Bond alchemy

The news that Portugal has asked for funding from the European Commission has raised the possibility that the 3 little periphery markets (the 3 little PIGs: Portugal, Ireland and Greece) could be funded using the existing structures and that the larger periphery markets (Spain and Italy) may be able to survive on their own. This incorporates the assumption that the property market problems in Spain are manageable and that the 3 little PIGs can achieve wage deflation and positive economic growth. However, we continue to believe that a restructuring of some peripheral debt is inevitable and, as yet, we do not have sufficient transparency regarding Spain to reach a conclusion. As a result, we will continue to avoid the 3 little PIGs and Spain, but will hold positions in Italian bonds.

The "bond alchemists" will work their magic to achieve lower borrowing costs and longer repayment schedules for the issuing countries. To do this, they must ensure three conditions: first, that the banks which hold the periphery bonds in the 'hold to maturity' part of their books do not suffer a significant loss; secondly, that the issuing countries can return to the markets; and finally, that investors will be confident that these countries will not default. Lower borrowing costs and longer maturities will provide these countries with the time they need turn to their deficits around and put their debts on a sustainable path. The fact that the debt of Portugal, Ireland and Greece will be held increasingly by the authorities (European Central Bank) and European banks will make this alchemy easier.

This form of "bond alchemy" was performed during the 1980s, when Latin American debt was re-packaged and resold via the "Brady Bond" plan. Something similar needs to be considered for the 3 little PIGs. The exact mechanism is not yet visible, and unlike the Brady plan, the authorities do not have 7 years to pull it together. Existing funding for Portugal, Ireland and Greece will start to run out next year, and the new mechanism, the ESM (European Stability Mechanism), will activate in 2013. A credible projection of better deficit management needs to be in place before investors are bound by the new 'bail-in' clauses connected to the ESM. Some examples of bond alchemy from the Brady Bond era included credible offerings such as PAR bonds, which were swapped for existing loans at face value (so banks didn't need to take a loss), but had below-market coupons and longer maturities, and DISCOUNT notes, which had current market coupons but were issued at a discount to par, creating a market for countries with default risk. Brady Bonds also, however, incorporated a handful of mysterious, complex and, thankfully, transient creations, such as 'front loaded interest reduction bonds' (FLIRBs), and 'past due interest bonds' (PDIs), which were of both limited use and value to investors. The "somethings" created by bond alchemy have therefore apparently involved a sprinkling of experimentation, much in the style of bygone sorcerers.

Unlike some other bond commentators, we are not convinced that the conclusion of QE2 will be an instant negative event for the US Treasury market. Much will depend on the underlying strength of the economy. It is true to say that some of the recent recovery in economic growth can be traced to official stimulus, either fiscal or monetary, but not all. Will the removal of one element of monetary stimulus, QE2, as well as some fiscal stimulus, produce a sufficient slowdown to prompt fears of a "double-dip", and give the bond market a reason to rally?

It is possible that the underlying economy may have moved to a more sustainable path, and does not need as much life support. We uphold the view that US Treasury yields should continue to rise in line with the stronger economy, but the upside limit on yields is not as high as some suggest. The other concern over which investors may pontificate is the credit quality of the US government itself (particularly in light of the S&P downgrade of its US rating outlook). The US is the only major country whose budget deficit is expected to continue to grow this year, and as yet no plan to turn it around has been announced. Forthcoming debt ceiling limits have focussed attention on this issue, and both sides of the political divide are putting forward their ideas as to how to address the situation. As in the past when such issues have been debated, these divisions appear to be primarily ideological, and therefore it is difficult to see how a compromise will be reached, although one will eventually materialise. The threat of default as the debt ceiling (US$ 14,294,000,000,000) is reached should ignite urgency to reach a compromise, but, in the meantime, anxiety over the credit risk of the US will rise.

So, the end of QE2 is not the only concern for US Treasury investors, but the fragility of the US economic recovery suggests US interest rates will not rise in the near-term. Holding US dollar denominated bonds issued by other countries (with better credit stories) therefore appears an attractive strategy to optimise returns, while we wait for the alchemic clouds to clear from global bond markets.