No treats on offer

Austria is taking a firm stance on bad debts left by the bad bank from the Alpine region of Carinthia, leaving the appealing sovereign in a strong position.

The Austrian state has given its postal workers bags of treats to protect them from aggressive dogs. It is not extending such largesse to the Alpine region of Carinthia, which is teetering on the brink of bankruptcy after the Austrian central government refused to vouch for debts left by Heta, the bad bank formed from the assets of failed lender Hypo Alpe Adria.

On March 1, the Austrian Financial Market Authority imposed a 15-month debt moratorium on all bond payments by Heta after the Austrian finance minister, Joerg Schelling, said that the government would not step in to plug a €7.6bn capital shortfall.

The picture is complicated further by the fact that Heta’s €10.2bn of bonds are notionally guaranteed by the Austrian province of Carinthia, and that has sparked legal action.

“These guarantees are equivalent to nearly five times Carinthia’s 2014 operating revenue and so have clear implications for its solvency,” said Julien Eberhardt, deputy fund manager and senior credit analyst at Invesco Perpetual.

Opening salvo

On May 5, Commerzbank became the first investor to file a lawsuit after Heta had failed to make a bond payment due to the German lender. It was the opening salvo in what is likely to be a messy fight as Austria becomes the first case to be handled under new EU-wide bail-in laws that were brought in under the Bank Recovery and Resolution Directive aimed at protecting taxpayers in the event of bank failures.

Hypo has already cost taxpayers €5.5bn after being nationalised during the 2008 financial crisis, but under new rules bond investors could face haircuts of up to 50%.

“Austria is the test case,” said Nicholas Spiro of Spiro Sovereign Strategy, “and from the Austrian government’s stance, it’s abundantly clear that the ground rules have changed from bail-out to bail-in.”

While Cyprus was the first example of where a bail-in was used, and it was deployed in Portugal with Banco Espirito Santo last year with barely a ripple on the sovereign, this is more contentious because in the case of Austria, the sovereign is rock-solid and so could ride to Heta’s rescue.

Creditors could argue that its refusal to pump more money into Heta could lead to financial contagion. Commerzbank has taken a €200m provision against its €400m Heta bonds.

The Hypo bonds were underwritten in the boom years before the Lehman crisis by Austria’s populist leader Joerg Haider, then governor of Carinthia. Current governor Peter Kaiser said Carinthia would go bankrupt by June without renewed access to borrowing via the federal treasury,

The FMA imposed the moratorium only a month after Fitch cut its rating on Austria by one notch to AA+ from AAA, warning that the country’s debt dynamics had “deteriorated significantly”.

Fitch said the debt ratio was likely to hit a record 89% of GDP during 2015, and that the bank bailouts had cost 11% of GDP.

Spikes and stalls

The International Monetary Fund has also weighed in, saying that its banking sector is vulnerable to writedowns and non-performing loans as reform has stalled and the Swiss franc spiked.

“Austria’s banks have massive exposure to Central and Eastern Europe. There has been some irresponsible lending – and this is not just confined to Heta,” said Spiro.

While the fallout from the Heta spat is still far from clear at this stage, there is not yet any sign of it contaminating a sovereign that is seen as a clean and popular credit.

“Austria has been an incredibly popular sovereign investment among investors, who like the fact it offers spread over Germany but remains a high-quality credit,” said Lee Cumbes, head of SSAR origination for EMEA at Barclays.

Shortly after the moratorium was imposed, it tapped the bond markets for five-year paper that printed with a negative yield for the first time as investors loaded up with sovereign paper ahead of the European Central Bank’s quantitative easing plan.

“Austria’s banks have massive exposure to Central and Eastern Europe. There has been some irresponsible lending – and this is not just confined to Heta”

The sovereign continues to trade close to Finland and the Netherlands, and it has remained solid throughout the ongoing rate volatility. That’s partly a function of quantitative easing, which is skewing yields across the eurozone, but also because of Austria’s relatively small size.

It issued around €28bn of debt in 2014, and is on track to issue up to €24bn in 2015.

Spirit of innovation

“If anything, investors want more Austrian bonds, but the market’s moderate size is really part of its attraction,” added Cumbes.

Being a small market has engendered a spirit of innovation – Austria was one of the first sovereigns to print a 50-year tenor bond issue and it pioneered the dual-tranche deal in syndicated form in order to spread issues across two different products and capture different pockets of demand.

It adopted this tactic in May 2014 when it printed a €6bn offering split between a 10-year fixed rate tranche and a six-year floater – its inaugural floating-rate note issue.

The deal was Austria’s biggest ever syndication and the floater attracted strong demand from central banks.

“Austria is very disciplined about pricing and has good grasp on fair value,” said an SSA banker.

Standard & Poor’s confirmed its AA+/A– rating on March 27, saying that it expected Austria would stabilise its debt burden “despite lower growth over the next two years”.

S&P added that Austria boasted the second-lowest unemployment rate in the European Union and the agency has backed the government to deliver on its debt consolidation plans.

Fitch says the implementation of BRRD will “limit Austria’s contingent liabilities from exposures to financial institutions going forward, although some legal and technical questions from the implementation of the law still exist”.

The ratings also reflect Austria’s high net general government debt, which S&P expects will “decline only slowly” from 2015, depending on the success of the work-outs of Heta.

While the spat with Heta will rumble on for the time being, the bail-in legislation is doing the job that it was intended for – decoupling the relationship between sovereign and bank sector. Sovereign investors are not yet het-up over Heta.