"Haircut" risk repricing euro debt

By Natsuko Waki

LONDON (BestGrowthStock) – Investors may be forced into a bigger re-appraisal of risks attached to holding euro zone government bonds, a process which could weigh on a wider group of risky assets as the year draws to a close.

Uncertainty over a new euro zone crisis mechanism and whether newly issued bonds would include a clause that could force creditors to take losses is fanning fresh risk aversion.

The euro hit a fresh two-month low against the dollar while the cost of insuring debt against a default by peripheral euro zone countries and banks rose. World stocks are down about two percent in the past week.

A key European barometer of investor anxiety, VDAX-NEW volatility index, leapt 15 percent at one point on Friday to a seven-week high.

An Irish Times report that the International Monetary Fund and the European Union are examining how senior bondholders could be compelled to pay some of the costs of rescuing Ireland’s banks also put focus on private sector burden sharing.

“If you change the basis on which you issue debt, there will be an impact on debt. It is a signal that the private sector needs to price risk appropriately,” said Philip Poole, head of macro and investment strategy at HSBC Global Asset Management.

“There was a perception that the euro zone umbrella protected creditors. There was mispricing of (peripheral) debt relative to Bund. And the mispricing led to more fiscal deficit which led to more problems.”

Practically, Germany wants private investors to face “haircuts” or other debt payment restructure measures. In order to include them, newly issued euro zone bonds would include collective action clauses (CACs).

The CACs would allow for a country to restructure its debt repayments should it be unable to meet them, either by extending the maturity of bonds, by reducing interest payments or by a so-called “haircut” — or writedown.

“This proposal, if implemented, could have a potentially negative impact on financial markets… As CACs would only be applied to new debt, it would essentially split the bond market into two and thus reduce liquidity,” Barclays Capital said in a note to clients.

“It could also make it more difficult for sovereigns such as Ireland, Portugal, Spain and Greece to issue new debt.”

According to JP Morgan, European bond managers increased their underweights in peripheral bonds over the past two weeks close to levels seen in June.

For some bondholders of Irish banks the restructuring process has already begun.

Last Monday, a group of creditors holding subordinated debt of nationalized lender Anglo Irish Bank agreed to take an 80 percent writedown on the value of their holdings.

In one possible scheme, bank debt would be converted into equity shares. In the second, investors would be given the choice of injecting fresh capital into the banks or face a cut in their investment.


The other risk for investors is a hawkish stance from some European Central Bank policymakers.

The ECB, increasingly impatient with banks reliant on its crisis loans, will say next Thursday how much of its support — mostly ultra-easy loans for banks — will remain in place beyond mid-January.

A few ECB policymakers are also due to speak in the coming week.

Analysts expect the ECB will limit its three-month lending but doubts have crept in given Ireland debt concerns and contagion fears.

BNP Paribas believes normalization of repo operations is unlikely to be enough and soon German officials will push for interest rate hikes.

Based on the Taylor rule on monetary policy, the bank calculates that Ireland’s boom was fueled by interest rates 500 basis points below the level most suitable for the country.

The bust is being intensified by rates 1,100 bps above the level that is now consistent with the Taylor rule. For Germany, the economy is in the boom phase of the cycle and credit conditions are improving yet real rates are negative, it says.

“If some view the ECB’s current stance as astonishing, they are likely to fall over when some on the ECB start pushing for higher rates next year, which they will long before the Fed even dreams of that,” the bank said in a note to clients.

“We expect to see German officials pushing for a rate hike next year. It is not our forecast that the ECB will deliver, but it is a clear risk. That cannot be good news for the peripheral economies of the eurozone.”

The ECB’s in-house economists will also publish a new set of growth and inflation forecasts in the coming week.

(Editing by Toby Chopra)

"Haircut" risk repricing euro debt