European countries are awash in debt that investors fear cannot be repaid. From Greece, which was the first to plead for help, to Ireland, now floundering under its toxic bank debt, to Spain and Portugal, which will be the next to go cap in hand to the International Monetary Fund and the European Union, the European bond markets are being sliced into the “haves” and the “broke.”

The major concern for investors is that EU member state bonds were given a welcome they did not deserve. That’s because the Basel II accords allowed any EU member state’s banks to hold the bonds of any other member state and to treat them as sovereign equals. So, iffy Irish sovereign bonds are held in German banks’ accounts at acquisition cost rather than at market value. So, if there is a default, those banks would have to take huge writedowns — the difference between artificial book value and true market value.

Cognizant of that, banks and institutions are selling off their Irish bonds, driving yields on 10-year Irish sovereigns to 8.5%. (By comparison, Government of Canada 10-year bonds yielded 3.14% as of Dec. 31, 2010.)

The origins of the disaster in Ireland echo those of the meltdown in the U.S. in 2008. Home prices in Ireland had quadrupled in the 10 years leading up to 2006. During that time, construction spending increased to 21% of Ireland’s gross domestic product from 11%. Then, the bubble burst. Banks found themselves with foreclosed houses they could not sell.

VACANT HOUSES

A quarter of the houses in Ireland are now vacant, mostly in the tracts of new houses financed by banks that believed their own blarney about being a Celtic tiger. Ireland’s government then saved the banks about to be toppled by soured loans to builders, transferring the banks’ debt to the nation.

In response, Moody’s Investors Service Inc. downgraded Ireland’s sovereign debt to a Baa1 rating from A1 on Dec. 17, 2010. The new ratings are just three pegs above junk. And Moody’s has warned that more downgrades will come if Ireland’s government cannot stabilize its growing debt.

On the corporate side, Irish bank debt has become toxic, with major lenders making king-sized provisions for losses. Lloyd’s Banking Group PLC has reported it will have to set aside £3 billion ($4.7 billion) more than previously anticipated for defaults by property developers. Already, £2.7 billion in Irish loans had become non-performing in the six months ended Dec. 17, 2010.

As a result, Lloyd’s has announced that it will suffer a drop in earnings because of the writedowns. Ironically, Lloyd’s itself is 41%-owned by Britain’s government as a result of an earlier bailout.@page_break@Many bond investors are staying on the sidelines during this crisis. The reason? It’s unfamiliar territory. Says Barry Allan, president of Toronto-based high-yield bond fund management firm Marret Asset Management Inc. : “We don’t invest in what we don’t understand.”

And more trouble lies ahead. Moody’s has warned that it may downgrade Portugal’s government bonds because of concerns about that country’s ability to continue to fund its debt. In a statement issued on Dec. 21, 2010, Moody’s said it would put Portugal’s A1 long-term government bond ratings “under review for a possible downgrade” within the next three months.

Spain is next — and the markets are ahead of the bond raters.

DEFAULTS A POSSIBILITY

On Dec. 21, 2010, Spain sold 3.9 billion euros ($5.1 billion) worth of three- and six-month treasury bills. The yield on the 90-day bills was 1.8%, up from 1.7% in the previous auction, which was held on Nov. 23, 2010. The yield on the six-month paper was 2.6%, up from 2.11% on Nov. 23. In the spring, both Spain and Italy have to refinance 400 billion euros worth of maturing bonds. Chances are that each country will spread the debt out along its yield curve, jacking up rates all the way.

Default by a major debtor is no longer out of the question — nor is dumping the euro. If a nation were to abandon the euro and shift back to its former currency — Ireland reintroduces the punt, perhaps — then banks would revert to paying bondholders in the “new” currency. So, a bank in France that’s still on the euro would see its Ireland bonds written down. On the flip side, it could then repay its depositors in Ireland in devalued punts at its branches.

The euro has taken a hit from investors worried about the value of their assets. On June 7, 2010, the euro hit a low of US$1.19, but has since recovered to about US$1.31. That’s still below its historical high of US$1.60, which it reached on July 31, 2008, as the U.S.-made global financial crisis began to unravel.

For bond investors, the debt crisis is not likely to be resolved by an exit from the euro. “It would be messy and difficult to do,” says Camilla Sutton, currency strategist with Scotia Capital Inc. in Toronto.

Those who believe that the European Central Bank and Germany will act to support the euro can buy troubled bonds and potentially reap a handsome return over German bunds. The cautious will wait on the sidelines.

Ruminates Richard Gluck, principal in charge of global bonds with Trilogy Advisors LLC in New York: “It’s not over yet.”

In fact, that is the bottom line about this crisis, which shows no sign of ending. IE