Editor's Note: This is an update to the article originally published in EWI's August 2010 Global Market Perspective.
June 13, 2011 (Bloomberg): "Greece was branded with the world’s lowest credit rating by Standard & Poor’s, which said the nation is increasingly likely' to face a debt restructuring and the first sovereign default in the euro area’s history."
The 1964 top 10 hit song, "Dead Man's Curve" by Jan and Dean, ended with a sound of a disastrous car crash. Lately, it seems that many bond issuers are flirting with their own Dead Man's Curve.
EWI president Robert Prechter wrote in his best-selling book, Conquer the Crash: “Any bond that is AAA at the start of the depression and remains AAA throughout it will be a satisfactory investment. The problem is, who can figure out which bonds those are?”
A problem made more difficult, Prechter points out, because many companies, municipalities and sovereign governments will likely come face-to-face (and some have already) with the prospect of default.
The problem Bob poses piqued my interest, and I devised a new way to look at the different risk levels of bonds -- the Debt Parabola, a.k.a. Debt Man's Curve.
Essentially, this configuration graphically depicts recent 10-year yields from various bond issuers, domestic and international. [As of July 2010 -- Ed.]
What's special about this chart is that it shows sovereign, municipal and corporate issues on the same spectrum -- so that we can see, for example, how high-yield corporate U.S. bonds compare with Greek debt. I chose a parabola as my graph to depict the situation of debt issuers because debt gets exponentially harder to repay or refinance as the interest rate rise, especially for large debtors. So problems tend to intensify exponentially the higher up the curve one goes -- just as the angle of a parabola's ascent grows steeper.
By the way, since we first introduced this graph in July 2010, some countries have slid farther up the curve, which put them squarely in the "Trouble Zone." Here are the current rates for some of the PIIGS nations, for example:
- Greece 16.62% (up from 10.35% in July 2010) -- which now puts it at the top of the Debt Parabola, above Venezuela
- Portugal 11.72% (up from 5.44% in July 2010)
- Ireland 11.40% (up from 5.41% in July 2010)
Two observations:
1. Shorter debt maturities do better: As Prechter stated many times (in Conquer the Crash and his monthly Elliott Wave Theorist), short-term U.S. T-bills carry less risk than do longer-term maturities. This point is no secret to the market, which is willing to lend money to Japan, the U.S., Germany and even the UK at less than 1% -- as you can see in "The T-Bill Zone" at the bottom of the chart. "Shorter is better," with respect to duration.
2. Debt-to-GDP ratio is not the deciding factor: Many people believe that a high debt-to-GDP ratio devalues a country's debt in the eyes of creditors and pushes interest rates higher on the country's sovereign debt. Yet note that even though Japan's sovereign debt is at one of the highest levels in the developed world (200% of GDP), its bonds are held dear despite the tiny interest rates they pay. In contrast, the market requires Greece to pay much higher rates, even though it has a lower debt-to-GDP ratio. [Ed.: 115% as of July 2010; expected to be 150% by end of 2011.] Why? It's another display of non-rational, emotion-driven markets, since it's not the actual ability to repay that matters in the near term -- it's the perception of the ability to repay.
Of course, the argument is somewhat circular: Japan pays low interest rates, therefore its ability to repay its debt is high. But if Japan had a 10% rate, its massive debt load would likely be "too large to carry," and it would join the ranks of Venezuela. In other words, Japan's low position on the parabola means near-term debt repayment is highly likely, even though its large debt means investors should be wary of exponentially larger problems in the future.
If EWI's big-picture forecast for a deflationary depression comes to pass, not all bonds will perform well; far from it. We anticipate more issuers reaching the "Trouble Zone" over the next few years. Also, remember that the larger the debtor, the more difficulty higher rates impose, and the greater the contagion risk. Other signals that can drive a debtor up and over Debt Man's Curve include 1) large foreign currency-denominated debt, which often makes repayment more difficult, and 2) having a high level of short-term debt, which increases refinancing risk.
Where does it leave the U.S., you may ask? Well, the International Monetary Fund projects the U.S. debt-to-GDP ratio to be around 99% by the end of this year. But as I explain above, it's not the absolute debt-to-GDP ratio that matters -- it's the market's perception of the country's ability to repay its debts that does.
Hope you've enjoyed this quick update. We will probably return to the Debt Man's Curve model in the future as investors realize that suspect issuers' debt is truly "no place to play."
Dead Man's Curve, it's no place to play.
Dead Man's Curve, you must keep away.
Dead Man's Curve, I can hear 'em say:
"Won't come back from Dead Man's Curve."