If you recall, the sovereign debt issues started with Dubai, and investors quickly dismissed them as a one-off event from a small country. Then the ugly truth about Greece started to surface. And commentators have taken the same position arguing that the total amount of debt at risk isn't a big deal.
And for the last week, the Greece issue has faded from the radar screen as the country has been cloaked in the protection of comments from the EU.
But you know who won't forget: bond traders. While bureaucrats sleep, there is some young bond trader burning the midnight oil with a couple of cans of Red Bull and some spreadsheets hoping to make a fortune for himself.
Understanding what motivates bond traders will help you understand what risks you're still facing as an investor. Here's what I mean:
- If you and I see a problem in the markets, our choice might simply be to avoid it. So if I don't like the financial conditions in Greece, I just avoid buying their bonds, and you might do the same.
- But there are others who don't just avoid it, they jump in head first on the other side. They execute trades that will be highly profitable if the situation in Greece gets worse. So they have a vested interest in discovering the bad news first, and then making sure the rest of the market knows about it.
- They enforce a sort of brutal market justice on companies or governments that aren't doing a good job of being fiscally responsible.
The reason this is important is because bond traders won't let up until the ugly truth is known. Why? Because there's lots of money to be made by doing so.
Who knows where it will all lead and how long it may take to uncover whatever lies beneath these government balance sheets. Finding these problems is often harder with governments because they have the ability to hide all sorts of liabilities that private companies can't.
- For instance, Greece was recently accused of entering into a transaction with a Wall Street firm to re-characterize certain liabilities, and in essence reduce the appearance of the amount of debt Greece had. Now Greece claims it was all legitimate, and it probably was. But that isn't the point. The point is if they've been doing it, you can bet other governments have as well. All kinds of financial transactions are often marketed to governments as a way of massaging their finances, and the odds are more than one did similar types of deals.
- That's what those bond traders are looking for, and when they find evidence of dubious debt behavior, they'll pounce on it.
What To Do. As has been the case for the last three years, make sure you understand how much risk you're taking with your money, and make sure it's appropriate for where you are in your financial life cycle.
Last year, huge amounts of money poured into foreign stock and bond markets. Now, it's one thing to allocate money to those markets if you're doing so for diversification purposes. But if you thought you were going to get something that was safer than you can get back home, you might want to think again.
If investors get fearful about foreign government debt, you can be pretty sure that their stock markets aren't far behind. Because of the heirarchy of assumptions about credit and market risks, if bonds come under pressure, it's usually bad for the stocks that are also associated with those entities.
Also remember that a crisis often takes longer to unwind than people anticipate. So don't lose your vigilance. And even though the initial amounts at risk seem small, the system is highly leveraged. So what seems like a small problem can be magnified into losses that are 10 to 20 times larger than the initial dollar amounts.
Bottom line. If government debts are bigger than advertised, bond traders will eventually find them.
As with all financial matters, consult your individual advisor prior to making any financial decisions.
Learn More: Want to learn about a simple way to manage your personal finances and prepare for retirement, investigate my new book Your Money Ratios: 8 Simple Tools For Financial Security, available in bookstores and at amazon.com The Wall Street Journal called the book "one of the best finance books to cross our desks this year." WSJ 12/19/09.