From Safe Haven To Potential Short

Includes: BUND, BUNL, BUNT
by: Colin Lokey

Throughout the European debt crisis, German bunds have enjoyed a near automatic safe haven bid as investors fleeing the distressed debt of the eurozone's periphery nations seek capital preservation amid the burgeoning chaos. The historic rally in German debt drove yields (which move inversely to price) on German 2-year bonds to a record low of .021% on May 23, the same day yields on German 30-year notes fell below 2% for the first time. Similarly, German 10-year yields touched a record low 1.12% on June 1.

There are many reasons however, to believe Germany's perceived safe haven status is just that--perceived. Time and again over the course of the last year German Chancellor Angela Merkel and German finance minister Wolfgang Schaeuble have resisted calls for more lenient, less punitive terms for bailouts and remain vehemently opposed to the idea of shared liability for the region's debt (eurobonds). Despite Chancellor Merkel's recent contention that their will be no debt-sharing 'in her lifetime', pressure on Germany to soften its stance is growing as yields on Spanish and Italian debt linger precariously close to levels widely viewed as unsustainable. One of the issues purportedly under discussion is a new policy that will allow the European Stability Mechanism to purchase Italian and Spanish debt when yields cross a predetermined threshold--an idea Germany has categorically rejected but which nonetheless remains a possibility.

The fact is, it is looking increasingly likely that Germany will end up on the hook for at least a portion of the region's debt as some form of burden-sharing will ultimately have to materialize lest the whole union should come apart at the seams. Just how much these concessions will cost is not clear, but what does seem readily apparent is that as soon as Germany throws its lot in with the rest of Europe, yields on its debt will rise.

On top of this there are other concerns, some of which were cited by independent ratings agency Egan Jones when it downgraded Germany from AA- to A+ Tuesday. The firm noted that

"...whether or not Greece and other EMU members exit, Germany will be left with massive, additional, uncollectable receivables. Via the ECB's Target 2, Germany is owed EUR700B of which perhaps 50% is collectible and then there is the banks' southern EMU exposures. Germany's debt to GDP was 87% as of 2011. However, increasing Germany's debt by EUR700B to EUR2.9T for its indirect exposures raises the adjusted debt to GDP to 114%."

First, note that 'Target 2' is the EU's real-time gross settlement system, so the idea of Germany is owed 700 billion euros presumably refers to debts owed by nations who received bailouts and will likely never settle-up. More importantly however, is the fact that while the debt-to-GDP ratio posited by Egan Jones (114%) may sound bad compared to the 75-87% investors are used to hearing, consider that if unfunded liabilities are included, the figure is more like 200%.

Lastly, consider that the German economy has shown some very real signs of weakness of late as manufacturing activity recently hit a 3 year low, "suggest[ing] Europe's largest economy may contract in the second quarter as the euro zone debt crisis intensified", according to Reuters.

Taken together, all of this makes a strong case for impending weakness in German debt. Some are already placing their bets: billionaire hedge fund manager John Paulson disclosed in April that he is short German bonds via credit default swaps (a position which very well could have lost money before it made money as German bonds rallied into late May).

Over the past three weeks, German bonds have indeed begun to sell-off. Yields on the 10-year have risen steadily from their record low of 1.12% on June 1 to 1.5% as of Tuesday. Similarly, two year yields have risen from near zero in May to .10% currently. German bonds have returned negative 5% this month alone. Any indication from the EU Summit later this week that Germany is giving ground on the issue of collectivized debt, and the sell-off could continue. This is truly a situation wherein the risk factors are many but the underlying asset still trades in bubble territory. Perhaps the best indicator of the rising risk of holding German debt is German CDS, which has risen from a YTD low of 66.89bps in March to 102.08bps as of Tuesday. Shorting German bonds could prove to be one of the year's best trades.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.