Crumbling values of Greece’s and other European sovereign bonds have created a “once in a lifetime” opportunity to buy bonds that, although shrouded by fears of default, continue to pay interest on time.
So, if your clients can handle the risks of sovereign debt trading with junk bond-like returns or the senior debt of banks that hold the questionable bonds, they may want to take a fighting chance at these profits.
Central banks and European rescue teams are working to boost Greece’s ability to service its bonds on time and to recapitalize troubled banks stuffed with the affected bonds. Both jobs are challenging, for Greece’s problem has spread to other countries in which wholesale markets that provide short-term financing for national and commercial debt are running scared.
On Oct. 4, Moody’s Investors Service Inc. downgraded Italy’s sovereign debt by a notch, to Aa2 from A2, referring to “the erosion of confidence in the whole finance environment for euro sovereigns due to the current sovereign-debt crisis” as the reason. Then, Fitch Ratings Ltd. dropped Spain’s rating to AA- from AA+.
Although these downgrades are embarrassing for Italy and Spain, “the countries have been paying so far,” says Roger Lister, chief credit officer for European and U.S. financial services institutions with DBRS Ltd. “They have not yet missed an interest payment. There is no default yet.”
The bond market, however, is viewing troubled balance sheets as defaults in all but name. Greece’s bonds have been so beaten down that they yield 23.8%, on average, to their theoretical maturity. Most of that double-digit return is based on the notion that these bonds, trading at a deep discount to face value, will be redeemed at par. The likelihood of payoff at par is shown by what it costs to buy a credit-default swap on Greece’s sovereigns — 65% of face value.
Although the default is priced as being almost certain, it may not be as bad as all that. A bust by Greece’s sovereign bonds would probably result in the restructuring of Greece’s national debt. Holders of these bonds would be forced to take a haircut, which would remove what is widely expected to be 50% of the value of those bonds. Bought cheaply enough, these deeply discounted bonds, even with a 50% haircut, would be a bargain, as the bonds are already priced for default.
In a market in which risk is shunned, any uncertainty drives down asset prices. It is clear that Greece cannot survive with its current debt levels. “It can keep on going and borrow in private markets at rates of 30%-50%, which is impossible,” says Chris Kresic, co-head of fixed-income and partner with Jarislowsky Fraser Ltd. in Toronto, “so [Greece] is in the process of restructuring.”
Banks, too, are in line for grief. “The banks that hold [Greece’s] debt don’t have the equity to write it off,” Kresic adds. “The problem is ultimately about the banks.”
The majority of European banks have already marked down Greece’s debt by 50%, he says. The problem is the banks that have not written off enough of this debt.
Dexia NV/SA, the Belgium-based bank that also operates in France, has marked down its Greek sovereign debt by only 21%. As a result, Dexia, which had assets of 518 billion euros as of the end of June — as much as Greece’s entire banking system — is being nationalized. The plan is for Belgium’s government to take over the bank’s retail banking operations, recapitalize the technically insolvent bank, take shares and then sell those back to the private sector after the markets have recovered.
The effect would be to clean out existing shareholders but limit the damage for the bank’s bondholders. Some bond experts view the plan as evidence that a kind of normalcy will eventually return to the credit markets.
“I am optimistic that the Greek bonds will be restructured and the banks that hold them will be recapitalized,” Kresic says. “The question is whether the financial system will be kept together. The cost of reverting to national currencies would be far greater than the cost of bailing out Greece. A rational person will not want to go down that road. I am hopeful that cooler heads will prevail. A year from now, the problems will be behind us.”
The problem of bank insolvency is being dealt with via the European Financial Stability Facility, which is providing more than 440 billion euros in credit lines. Meanwhile, the European Central Bank has acted to boost bond prices. On Oct. 6, the ECB announced a program to buy 40 billion euros worth of covered bonds — bonds that have specific assets designated as collateral — and says that it will provide banks with unlimited draws on ECB cash until January 2013. This means that even if banks are insolvent, they will not be illiquid.
“What the market shows is that investors are trading for the worst and hoping for a better outcome,” says Edward Jong, vice president, fixed-income, at TriDelta Financial Partners Inc. in Toronto. “We don’t see a Lehman Brothers [type of] debacle of the kind that happened in 2008. The sovereign issuers that are in trouble will be bailed out to preserve the European Union.”
In spite of the obvious opportunity to buy into sovereign junk, some advisors are encouraging clients to stay on the sidelines. “Greece may be a sacrificial lamb,” says Marc Stern, vice president and head of discretionary wealth management with Industrial Alliance Securities Inc. in Montreal. “Until the potential damage can be measured, I am staying on the sidelines and not going into European bonds.”
As for Greece, defaults are nothing new. The country has been in default on its sovereign bonds for about the half the years since its independence in 1829. Based on history, and on Greece’s national accounts, no one can say that the problem was not foreseen. IE