THE OTHER STEEP CURVE / THE WALL STREET JOURNAL ( HIGHLY RECOMMENDED READING )

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DECEMBER 3, 2009, 10:10 A.M. ET.

The Other Steep Curve

By RICHARD BARLEY

For government bond traders, this year has been all about the steep yield curve, which has provided booming profits. Loose monetary policy has anchored short-dated yields and pushed long-dated yields higher as investors anticipate an economic recovery. But for some of the largest sovereign borrowers, this has been accompanied by a worrying steepening elsewhere: in their credit default swap curve. The lines between supposedly risk-free and risky debt are blurring.

For developed countries such as the U.S., U.K., France and Germany the concept of a CDS curve hardly existed two years ago: credit risk over five, seven or even 10 years was viewed as negligible. That has changed. The U.K. is the most egregious example: Two years ago, it cost $5,000 a year to insure $10 million of the country's debt against default for three years, and the same amount for a five-year contract. But now, it costs $70,000 a year to insure U.K. debt for five years, $18,000 more than it costs for three years.

These steeper sovereign credit curves now look more like those of corporations pre-crisis. By contrast, the curve shapes for large multinationals such as International Business Machines, BP and Siemens are little changed from two years ago; BP's has even flattened marginally. What's more, the cost of insuring BP's debt for five years is now $28,000 less than that of the U.K.

The prices and curves don't indicate concern about a default but reflect worries over relative credit quality. When this pricing anomaly first arose in 2008, it was regarded as a market distortion that would be removed over time. But it is proving durable. A model that maps CDS prices to implied Moody's ratings suggests that BP looks more like an Aaa credit, while the U.K.'s implied rating has moved between Aa1 and A3.

Occasionally, very high quality corporates can pay less to borrow than their governments. In 1984, IBM sold a $100 million bond in Europe at a yield more than one percentage point below the comparable U.S. Treasury. That may not be repeated. Governments may succeed in rebuilding their finances – with the U.K. clearly under the most pressure to do so. But the CDS market is warning of what might happen if they don't.

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