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Thursday, 24 April 2014

Spain with ESM first-loss guarantee is a sound idea

IFR Editor-at-large Keith Mullin

IFR Editor-at-large Keith Mullin

YOU MAY HAVE noticed that I’ve resisted writing too much about the eurozone saga for some time now. There’s been so much political front-running, saying and nay-saying, contradiction, obfuscation, fact and counter-fact that I confess to having suffered a serious bout of euro crisis fatigue. And the incredibly tedious will-he-won’t-he-ask-for-a-bailout that’s been a feature of the daily news flow around Mariano Rajoy has been doing my head in.

But talk that Spain is looking to tap the European Stability Mechanism’s ECCL+ to facilitate access to the capital markets in 2013; Portugal’s first foray into the public bond market since it was bailed out; plus Ireland’s improving public market access that has eroded its 2014 funding cliff have all offered some relief from the political ping-pong – and some optimism that we’re progressing through the drudgery.

WITH REGARD TO Spain, like everyone else I have no idea whether Rajoy’s reticence to seek a fully-blown bailout is down to his belief that Spain doesn’t need one; whether it’s a timing issue driven by internal politics; or whether he’s been instructed not to for the time being by Germany. But I must say I much prefer the idea of an Enhanced Conditions Credit Line with sovereign partial risk protection – aka “bailout lite” – to the notion of a full bailout with its attendant onerous conditionality.

The ECCL+ facility has been in the ESM toolkit since October 2011 and was created as one of the EU’s crisis-prevention measures. The embedded leverage factor in having the ESM provide credit protection to sovereign bond investors through a first-loss guarantee (in the form of a Partial Protection Certificate or PPC) of between 20% and 30% of primary bond issuance is a lot more efficient than having the rescue apparatus invest directly in new issues.

And it’s cheaper: the estimated cost to the ESM of ensuring Spain maintains access to private capital through 2013 using this route is about €50bn – around one-third of the annual cost of a full bailout. The facility has a maximum tenor of one year, renewable twice for six months. In practical terms, the sovereign bond and the PPC are delivered as a package but the two can be detached and traded separately. The all-in cost to Spain will be the bond coupon plus a commitment fee payable to the ESM plus any and all costs related to protection payments. It’s likely to offer some decent savings vis-à-vis naked sovereign bonds.

The ECCL+ doesn’t come with full conditionality but the Spanish government will be placed under “enhanced surveillance” and have to take corrective measures. I think the market would take to credit-enhanced Spanish sovereign bonds, not least because as hybrid securities they would pay a decent spread over EFSF/ESM bonds for risk that is likely to be seen as containable since the Spanish banks have already been given their own rescue facility.

MEANWHILE, PORTUGAL RETURNED earlier than planned to the voluntary public capital markets with a €3.757bn exchange of 5.45% OTs due September 2013 for an equal amount of 3.35% of OTs due October 2015. That chunky 2013 redemption had been causing some consternation as it won’t be covered by EU bailout funds, but the debt swap chopped the outstanding amount by over 39% to €5.8bn and was another step in Portugal’s own redemption in the eyes of international investors.

This is all cause for good cheer and demonstrates how far they’ve come

The country is by no means out of the woods on its economic rehabilitation programme but it’s making progress. For sure, that progress isn’t coming without severe hardship – the tax rises unveiled by Finance Minister Vitor Gaspar on October 3 will pile yet more pain on the country’s embattled citizens – but regaining market access is essential if Portugal is to move beyond its bailout towards a phase of growth.

The government is due to implement a financial transactions tax to boost revenues in the short term but details are still being finalised and weren’t included in the latest fiscal package. It’ll probably be in the region of 25bp.

Portugal has €93.6bn of bonds (OTs) outstanding through 13 lines of stock going out as far as 2037 but its redemption profile is relatively smooth: 2014 to 2016 are challenging (€15.8bn, €13.0bn and €9.7bn respectively) but after that they’re a more manageable €7.2bn average for each remaining outstanding issue.

Portugal’s return to the markets had come in the wake of Ireland’s: in August, Dublin sold a little over €1bn in five lines of new amortising bonds due 2027 to 2047 at an average yield of 5.91%. Like Portugal, Ireland had a worrisome debt redemption looming in January 2014, but the combination of bond switches and outright sales this year has cut the original amount to be repaid by 80% from €11.9bn to just under €2.4bn.

Ten-year Portuguese government bonds are trading at a yield of 8.67%, having tightened by almost 1,000bp since they spiked in February, offering phenomenal returns for those holding paper. In fact, Portuguese sovereign debt is the best performing asset around on a total return basis, followed by second-placed Ireland.

This is all cause for good cheer and demonstrates how far they’ve come. But it’s all relative. The only thing that’s going to make all the sacrifices that have been made to get this far worthwhile is an aggressive EU growth-oriented agenda.

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