UBS draws attention on Monday to the fact that widening G7 sovereign CDS spreads are as yet not being mirrored by rising bond yields.
That’s not to say that CDS are being mis-priced. There just happen to be other extenuating circumstances keeping yields low, according to UBS. However, in most cases the correlation you would expect to get between sovereign bonds has been decreasing over the course of the year.
As the UBS analysts put it:
…among the G7 economies it remains the case that while sovereign risk is probably driving bond cross-correlations lower and is showing up in CDS pricing, it is not yet the case that it is driving yields higher. We suspect that’s because other cyclical circumstances have mattered more at this juncture. Specifically, recession has lowered real rates and expected inflation. That raises some questions: Under what conditions will higher sovereign risk premiums begin to assert a greater influence on G7 bond returns? And what are the implications of what is going on for portfolio risk management?
Looking towards bond correlations hence might be more useful for determining sovereign risk premia, than outright yields.
According to UBS, there are three sovereigns in particular whose bond yields have become more discorrelated than most. These are the UK, Japan and Italy:
And as the analysts explain, this most likely reflects investor sensitivities regarding the countries’ growth prospects and fiscal imbalances:
On the surface, countries with more weakly correlated bond markets have something in common—they suffer from a combination of high debt and deficits, as well as slow growth. Equally, credit default swap prices for Italy, the UK and Japan have risen more than for other G7 markets over the past few months (Chart 3). Greater sovereign risks in those markets, in other words, may explain why their bond markets have started to diverge from others. Financial markets have become more sensitive to the potentially worrisome combination of weak growth and fiscal imbalance.
Related links:
Chart du jour – sovereign risk - FT Alphaville
Sovereign CDS is spreading – FT Alphaville