You saw Europe’s two-tiered rates market, and were chilled.
Now see Europe’s possible two-tiered bond market, and be confused.
Away from the sound and fury (signifying… nothing?) of Irish bailout talk, Nomura strategists Nick Firoozye, Guy Mandy and Sean Maloney have looked at one background cause of Europe’s renewed crisis: negotiations over setting up a future Sovereign Debt Restructuring Mechanism.
First, a quick recap.
The idea’s had a short, confusing existence so far. According to German proposals, the SDRM could be used for facilitating bondholder bail-ins on sovereign debt to burden-share in any future country bailouts. But only after mid-2013, on bonds issued after mid-2013.
European leaders at the G20 were very keen to remind markets of this point last week, after a very unfortunate spot of confusion led investors to ditch Greek, Irish, and Portuguese bonds on fears that the SDRM amounts to a green light for imminent restructuring.
Actually, a G20 statement said, Europe’s current bailout fund lasts until 2013 and doesn’t involve private involvement, while any future bail-in mechanism won’t affect debt outstanding before mid-2013.
Phew. Is that clear?
Well — maybe not really.
Nomura point out one very crucial ambiguity here (emphasis ours):
This statement gives us assurance that old (i.e., currently outstanding) bonds will not be expected to participate in any EFSF-style funding. While this seems to mean that old bonds will not participate in any future (post-EFSF) rescue, we do not find this completely credible.
This is because there’s a huge difference in the value of a debt-distressed sovereign of restructuring old bonds, versus new ones issued after 2013.
Here’s how Nomura explain it (emphasis ours):
The vast majority of euro-area bonds are issued under local law. This means that there are no collective action clauses in the bonds, largely because they can be amended with relative ease by acts of parliament. While this would have reputational repercussions for the sovereign, and for the EU as a whole, technically, new bonds would increase investor rights in spite of the explicit mention of participation.
Old bond CACs = easily amended, not to mention probably tied to specific bonds, we’d add. New bond CACs possibly introduced under the SDRM or similar facilities = enforced by an EU directive. Plus, as Nomura go on:
Moreover, with standard issuance profiles for all countries in the euro-area remaining unchanged, it is likely that a relatively small amount of new bonds will be outstanding. Their having to bear the brunt of any possible restructuring should make them trade at a significant premium discount to old bonds or make them not easily saleable.
So you can see why there’s a real chance of an old-new tiering in eurozone sovereign debt markets.
There’s not much of appeal in the alternative — chucking bonds old n’ new into the bail-in pile. Nomura note that this will likely overload yield curves with restructuring risk after the EFSF ends in 2013. Given that Greece’s bailout ends around the same time, its distorted current curve provides a taster of this dystopian future.
Nomura reckon it’s much better to target bonds based on whether they are actually unsustainable. However, we’d point out that this is itself massively difficult to assess. You’d possibly have to combine a sovereign’s weighted average maturity, their debt maturity profile, the size of their debt stock, not to mention the politics of fiscal reforms.
Phew again, basically. But still, perhaps the best solution all round as it’s, y’know, precisely how investors should assess bond risk in the first place.
But back to this old-new distinction. There’s a certain wry irony in Nomura focusing on which bonds are subject to collective action clauses, and in which forums these clauses are enforced.
CACs and SDRMs have clashed once before in a sovereign debt discussion, of course — during negotiations in the early 2000s on a SDRM overseen by the IMF, directed at sovereigns in frontier and emerging markets.
Talks failed in part because CACs were generally seen as easier to use than a central SDRM; they’re enough to allow majorities of bondholders to vote for restructuring. The bond-specificity of CACs also gave way to aggregate CACs over time, including in a particularly well-designed Uruguayan restructuring in 2003, which also involved hefty exchanges of new for old bonds.
Which, funnily enough, is much the future that Nomura are seeing. With a renovated SDRM concept likely to include aggregate CACs in their opinion, they also observe the following:
EU directive puts the possibility of unilateral amendment further out of reach and gives some credibility to bondholder rights, effectively enhancing new bonds relative to old (barring considerations of bailout packages). Moreover, with treaty change and EU directive as a means of imposing uniformity on the legal issuance platforms across the euro area, we think this may usher in a form of Eurobond, with legal uniformity but credit differences…
It may be feasible to incentivise exchanges of old bonds into new bonds. This could be done through a methods of incentives and disincentives: by enhancing the liquidity of new bonds and spelling out the legal advantages, while possibly delisting old bonds. But the sheer size of outstanding bond markets makes this far less straightforward.
But, given the relative ease of change to existing or old bonds, by EU directive again and act of parliament, old bonds may have legislative aggregative CACs imposed on them, effectively bringing them more or less in line with new bonds. While taking old documentation and adding CAC clauses may not remove all differences with any new bonds, this would probably keep the euro-area bond markets from trading with two completely different tiers.
The question beyond even old and new bonds, of course, is whether ‘legal uniformity and credit differences’ are enough to keep this currency union going in the long term.
Related links:
Why Ireland fears a bailout – Marginal Revolution
The distorted European bailout – FT Alphaville
The ‘pre-emptive’ Greek default - FT Alphaville