Prime Minister designate Mario Monti gestures as he talks during a news conference at Giustiniani palace in Rome on November 15, 2011.TONY GENTILE
Government bond markets across the euro zone are showing signs of severe strain. Even yields on the debt of previously safe countries such as France and Austria have widened relative to Germany. An Italian default and subsequent euro zone breakup may still be unlikely. But investors are now clearly factoring such a scenario into their calculations.
The market price of Italian debt is effectively a weighted average of two outcomes: either the country recovers, or it defaults and investors take a haircut. Normally, Italian bonds should trade at around par. But given the recent turmoil, the premium that investors demand to hold euro zone government debt may have been permanently raised. Even if Italy gets back on track and yields settle at about 5.5 per cent, its 10-year bonds would be worth about 94 per cent of their face value.
What if Italy defaults? Though the country is not as much of a basket case as Greece, a full-scale restructuring would still be messy. Investors might expect to take a 50 per cent haircut on their debt. Apply a discount rate of 9 per cent to reflect the increased risk, and those restructured bonds would have a current value of just 37 cents on the euro.
However, if Italy defaults, it might also leave the euro zone and redenominate its debt into a new currency. Investors might only recover 25 cents on every euro they have lent. With 10-year bonds trading at 85 per cent of par value, the market is currently attaching a 13 per cent probability to such a scenario.
Similar strains are now visible elsewhere. If investors did not doubt the euro zone's future, they would not demand a big premium to hold French 10-year debt instead of German bunds. This suggests markets are even pricing in some possibility of a future French devaluation.
Of course, market prices also reflect supply and demand. Banks are dumping sovereign bonds, and volatility has made investors wary of anything other than safe German debt. The only buyer is the European Central Bank, which is trying to prop up Italian and Spanish bond prices. Even if some investors think the implied risk of a breakup is excessive, they will want to wait until the euro zone shows more sign that it can tackle its problems before jumping in.