Spanish credit curve beginning to invert

Alphaville points out that the Spanish Credit Default Swap (CDS) curve has joined the Greek and Portuguese curves in inverting.  They explain it as the market pricing in a higher likelihood of default in the early years of the curve.

My explanation would be that the market is expecting a restructuring.  Restructurings tend to haircut the payments due at all maturities by a similar amount.  Thinking in simple terms as if all the debt were zero coupon bullets, a 20% loss on principle expected to be repaid  a year from now is more painful than 20% lost on principle due back 10 years from now.

If investors are beginning to fudge their models to account for principle write-offs they will want to pay lower prices for the short-term debt.  Putting these lower prices back into a standard model that still assumes the full principle repayment will show a higher yield to maturity for the short dates.

In such situations it can be useful to compare the bonds on prices rather than yields.  It also makes sense to consider cash neutral hedges rather than duration weighted hedges.

More evidence that I am not alone in expecting a restructuring.  I should add though that the plunge in the Euro this week on news that Germany might not be carry out its part in the bailout points to continued belief that creditors will be protected at the expense of the currency.