An SPV to save the eurozone...?
Global bonds and currencies
Newton Fixed Income
June 2010
Paul Brain
No. 303
The European Financial Stability Facility (EFSF), a special purpose vehicle (SPV), was established on 7 June and will issue bonds to fund eurozone countries if they struggle to obtain financing from the markets. Each individual bond issued by the EFSF will be backed by eurozone member guarantees (excluding Greece) that cover 120% of the issued bond's notional value. An additional cash buffer will be raised to cover defaults. When a country requests aid, it will be eliminated from the guarantee pool for future debt issues for as long as it requires funding.
As part of the European package announced in early May, an SPV has been created to provide support for those eurozone countries that require it. In our recent global bonds and currencies articles we have suggested that we are coming to the end of the worries about the eurozone, and that the inclusion of the European Central Bank (ECB) in the latest rescue measures will provide a 'buyer of last resort' in European bond markets. However, there is bound to be some short-term volatility until the ECB's full intentions are known and understood, especially as we approach the next refunding hurdle (Spain's requirement to raise €16bn in July). If the ECB will step in only when all else fails, yields will rise ahead of the refunding. What is needed is another structure that could give the market some confidence.
The EFSF could be that structure, by providing support for eurozone countries that need to finance their short-term borrowing but are unable to do so without paying too high a rate of interest.
The fiscal austerity path that the European economies have begun to tread will be very challenging without the support of low interest rates, hence the requirement to lower the financing cost of peripheral European debt. In the meantime, the European banking sector continues to shrink into its shell as it tries to rebuild shaking balance sheets and work through disastrous credit investments. This will take time, and the last event needed in the interim is a fall in prices of 'safe' government assets, which would undermine balance sheets further; the suspicion that German Landesbanks are heavily exposed to peripheral European debt is keeping bond investors up at night. It is ironic that the perceived solution to these challenges is to set up an SPV, 'over-collateralise' it (provide excessive guarantees in relation to it) and give it a credit-enhanced 'AAA' rating. Was it not these sorts of instruments that got us into the credit crisis mess in the first place?
If one of the near-term difficulties for the European periphery is the short-dated nature of its debt, the existence of an SPV that could provide cheap funding and perhaps extend troubled countries' debt maturity must be seen as good news. The problem is that, as soon as countries go to the EFSF for support, they are kicked out of it, which increases the burden on the countries that are left in it. As there are few 'AAA' countries in the EFSF at its inception, preservation of the facility's 'AAA' rating may prove difficult.
Spain's share of the original €440bn facility is 12.2% (€53.9bn) and Portugal's is 2.6% (€11.4bn). Portugal could use the facility without upsetting the structure, but Spain's use of it would be more problematic.
If Spain and Portugal were not acting as guarantors, in the event that they required assistance, one could argue that it would be easier to achieve a 'AAA' rating for the EFSF (since these two countries' ratings are AA+ and A+ respectively).
So, initially, as the weaker countries request aid and the EFSF comes to the rescue, the system should work. However, if a larger guarantor (such as Spain, Portugal or Italy, which accounts for 18.4%, or €81.1bn, of the facility's original size) were to require assistance, the burden on the remaining guarantors would likely become too great, thereby threatening that country's credit rating and endangering the whole 'house of cards'. The best solution seems to be keeping the EFSF in the background, and never finding recourse to use it. It is to be hoped that only the smaller nations would need to tap the funds.
Meanwhile, the money available to the real economy remains painfully scarce, and relief from low interest rates is essential. Rapid fiscal contraction, as stipulated by the 'core' members of the eurozone, runs the risks of a 'double-dip' recession scenario in Europe and of undermining the euro. The single currency is the safety valve which will ultimately allow fiscal restructuring to play out.
A difficult summer lies ahead for the eurozone, and the ECB is likely to have to be involved as the buyer of last resort in the region's government bond markets. Once this summer's hurdle is overcome, the markets will have less issuance to worry about, and the publication of better budget deficit numbers should make current events seem like a bad dream.
Conclusion
We favour maintaining investments in US Treasuries and in core European (German, Netherlands, and Finland) government issuers, supported by the beliefs that cash rates will stay low and that inflation will not be a significant problem in Europe. Opportunities to invest in the periphery of the eurozone should present themselves during the summer.
All data is sourced from Bloomberg unless otherwise stated.
This is a financial promotion and is not intended as investment advice. The opinions expressed in this article are those of Newton Investment Management Limited. Past performance is not a guide to future performance. The value of investments, and income from them, is not guaranteed and can fall as well as rise due to stock market and currency movements. When you sell your investment, you may get back less than you originally invested. The opinions expressed in this article are those of Newton Investment Management and should not be construed as investment advice. Yields are not necessarily a reliable indicator of future or actual performance of securities.
Issued by Newton Investment Management Limited, The Bank of New York Mellon Centre, 160 Queen Victoria Street, London EC4V 4LA. Registered in England No 1371973. Newton Investment Management Limited is authorised and regulated by the Financial Services Authority.
