What Is Risk Premium, And How Does It Work?

The Euro Crisis
What Is Risk Premium, And How Does It Work?
El País: ¿Qué es la prima de riesgo y cómo funciona?
Álvaro Romero reporting from Madrid December 15, 2010 (Numbers Updated August 4, 2011 by Translator)

The pressure Spain is feeling in the secondary debt markets because of doubt about its treasury’s solvency has made its risk premium shoot up (as of August 3, there are 407 basis points of difference between its 10-year bonds and Germany’s). But what does it mean for the state’s finances if its risk premiums or bond yields increase? The latest chapter in the euro crisis brings to the forefront economic vocabulary which is unfamiliar to the general public. Here you can learn what they are and what are the consequences.

What is risk premium? It’s the surcharge investors demand in order to buy a riskier asset, in this case Spanish debt rather than German debt, whose price is the basis of reference because it’s considered the safest: the least likely to swerve in the face of a budget shortfall or economic recession and the most likely to be paid on time. In general terms, it can be translated as how much money is required for buyers to set aside their fears about the risk that comes with buying debt in countries plagued by the aforementioned problems of deficit or slow growth. Debt sales are rejected if the investor suspects that the state won’t have the money to reimburse its creditors.

How are bond yields determined?
Before explaining how risk premium is measured, we have to deal with the profitability of sovereign debt and how it is determined. The State emits a bond through an auction on the primary sovereign debt market at a price (the interest) which varies in function of its demand or expiry, which do not change over the course of the term. The term of the security can be short (3, 6, 12, or 18 months) or long (3, 5, 10, 15, or 30 years), but the longer it is, the higher the yield investors demand, since the money will not be returned until the term is concluded, and they need a good incentive to put away money that long. The principal purchasers of securities are so-called investment institutions: bands and large investment funds that move millions of euros at the click of a mouse. In the words of the governor of the Bank of Spain, Miguel Fernández Ordóñez, in reality they are “only people” and he has to listen to them when they’re right, but if they’re wrong, it’s better to try to convince them with data and objective reasoning than to attack them.

What determines debt yields?
In times like these, when investors are prioritizing security, requests for German debt are increasing, as it is considered a refuge against the typhoon in the Eurozone, and there is great confidence that it will be paid no matter what. Because of this bulging demand, the interest in its bonds is decreasing; it is 2.38% now for 10-year bonds (compared to 3.5% in May). That is, for every 100 euros of German debt, the buyer will receive 2.38 euros a year for 10 years, at which point 100% of the original payment will be returned. Spain, on the other hand, must pay 6.45% annual interest to sell 10-year bonds, about 2.7 times Germany and the highest price for the country in 14 years.

What influences yields and what are credit ratings?
There are currently only three important credit rating agencies: Standard & Poor’s, Fitch, and Moody’s. These groups are charged with grading the security of all bonds, sovereign or corporate. That is to say, they study the history of payment by debtors on their previous bonds, their current circumstances, and the risks and threats they are facing. The greatest degree of security and confidence is AAA. Their valuations are enough to convince investors like American pension funds, which administer hundreds of billions of dollars and only buy AAA-rated bonds. It also affects the abilities of debtors to finance themselves, since some markets use ratings to decide who can negotiate with or solicit them. Yet it must be remembered that they are not infallible: we know too well that some bonds, like subprime mortgages, undeservedly receive AAA ratings. Some have accused the credit rating agencies of acting too slowly during the current crisis – waving their capes at bulls that have already run by, if you will.

How is risk premium calculated?
The bonds of a given country, once emitted, can be freely traded in the secondary debt market at interest or yield rates which change as a function of demand. This is where the differences in 10 year bonds are instantly calculated, as this market, which has the same investor profile as the primary debt market, is more easily affected by concrete circumstances and better reflects investors’ current perception of risk. Although the primary and secondary markets are different, there is feedback between them, and the interest rates quoted for bonds on the secondary market are always translated to the primary market, from which they affect Treasury bids at auction and hence the amount of money held by the Treasury itself, which brings us back to the beginning.

How will the Treasury be affected?
German bonds on the secondary market are at 2.38% and Spanish bonds at 6.45% because of the possibility, minimal as it is, that Spain will have problems paying off its debt. The risk premium is 4.07%, or 407 basis points. In other words, if the two countries’ 10-year bonds were sold at auction today, Germany, which is less risky, would have to pay 2.38 euros of interest per 100 of debt for the next 10 years while Spain would have to pay 6.45. Multiply the difference by the tens of billions in debt each country issues each year to finance itself, it’s nothing to sneeze at.

How are banks affected?
We say “dime con quién andas y te diré quien eres (tell me who you walk with, and I’ll tell you who you are).” The banks of each country are inextricably linked to the states in which they are headquartered. If a country has problems, its banks will have problems: on the inter-bank market, where banks lend money to each other to finance themselves, they will pay more or less based on the size of their risk premiums. If it costs banks more to raise money, they have to increase interest rates on their clients who are seeking credit. If it is more expensive for citizens to borrow, there is less money for families and businesses, and they will spend less and weigh down the economic recovery. If there is less growth, there are less jobs and thus less tax returns and more unemployment payments for the state. With less funds, it is harder to reduce the deficit and pay creditors; that makes it more difficult to return to solvency as interest rates inexorably rise, but taking the shears to the budget could cut off growth…as a certain popular animated character would say, the vicious cycle can continue “to infinity and beyond!”

What does this mean for the European Union?
According to Brussels’s calculations, if a country has a risk premium of 400 basis points and doesn’t take action on it, the surcharge will probably decrease the country’s Gross Domestic Product at a 0.8% annual rate. In these times when decimal points separate growth and recession, that could be the difference between success and failure.

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