La prima de riesgo: a Spanish obsession

If you travel to Spain, you will certainly be surprised by the media’s obsession with the prima de riesgo or “risk premium” in English. It has been all over the news since 2007 and it has even become a small talk topic. If you’re stuck in the elevator/lift with your boss and have no idea what to say, you don’t need to talk about the weather anymore! The weather is so 1990’s! Here in Spain, “what’s the weather like?” has become “where does the risk premium stand at?” Few people actually know what it means but when something goes wrong, you can always blame it on the prima de riesgo. Unemployment, sluggish economy, corrupt politicians: all of this might very well be the risk premium’s fault.

What is risk premium?

In finance, risk premium is the extra return that investors require from a risky investment of any type (stocks, fund units, bonds, etc.) compared to a hypothetical “risk-free” investment. In stable countries, “risk-free” is a near-synonym for “government debt” but as some countries have faced difficulties servicing their debt, it is no longer the case. For instance, bonds issued by healthy corporations may now appear less risky than Spanish debt…

What risk premium is being so closely monitored by the Spanish media?

Since the 2007 crisis, Spanish analysts and journalists have focused on the risk premium of 10-year Spanish government bonds taking German government bonds of the same maturity as a benchmark. The prima de riesgo is, therefore, a risk premium of Spanish debt “versus German sovereign debt”. In Spain, the usual paradigm that risky assets issued by private companies are to be compared with so-called “risk-free” government bonds doesn’t hold anymore as Spain’s public debt is now considered risky and has a benchmark of its own. If the Spanish government borrows money over 10 years at a 5% interest rate vs. 2% for the German government, then the risk premium you will hear about on TV will be 5% - 2% = 3% or, to be more accurate, 300 puntos básicos (300bps). Easy, right?

Why is it a relevant indicator?

Well, before the crisis, Spain was an AAA-issuer according to all credit rating agencies, just like Germany. Until 2007, the spread between Spain’s and Germany’s government bond interest rates was near zero! Both governments borrowed money at very similar and rather advantageous rates. Therefore, monitoring this spread was irrelevant. Then things got a little more complicated... and the prima de riesgo became meaningful as it started to reflect events in real time, as shown below.

In 2007, investors started to realise that Spain’s public finances weren’t heading in the same direction as Germany’s and the prima de riesgo rose from 0-10bps in 2007 to 100bps at the end of 2008, right before Spain lost its AAA rating. But it should be reminded that back then, the future of the German economy wasn’t bright either. In fact, German GDP fell by as much as 5.1% in 2009 while the Spanish one was down by “only” 3.8%. So yes, in 2009, the prima de riesgo did tighten temporarily to 50-80bps as investors feared that Germany was finally heading in the same direction as Spain. But German government bond rates managed to impose themselves as benchmark, supposedly “risk-free” rates for all European issuers as Germany’s AAA rating has remained unchanged throughout the crisis.

In May 2010, after months of uncertainty over Greece’s fate, the EU agreed to bail out the country. The situation in Greece triggered panic over the weak position of public finances in other peripheral countries including Spain. The prima de riesgo more than doubled to 200bps at the end of 2010 and kept rising sharply after that, exceeding 300bps in Q3 2011 and even 400bps in Q4 2011! Spanish bank Bankia then had to be bailed out and nationalised in May 2012, increasing the country’s debt burden and resulting in a downgrade to Baa3 by Moody’s a few days later and to BBB- by Standard&Poor’s in October. Both grades were just one notch away from the “non-investment grade” category… The prima de riesgo jumped to over 6%, meaning that the Spanish government was borrowing money over 10 years at an interest rate in excess of 7% while Germany was enjoying near-1% rates –as investors flocked to Germany looking for high quality government debt, dragging German interest rates to record lows!

Fortunately, in September 2012, ECB president Mario Draghi managed to restore investor confidence by announcing he was ready to back ailing countries whenever necessary. This was enough for investors to believe the Spanish government would receive full support in case of an emergency. Since then, the risk premium versus Germany has gradually gone down. Since mid-January 2014, it has remained below 200bps, falling below the 150bp mark in May 2014! Good news, Spain can start borrowing money at affordable rates again… although the money borrowed over the past 5 years at impressively high rates is still to be repaid!

Anyway, this was the story of why the Spaniards are obsessed with the prima de riesgo. The risk premium of the government debt vs. German debt is now an inevitable indicator of the state of Spanish public finances, assuming German public finances remain as good as they are. So don’t forget: if you want to have a conversation with a Spaniard, don’t bother them with the weather or with the Champion’s League, just talk about the prima de riesgo!