The latest Spanish bond and T-Bill auctions resulted in high short term yields and 10-year rates around 5.75% (lower than the over 6% secondary market yields of the previous days). An interesting development is that, both for Italy and Spain, short-term rates are now much higher than corresponding Euribor funding costs, in contrast with previous T-Bill auctions (where the Euribor spread was negative). It seems that even short-term Treasuries are not considered risk-free anymore and the LTRO effect is fading away (since Spanish banks could use LTRO liquidity and earn a decent carry with the previous 12M 1.418% and 18M 1.711% rates). What seems strange is the fact that the yield on the 2-year bond was somewhat lower in today’s auction compared with the previous on March 20 (3.463% vs 3.495%).

Based on the usual risk-neutral default probability/intensity calculation formulas (recovery rate of 40%, risk-free rate at swap rate minus 10bp), the corresponding numbers are as follows:

The calculated default rates are closer to a B rating than the current A rating for Spanish government debt (based on Moody’s statistics for real-world default rates). The short-term hazard rate curve has ‘inverted’ compared to previous auction results signaling a deterioration of short-term debt prospects for Spain.

In general, cumulative default rates are lower than B rating for maturities up to two years, very close (to B) in the 3-5 years horizon and move to Caa-C territory for 10 year maturity. A restructuring event is quite certain in the long-term, credit quality is very low beyond the LTRO maturity and a substantial deterioration is evident in the short-term. Since both sovereign and bank funding needs are now higher (due to large NPL ratios, deeper economic recession and hidden regional debts), LTRO liquidity is now considered inadequate and funding cost is priced in, especially since remaining to-be-pledged bank assets are of low quality.

The chart below (from soberlook) shows the large difference between secured and unsecured lending rates (Eurepo and Euribor), highlighting the fact that Spanish and Italian short-term T-Bills are very far from being risk-free:

Since mostly only Spanish and Italian banks (along with other institutional investors like pension funds) buy their countries sovereign debt, another way of looking at short-term T-Bill rates is as representing the corresponding banks funding costs. LTRO liquidity is probably projected to dry up in the following months and banks will find a hard time financing their trade positions either through ECB or money markets (due to high rates and/or haircuts), especially counting collateral price volatility.