Bond investors, pay attention to Europe

Market Beat

Americans bought bonds in record sums last year. Most did so because they were looking not for excitement, but rather for a place to hide.

Now, 2010 may be promising just the kinds of thrills that newbie bond investors wouldn’t relish -- particularly if they also have to suffer through another stock market rout.

First, a bit of background: A year ago, as the economy seemed near collapse, one of Wall Street’s biggest concerns was that a slew of companies would be unable to make their debt payments -- fueling another wave of the credit crisis that began with the mortgage-bond debacle.

But 2009 turned into a year of recovery for the economy, and a corporate credit nightmare never came to pass. Bonds of major companies wound up being excellent bets.

As the new year begins, the bond market again has a case of jangled nerves. This time, however, investors’ focus on creditworthiness is on countries rather than companies.

“The risk factor du jour is sovereign credit risk,” said Tony Crescenzi, a strategist at bond fund giant Pimco in Newport Beach.

Consider what has happened with Greek government bonds over the last two months. In mid-November, despite the Greek economy’s dismal state, investors were confident enough about the nation’s finances to accept an annual yield of 1.4% to buy two-year government notes.

They were misinformed. With Greece’s budget deficit ballooning, major credit rating firms downgraded the country’s debt last month, turning it into a market pariah. Now investors are demanding a yield of almost 4.9% to buy a two-year Greek government note -- 3.5 percentage points more than in November.

If some poor Athenian pensioner plunked his savings into a government note at 1.4%, he’s now feeling like a chump. Not to mention that his investment is worth less than he paid, because rising market interest rates automatically devalue older bonds issued at lower fixed rates.

The debt woes of the Middle Eastern emirate of Dubai gave markets a brief jolt in late November. But Greece’s struggles are more worrisome. For one thing, European Union fiscal rules are supposed to ensure that member nations can’t borrow themselves into oblivion. Yet Greece’s budget deficit, at nearly 13% of gross domestic product, is four times the EU limit.

More troubling to bond investors is the idea that Greece could be foreshadowing a much broader European government-debt problem. The market already has coined an acronym -- PIIGS -- for the European countries that face the risk of digging themselves into perilous debt holes as they spend to shore up their recession-battered economies.

The PIIGS: Portugal, Ireland, Italy, Greece and Spain.

Naturally, Greece has promised that it won’t default on its debt. But outright default probably isn’t what most bond owners fear. They’re more likely to be worried about what will happen to the market value of their bonds if investors keep demanding higher interest rates on new debt to offset the perceived risks, including the concern that unchecked spending will eventually fuel serious inflation.

“Contagion” is a scary word in the investment world. This week, as Greek bond yields rocketed anew, Ireland was pulled along for part of the ride: The yield on two-year Irish bonds jumped to 2.09% from 1.79% a week ago.

So far, Greece has generated tremors elsewhere in Europe, but not panic. The share values of foreign-bond mutual funds owned by U.S. investors slipped an average of 0.7% in the week ended Thursday, according to Reuters/Lipper data. There’s no way to tell how much of that was a knock-on effect from Greece’s woes, but some of it surely was.

Last year, as interest rates overseas mostly declined and bonds rose in value, the average foreign-bond fund posted a hefty total return of 18.5% -- the kind of number that attracts investors hoping for an encore.

Investors have faced sovereign-debt crises before, but those crises typically erupted in emerging-market countries, as in Latin America in the mid-1980s. The difference this time is that it’s the developed world that is dangerously out on a limb in its borrowing.

We all know how this happened: To save the global economy and financial system from collapse in 2008, major and minor countries, led by the U.S., committed trillions of dollars in loans from their central banks and in direct government spending that was financed by bond sales.

In effect, the debt crisis wasn’t solved; it was just papered over, as governments borrowed to bail out private borrowers (mainly the biggest banks), to spend on economic-stimulus programs and to support the ballooning ranks of the world’s unemployed.

The World Economic Forum, the group that hosts a meeting of the planet’s corporate and government elite every year in Davos, Switzerland, issued a report this week that flagged the developed world’s burgeoning debt as nearing a flash point.

The massive, debt-financed intervention by the developed world “proved vital,” the report allowed, but warned that “governments now need to avoid becoming the main cause of the next crisis.”

To pare its debt load, Greece is pledging to slash spending and start collecting from its notoriously huge pool of tax evaders. But the continuing surge in Greek bond yields shows that investors remain dubious. Austerity, after all, exacts a painful social toll that can push people to overthrow their governments, peacefully or otherwise.

The issue of how much debt is too much is, of course, of mounting concern to America as well as to Greece, as the U.S. Treasury’s borrowing continues unabated.

For now, there’s little doubt that America can find investors to buy its bonds. The question is the price.

Investors already are demanding higher yields on longer-term Treasuries -- 3.6% on a 10-year T-note compared with 2.6% a year ago -- but those year-ago yields were depressed by fear of global calamity.

What Greece’s bond turmoil shows is how quickly investors can push longer-term interest rates higher if they perceive that borrowing has reached unsustainable levels.

If that perception takes hold in the Treasury market this year -- still a big “if” -- Uncle Sam will be paying more to borrow. And that could drive up yields on other bonds as well.

New bond buyers may be thrilled. But anyone stuck with older bonds at lower rates is likely to face a bad case of buyer’s remorse.