Montreal, Canada

The explosion of global sovereign debt issuance since last year combined with a marked deterioration of public finances has fueled a new market for betting against governments bonds. And that’s great news for aggressive investors because before this credit unwinding is over several nations will default on their sovereign debt obligations.

The enormous weight of this financial crisis has caused severe damage to balance sheets in many regions but most notably in the United States, Western Europe and especially in the emerging markets of the Baltic Republics, the Balkans and Central Europe. The odds are high that one or more of these emerging market sovereign issuers will default over the next 12-18 months. Unlike the West these countries simply don’t have the capacity to spend their way out of economic misery.

The International Monetary Fund or IMF has already bailed-out several countries – Ukraine and Hungary among them – but it’s highly unlikely the lending agency can forestall every default once a major issuer in a region triggers a chain panic reaction. I’m convinced we’ll see a credit default in Central Europe before this credit unwinding is over.

Sophisticated investors can now place bets buying credit default swap indices (CDS) that speculate on sovereign government defaults in major and emerging markets following the creation of the first tradable indices tracking the risks of countries defaulting. Credit default swaps – chastised by George Soros – are used as insurance against a bond defaulting.

Markit, the service-provider, is launching four CDS indices today including the iTraxx SovX Western Europe Index and the Markit iTraxx CEE-MEA Index. The latter looks especially appealing because it includes Central European and Middle East countries – both regions that are vulnerable as debt financing bleeds them dry. The other two indices are based on a group of industrialized countries (G-7) and a diversified basket of credit default swaps speculating against issuers in Europe, Asia, Latin America, the Middle East, Africa and North America.

Another sector that extremely vulnerable to refinancing is the U.S. junk bond market. This asset class is now in a “bubble” following a 35% rally since March and a crash in credit spreads. The default rate, currently at 7% through May, is probably going to double before it bottoms in this economic cycle; I highly doubt investors have discounted a 14% or 15% default rate ahead of $950 billion dollars of refinancing coming due from now until 2014 for high-yield bonds.

In the next issue of The Sovereign Individual I’ll be betting against junk bonds with a fury.

This is not a normal economic cycle and credit deflation remains a central theme over the next few years as governments, companies and consumers alike struggle to raise capital.