Speculating against sovereign debt, how does it actually work?

BondsIn recent months we have heard that some countries such as Ireland, Portugal and Spain, but also in a lesser way Italy or Belgium, are having trouble in issuing their debt because there is a lot of speculation and betting against them. This has happened in the past in other regions of the world such as Latin America or Southeast Asia.

As an economist I think I understand the basic mechanism behind this. If any economic agent, and a government is no more than an economic agent, casts some doubts about the capacity of repayment it will have more trouble in refinancing its debts and this eventually could lead to a spiral that would cause a default. But, how does speculation against the sovereign debt of a country work? If I had enough money to do it, how could I actually benefit by speculating against the sovereign debt of Spain, for instance?

Suppose A got a new job, under a probation period, and borrows 50 euros from B and agrees to return this debt in 10 years (5 euros each year) paying 1 euro as interest rate each year (let us ignore inflation, or in the case of foreign debt, currency exchange issues). Now C offers B a contract to cover part of the loss B would incur if A does not pay, say by paying B 30 euros in case of A defaulting. For this B has to pay 0.20 cents to C each year. But B has bet on A prospects of improving, and A gets a permanent job after the probation period so that the bet was succesful. This makes the whole package attractive, that is A's debt and C's default warranty, and so B goes and sells the package to D for 54 euros. B could now go and look for other investment opportunities, maybe cashing part of the gain or reinvesting it fully.  But this is a lottery, A may be fired after the probation period in which case the default would materialize and B and C would share the loss, as they shared the risk because of their contract. The whole example wants to show that the financing needs of A triggered not only the initial debt but also two other derived instruments, the contract between B and C, which is what is called a credit default swap, and the final package that is also traded.

Speculation can be understood as any other investment under risk. The key to understand the attractiveness of risky debt of countries which have economic difficulties is that they offer high risk but in expected returns terms they may be attractive to some investors with the right degree of risk propensity. This is the reason why some type of investors are looking around for countries in economic trouble, that may have a chance to default on their debt. In expected terms the returns may be right if you have the right propensity to risk, despite the fact that it would be safer to invest in the debt of a country with a lower probability of defaulting on its debt, say for instance Germany or Norway. In other words, if you love to play lottery, you need to find a lottery where to play, that is what makes countries with fiscal problems attractive. But it is actually more complex as it is not a simple matter of choosing among debt offers with different degrees of risk, and therefore different premia for that risk. There are furthermore several derived investments around the direct investment in the sovereign debt of a country, so let us look with a little more detail  at how the investment in sovereign debt works.

What is sovereign debt? It is simply the debt issued by a country in the form of government bonds. Government bonds in principle are risk-free, and therefore pay a very low interest rate, because a government has full power to raise taxes and this assures payment when the bond is redeemed. But some governments have defaulted to their payments, recent examples are Russia in 1998 or Argentina in 2002, due to severe economic crises that translated into a fiscal crisis. In the midst of a severe economic crash there may be not enough economic activity to raise taxes and this will not only affect current public spending but also the repayment of interest rates and capital of old debt.

To repay old debt and interest rates, since taxes and other resources are not entering into the treasury in a continuous way, governments have to periodically issue new bonds. If at some point reduced economic activity casts doubts about a government's ability to raise enough proceedings, it may be impossible to raise enough money to pay these short-term requirements and they may default on their debt.

So the first source  of speculation could come from betting on rumors about the economic situation of a country and waiting to buy bonds of a government in trouble until the interest rates offered are large enough to make it attractive, but this is not the only possible bet. Here is where credit default swaps jump in. What is a credit default swap? It is just a private contract, that is a unregulated financial instrument, by which two parties agree to trade on the credit risk of one ore more third-parties. In other words, it is similar to an insurance, where somebody holding the debt of a country pays a periodic fee to a protection seller and the protection seller guarantees to pay in the event of default of the bond issuer.

But credit default swaps are not like insurance in all aspects. For instance if I want to buy insurance on a house I normally will own or rent a house, but one buys credit default swaps without owning the underlying asset. So they are similar to insurance since debt owners can use them to hedge, or insure, against default on a loan. However, because there is no requirement to actually hold any asset, credit default swaps can be used to speculate on changes in economic conditions and therefore changes in credit spreads.

So now a holder of government bonds also holds credit default swaps related to these bonds, and can resell the whole package if the opportunity arises and get new capital to go around and look for new opportunities. There are large funds moving around the world looking for this type of opportunities as soon as a country or region starts looking attractive from their point of view.