Take it from the bond market: the world is getting riskier. The issue at hand is that a significant amount of European sovereign debt — pretty much all of it, except for bonds issued by Germany and France — is widely regarded as junk. Meanwhile, much U.S. state and local debt is being priced below investment-grade corporate bonds.

The backing of monoline insurance, which used to turn local government debt into AAA-rated debt, is almost impossible to obtain. That means the global bond market has turned downright dangerous for investors. In fact, many European sovereign bonds are now seen as being riskier than investment-grade corporate bonds.

“It’s like shopping in a bad neighbourhood,” says Rémi Roger, vice president and head of fixed-income with Seamark Asset Management Ltd. in Halifax.

So, it’s the old question of whether you should seek return on capital or return of capital for your clients. If you choose low default risk and take shelter in U.S., Canada or Germany government bonds, the risk shifts to the chance of loss when rates rise.

Interest rates tell the story: as of early December, Republic of Ireland government debt was being priced as global junk, with 10-year bonds yielding 8.47% a year to maturity. Meanwhile, according to Bloomberg LP data, Portugal’s 10-year bonds were yielding 6.04% a year and Spain’s 10-year bonds were yielding 5.07% a year. In comparison, annual interest to maturity on bellwether 10-year German bunds was 2.87%.

Bargain-shoppers with a taste for risk might go for the Irish bonds — but liquidity is drying up in that sector. The implication is that not many traders want to play in the Celtic sandbox.

Not only are Irish bonds chancy, but the euro, as a currency, has significant downside risk in the next few months as well, says Camilla Sutton, currency strategist with Scotia Capital Inc. in Toronto. “If the U.S. dollar weakens early in 2011, then the euro could see some strength,” she says. “The market is extremely nervous about Irish debt and the euro. We see Spanish [bond] yields rising, and those of Portugal [bonds as well]. It looks like a loss of confidence.”

With Ireland’s deficit equal to 32% of gross domestic product and all of Europe seemingly hanging on to what Dublin does, Germany — which is stuck bailing out every problem state — wants Ireland to settle up with its creditors. The European Central Bank doesn’t want Ireland’s problems to wreck the credit ratings of other countries using the euro. The issue is no longer just what a smallish state in Europe does, but what governments around the world will do with debt they cannot service.





@page_break@Even the U.S. is being dragged in. For instance, municipal bonds, which amount to 15% of all domestic government debt in the U.S., are under pressure from lack of monoline insurance to cover default risk. “Munis” are showing signs of recession-induced weakness as foreclosure and recession have cut realty and sales taxes that support local governments.

In mid-November, the town of Hamtramck, Mich., a working-class suburb of Detroit, asked the state government for permission to declare bankruptcy. The state declined. This means Hamtramck will have to find a way to pay its bondholders. Thus, it may have to raise taxes and that, of course, will force more residents to flee. It’s a no-win situation for the town.

“If municipal bonds produce negative returns, investors will shift to safety,” says Chris Kresic, co-lead manager of fixed-income with Jarislowsky Fraser Ltd. in Toronto. “They have already shifted to short-term corporate bonds for annual yields of less than 1.5%.”

Lost in the rush to sell off U.S. munis has been the larger concern relating to the U.S. bond market’s integrity. In the years leading up to the autumn 2008 market crash, monoline insurers took fees to guarantee the bonds of municipalities. They saw greener fields in moving to insure packaged mortgages and other derivatives. When those investment products collapsed, the monolines had to pay up. The result is that monoline insurers are in deep trouble.

On Nov. 1, New York-based Am-bac Financial Group Inc., one of the largest monoline insurers, revealed that it would skip an interest payment on one of its own bonds. Moody’s Investors Service Inc.had already cut Ambac’s credit rating to C, the level just above “default,” in March 2010. Ambac has said that it has enough cash to pay claims through March 2011, but a bankruptcy filing is expected. The company is now less solvent than most of the debt it would be asked to insure.

Ambac and its competitors had filled an important niche in the bond market. When they were awash in premium income to insure bonds and paying out little in claims, their insurance provided AAA credit ratings to municipalities. That allowed the towns and cities to get lower interest rates for their debt.

Now, however, the monoline insurers have more cash calls than income. Ambac, for example, has less than US$80 million in cash on hand to pay an estimated US$1.6 billion in debt it insures. The firm is being saved only by a $2.5-billion tax-loss carryforward. Ambac is fighting for its life, and other monoline insurers have similar stories. The result is that these insurers, which at one time financed almost 60% of all new municipal bonds, now cover less than 10%.

Investors who once would put money into municipal bonds have voted with their wallets for U.S. Treasury debt, in spite of its low returns. The great sell-off of risky government debt shows no sign of ending. Cautious financial advi-sors and clients can be forgiven for staying on the sidelines until there are signs the carnage will end. IE