Three weeks ago, the yield on ten-year shekel-denominated Israeli government bonds surpassed 5%, for the first time since 2011, reflecting a slump in demand. In recent sessions, the yield has moderated slightly, but examination in depth reveals that the situation is still far from good. The yield is currently around 4.85%, and trading in an instrument generally considered solid has become relatively volatile.
Whence the decline? The explanation lies partly overseas. The main benchmark is US ten-year Treasury bonds, which are considered extremely safe. Since last week, following the release of the May inflation figures, the yield in the US has fallen sharply. In Israel, the fall in yields has been more moderate. Why? Among other things because in the US the market is pricing in an imminent interest rate cut, while in Israel it is not, in the light of the economic and security uncertainty.
Gap between official rating and the market
In order to understand the degree to which foreign investors see Israel as a risky investment these days, it is necessary to look at another figure besides shekel-denominated bonds, namely the dollar yield spread versus other countries. Why? Because the yield spread reflects the difference in credit risk between the countries. A country with a higher credit risk will have to offer a higher yield in order to attract investors, and its spread will therefore be higher than that of a country with a lower credit risk. The benchmark is the US 10-year Treasury bonds. Wider spreads can signal fears on the part of investors about the economic and financial stability of the country in question.
Since the early months of the war, a significant spread has opened up between yields in Israel and in the US. Although Israel’s sovereign rating from the major rating agencies such as S&P and Moody’s is fairly high, in the A band, in practice, the markets are penalizing Israel and pricing a much higher risk.
Israel is currently priced as a country rated BBB, and in the past few days there has been a further deterioration. The yields demanded on Israel’s dollar-denominated bonds are beginning to approach the level of developing economies rated BB.
What does this mean? Here are a few examples. Israel’s dollar denominated bonds are currently priced as bearing a higher risk than those of countries like Hungary, Peru, and Mexico. In fact, we are approaching the levels of Romania and the Dominican Republic. The spread on Israeli government ten-year dollar bonds is 1.75% above the equivalent US security, while the spread for the Dominican Republic stands at 2.05%. For the sake of comparison, Hong Kong’s spread is 0.1%.
Bank Hapoalim chief financial markets strategist Modi Shafrir also highlights the fact that Israel’s position continues to worsen. He says that the average spread for countries rated BBB- is only 1.5%. "We are not at a junk rating, but Israel’s risk premium continues to rise in relation to other countries," he says.
It should be stressed that this does not mean that Israel’s economic situation is similar, or even close, to that of countries like the Dominican Republic. Israel is still a country with a strong economy, a good debt:GDP ratio, a stable currency, and so on. The great uncertainty arising from the war is the main reason for the rise in its dollar yield spread. Furthermore, the Ministry of Finance has mainly raised debt in the local market, around 70%. There too, yields have risen to some degree, but they are at lower levels than those on dollar-denominated bonds. The risk there is much lower, since there is almost no fear that the state will not be able to pay its shekel debts. Moreover, even the Ministry of Finance’s bond offerings overseas have so far drawn fairly high demand.
Uncertainty, and the deficit
Another statistic that indicates high risk levels for government debt is the credit default swap (CDS). This is a financial instrument that in effect insures against default on debt. By this metric, the risk premium on ten-year Israeli government bonds is double or more what it was before the war.
Meitav Dash chief economist Alex Zabezhinsky told "Globes": "Israel’s risk premiums on international markets are far higher than what would derive from its credit rating. Actually in the local market there has been a widening of the gap between Israeli shekel bonds and US government bonds to levels not seen in a decade. This is the sign of a rise in the risk premiums."
Zabezhinsky explains that one possible response is that the Bank of Israel could intervene in the event that the local bond market becomes dysfunctional, as the Bank of England did in the UK two years ago. First and foremost, however, it is the government and not the Bank of Israel that needs to take action, since "besides developments on the security side, investors are paying particular attention to the credibility of the government’s economic policies," Zabezhinsky says.
The rise in the yield demanded for investment in Israel is taking place against a problematic background, particularly in fiscal policy. Israel’s fiscal deficit swelled to 7.2% of GDP last month, and the Ministry of Finance points out that even were it not for the war, government spending would have risen by 10% so far this year in comparison with the corresponding period of last year.
How have such situations ended in other countries?
A glance at two current examples can provide a glimpse of what could happen to the Israeli economy if the situation continues. Spoiler: Generally, when investors’ confidence is damaged and the risk premium rises, it ends very badly. When this happens, all eyes are on the measures adopted by the government, and if they do not broadcast credibility, the situation is liable to deteriorate rapidly, leading to swift erosion of the currency and soaring bond yields.
In Mexico, for example, the peso has depreciated sharply this month. The reason, according to Bank Hapoalim’s Shafrir, lies in the election of a president who intends to promote controversial legal reforms. Fear of such moves have led to the currency depreciating by more than 10%.
Another instance is the UK two years ago, when then-prime minister Liz Truss attempted to carry out an extensive economic program during a period of rising inflation. The result was a meteoric rise in yields on UK government bonds, and the Bank of England had to intervene in the market to prevent a collapse that would have dealt a severe blow to UK pensions. Truss exited 10 Downing Street after just 50 days in office.
Such examples make clear the risks and the economic consequences of a loss of investor confidence in economic policy. "The instances that took place were in countries in much better geopolitical situations than ours, which brings home the danger to the Israeli economy," says Shafrir.
The bottom line is that without measures to reassure investors and give them confidence, the Israeli bond market is liable to deteriorate further. The Ministry of Finance is mainly raising debt locally, but the cost of doing so is rising here as well. What can the government do? It can try to provide some kind of certainty. What else? It can cut spending, reduce the deficit, and broadcast to investors and to the rating agencies that there’s a responsible adult in charge capable of introducing painful measures, certainly when the discussions on the next state budget get into high gear.
Published by Globes, Israel business news - en.globes.co.il - on June 19, 2024.
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