Analysis: A curious case of German risk and safety

LONDON Thu May 17, 2012 9:52am EDT

LONDON (Reuters) - Investors can't seem to buy enough German government bonds and yet the cost of insuring against a German default has slowly crept up.

It might seem counterintuitive that the two phenomena are occurring at the same time but they have a common driving force - growing concern the euro zone crisis has worsened so much that Greece could end up leaving the single currency.

Given European officials are publicly discussing the risk of an event they once said was unthinkable, German bonds are viewed as the safest option in the euro zone and are finding ready buyers even though yields have fallen to record lows.

But while investors prefer to hold German government bonds rather than ones issued by pretty much any other euro zone country, financial markets are also assessing what Germany stands to lose as the crisis deepens.

Their assessment is reflected in the credit default swap (CDS) market, where the cost of insuring against a German government default has risen, albeit from low levels, to its highest since mid-January.

"If there is a Greek exit, the credit metrics of all the euro zone sovereigns would come under pressure," Jeroen van den Broek, head of credit strategy at ING in Amsterdam, said.

"This includes the credit metrics of Germany, which would deteriorate if there were a change in the euro zone dynamics to that extent."

ON THE HOOK

While highly-indebted euro zone countries have borne the brunt of financial markets' concern about the precedent that would be set if Greece were to leave the euro zone, no-one expects Germany would escape the fallout.

"Part of the reason (for the widening in German CDS) is the idea that no country is completely insulated if there is an extreme event," Luca Jellinek, Credit Agricole's head of European rates strategy said.

For example, the value of Greek debt held by the European Central Bank, the International Monetary Fund and euro zone countries is approaching 200 billion euros.

If the ECB took a hit, euro zone countries would be on the hook for any money needed to recapitalize the central bank.

Of course, a Greek exit is far from inevitable. But some of the options available to euro zone policymakers to avoid such an event would also affect Germany's creditworthiness.

One of the biggest nagging doubts is whether the existential threat to the euro zone has grown to such an extent that Germany will be forced to agree to common euro bonds.

"The CDS market is reflecting a play on uncertainty about the euro zone," said Gavan Nolan, director of credit research at Markit, a financial information firm which provides CDS prices.

"There are lots of facets to this. This includes the ECB's exposure to Greece, which would see Germany hit more than other euro zone countries (if Greece quit the bloc). It also includes concern about the potential evolution of euro bonds."

THE WAY IT WORKS

Intrinsic differences between the government bond market and of the credit default swap market also help explain why German government bonds and the price of German default insurance can rise at the same time.

"They have completely different client bases," ING's van den Broek said. "The speculative client base is putting money into the CDS. There is a different client base in the cash (bond) market, which is seeing a real flight to quality."

It also takes far less money to move the German CDS price than the more liquid German government bond market.

With the value of outstanding CDS contacts greater for Spain or Italy than for Germany, trading can sometimes be lumpier in a strong credit, such as Germany, than in weaker ones, according to Ciaran O'Hagan, strategist at Societe Generale in Paris.

The current financial market environment may also be affecting supply and demand dynamics in the CDS market and facilitating the rise in default insurance prices.

"In the current circumstances there are more people who are worried about credit risk than there are people who are wanting to make money by selling such protection," said Credit Agricole's Jellinek.

Amid all the uncertainty and flux, the one thing analysts are confident about is that turbulent times are ahead.

That means the cost of German default insurance could keep going up even if German bond yields continue to fall.

"Governments are not taking the right actions to solve the current problems so I am inclined to think that (euro zone sovereigns') CDS will widen further," Societe Generale's O'Hagan said. "I would position for very risk averse conditions ahead."

(Reporting by Swaha Pattanaik. Editing by Jeremy Gaunt.)

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