Standard and Poor’s downgraded France’s credit rating last week from AAA to AA+. While this downgrade has gotten a lot of press coverage, there are a number of topics surrounding the downgrade that are worth noting.
First, France now has the same credit rating from S&P as the United States. As you’ll remember, S&P downgraded U.S. sovereign debt from AAA to AA+ back in August 2011. Second, the yield on France’s 10-year bonds is at 3.08%. While this yield is well above the U.S. 10-year Treasury yield of 1.9%, it is certainly not a sign that the bond market sees substantial credit or interest rate risk associated with France. The media response to the downgrade is reminiscent of the situation in July last year when there was a media frenzy surrounding the possibility that the U.S. would fail to raise the debt ceiling and technically default on its debts.
Third, we can better understand the markets for debt (bonds) if we also look at the markets for equity (stocks). They are related. The appetite of investors for risk (and that of the market as a whole) varies through time. When investors are broadly risk averse, they are less willing to take on equities and more inclined to put money into ‘safe’ assets such as sovereign bonds. We are in just such a situation today. Volatility in equities is high and investors are fearful—and perhaps rightly so. In this environment, it is perfectly predictable that government bond yields will remain stubbornly low. Let me explain.
The iShares MSCI France ETF (EWQ) is designed to track a broad index of French stocks. We can look at the historical volatility (risk) of this index fund versus the historical volatility of Germany and the U.S. I chose Germany for this comparison because the bond yield in Germany remains very low, with ten-year bonds at a yield of 1.8%. Volatility is a standard proxy for risk. Volatility measures the variability through time of the return on a stock, fund, or index around its average value. High volatility means that the market is constantly changing its consensus estimate of fair value. For this reason, volatility is a standard measure of risk. The larger the swings in value from day to day, the higher the volatility.
We can also look at the implied volatility, a measure of future risk. As the proxy for the German stock market, I will use EWG, the iShares MSCI Germany ETF. For the U.S. stock market, I will use the S&P500 ETF, SPY.
|Ticker||Trailing Three Year Volatility||Six Month Implied Volatility|
I have obtained the trailing three-year volatility of each of these ETFs and compared these to the implied volatility of put options with an expiration of about six months (note: there are options on EWQ and SPY expiring in June but not July and options on EWG expiring in July but not June, so I am using June options for EWQ and SPY and July options for EWG). There are several interesting features of the table above.
First, the implied volatility for the S&P500 (SPY) is very close to the trailing three-year volatility. The near-term risks in the U.S. stock market (as measured by options prices) look similar to the risks we have been facing for several years. Over the past three years, both France and Germany have been far more volatile than the U.S. The estimate of future volatility provided by options prices suggests that both France and Germany look riskier in the near-term than they have even in recent years, and that France has gotten more risky relative to Germany and the U.S. Interestingly, the trailing six-month volatility of EWQ is 49.8%, consistent with the forward view from the options. One important point to understand here is that all of these options are traded in U.S. dollars. For this reason, the implied volatility of the options reflects currency risk associated with the exchange rates between the Euro and U.S. dollars.
Let’s put the downgrade of French sovereign debt into context. The bond market has totally taken the downgrade in stride. The stock market, including the effects of currency risk, assesses France as a very risky proposition—about twice as risky as the U.S. when we look at implied volatility. In a detailed article that I wrote for Advisor Perspectives, called “The Danger in European Stocks,” (November 2011), I concluded that Euro-zone stocks looked very risky moving forward. However, the downgrade by S&P does not alter my outlook on European equities. Indeed, the fact that the S&P International Dividend ETF (DWX) has a yield of 6.15% tells us that investors see European stocks as a risky proposition (55% of the assets of this index fund are invested in what Morningstar classifies as Greater Europe). For investors to require a 6.15% yield to invest in stocks but only 3.1% to invest in bonds means that investors perceive very high risk in stocks. Investors see sovereign bonds in the largest Euro-zone economies as something of a safe haven from equity risk even as credit ratings fall.
In summary, the downgrade on French sovereign debt is of little significance for the time being. There is no new information here that the market has not already anticipated and processed into market prices. For U.S. investors, it remains unclear to me why one would want to put a meaningful allocation into international bonds. The fact that European equities look too risky to suit many investors’ risk tolerance does not mean that we should be willing to accept super-low yield on bonds issues by Euro-zone countries. The 3.1% yield on 10-year French bonds is generally on par with inflation in the U.S., but investors are taking on considerable currency and interest rate risk to achieve this modest return. My recent analysis of risk-vs.-yield across a number of asset classes does not make international bonds look attractive. The recent round of downgrades by S&P simply bolsters that perspective.
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