rather irrelevant.

Liquidity, liquidity, liquidity.


  1. Bill F.2:17 PM

    The inversion of Italy's yield curve says more about probability and timing of a potential default than it does about solvency.  Greece's yield curve is massively inverted, but it clearly is not solvent.  The inversion is simply a result of the relationship between yield, price, and absolute return. 

    Let's assume I could buy a 1 year bond with 5% coupon at 95 (roughly 10.5% return) or a 10 year 5% bond at 80 (roughly 8% return).  The 1y yield is better, but what if there is a restructuring with a 20% haircut?  I lose 15 points on the 1y, but only 5 points on the 10y. 

    As a bond issuer gets more distressed, the yield curve inverts (Italy) and continues to invert until bonds of any maturity trade at nearly the same dollar price (Greece).

  2. Anonymous4:57 PM

    But doesn't that only apply if the anticipated default/haircut happens in year 1?  If you expect it to happen in year 5 then there's no reason for the price of shorter term bonds to fall that much and for the yield curve to invert. So this still tells us that the market thinks the problem will come in the next 1-3 years, not in the long run.

  3. alfred8:02 AM

    Bill is right, the price of long bonds is still well below the price of short bonds. The 2 year is at about 85-90 cents on the dollar and the 10 year about 55-60 cents by back-of-the-envelope calculation against bunds. These prices indicate that the chance of default in the next 2 years is considerably lower than the chance of default over 10 years.

    But, I dont think that these prices (let alone yields) are a good indicator of liquidity v solvency. Illiquidity will turn into insolvency if it lasts long enough. One hypothesis could be that the market is expecting that Italy will be able to "manage" for a couple of years but become less solvent over time and is likely to default between 2 and 10.

    There might be better information from option prices. If the price of call options on Italian bonds is high, then there would be significant expectations of a shift to a new, liquid (solvent) equilibria with low rates, perhaps caused by aggressive ECB tactics.