A Better Way to Assess Sovereign Debt

Take a look at the price of credit default swaps when considering sovereign debt issues.

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I can understand why you are spooked by the financial media. The markets are extremely volatile, reacting to what seems to be endless bad news. Much of this news focuses on sovereign debt issues, in both Europe and the U.S.

At a recent conference of business leaders and finance experts held in Cernobbio, Italy, these concerns became recurrent themes. New York University economist Nouriel Roubini predicted a double-dip recession in the U.S. Grave concern was expressed about the exposure of European banks to sovereign debt. There was talk about a partial break-up of the European Union, with Greece, which appears to be on the brink of default, exiting. Roubini noted “global and systemic” consequences if this occurs.

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The financial media, always quick to instill fear in investors, seized upon this crisis. One commentator noted that, “Greece is merely patient zero in a European, if not global financial black plague. Speculation is now focusing on a Greek default as soon as this weekend.”

Credit rating agencies have only confused investors further. Japan’s debt is 184 percent of its gross domestic product. Its credit rating is AA/AA-. Much maligned Greece has a lower debt of 148 percent of GDP, yet its credit rating places it in junk bond status. This makes no sense to many investors.

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Fortunately, there is a far more accurate way to assess the quality of sovereign debt. As Jim Parker, vice president of Dimensional Fund Advisors, noted in a recent blog, the global marketplace trades credit default swaps on sovereign debt. A credit default swap is basically insurance against sovereign default. The price of the credit default swap is a good barometer of the view of the market about the likelihood of default. The higher the price, the more likely investors believe a government will default. Here’s a link where you can find prices of sovereign credit-default swaps.

Recent prices of credit default swaps indicate that the U.S., despite its downgraded credit rating, is less likely to default than any other country, including higher rated countries like France and Australia, which have the same rating as the U.S., but far less relative debt. Japan, a debt burdened nation, is only modestly more likely to default than Chile, which is one of the least indebted nations. Investors also believe lower-rated Mexico is less likely to default than higher-rated Spain. Greece is perceived by investors to have a very high likelihood of default.

Default by countries of their debt obligations is not a new phenomenon. Jamaica, Ecuador, Belize, the Dominican Republic, Uruguay, Nicaragua, Moldova, and Argentina have defaulted on their sovereign debt.

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Rather than relying on fear mongering and musings of financial talking heads, take a look at the price of credit default swaps when considering sovereign debt issues. The market incorporates all publicly available information about stocks, bonds, and sovereign debt. It’s a far more reliable indicator of the likelihood of default than the financial media.

Dan Solin is a senior vice president of Index Funds Advisors. He is the author of the New York Times best sellers The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, and The Smartest Retirement Book You'll Ever Read. His new book, The Smartest Portfolio You'll Ever Own, will be was released in September, 2011.