Pricing the EU WI bonds

Bruce Krasting's picture

It appears we are getting a Monoline to solve the problems in the EU. For the life of me I can’t figure how this will work, but we are about to find out. There are no details on this as yet, just planted rumors.

The talk is that EU sovereign debt to be issued in the future would have the benefit of an insurance guaranty that covers the first 20% in the event of default. This guaranty would be backstopped by the EFSF.

The thinking is that a new bonds issued by Spain, Portugal, Ireland, Italy (and presumably Belgium but not Greece) with the guaranty would be widely perceived as a money good investment. As a result, huge amounts of capital could be raised in the global bond markets under very attractive terms (total = Euro 2+ trillion). Funding costs for the PIIBS would plummet as a result. With the debt market stabilized, economic prosperity would soon follow. I say "rubbish".

The enhanced bonds would be “Story” bonds. In my experience story bonds have a very limited investor interest. I have no doubt that ten of billions of these bonds could be sold, but Trillions?

The USA Treasury market is the most liquid in the world. The total public float (excludes Fed and Intergovernmental) is about 9 trillion. The proposal is that an amount equal to 1/3 of the US public float of new EU enhanced bonds are issued in just a few years. IMHO that will never happen.

The global bond markets will have to figure out how to price this new debt. I’ve been pondering this for days. I can’t come up with a pricing structure that works.

Consider a newly issued ten-year Italian sovereign bond that has a 20% first loss guaranty by the EFSF. Assume that the German ten-year was 2% and Italian at 5% (about where we are today). You tell me, how is that new bond going to trade based on this?

This is not equivalent to 20% German risk and 80% Italian. That would be far too easy. But if the market were to trade it as an 80/20 it would imply that the new Italian Enhanced Bond (“IEB”) would yield about 4.4%. This would mean that the IEB/German spread would be 240bp while older Italian debt had a spread of 300bp. If that were the result, it would be a disaster.

While 60bp is a big deal, it would do nothing to stabilize Italy’s long-term debt cost. For a new program to work, it would have to drive the IIB/German spread to 100bp.

In order to evaluate the 80% Italian risk and price it properly one must first make an assumption as to the probability of an Italian default over the next ten years. One must also make some assumptions regarding what losses might be incurred should there be a default.

Folks, those are very complex questions to answer. I’ll give it a shot.

Probability of Italian default over ten years = 20%


Probability for loss > 20% in the event of default =100%.

While I think that Italian default risk is relatively low, I believe that should it happen, the net haircut would be substantially above the 20% first loss protection. A country like Italy would not go through the pain of a default to achieve a 19% debt reduction. If push comes to shove and Italy decides it is best to default, the haircut would be in the 50% range (a la Greece).

Any investor who looks at the new bonds and concludes that they’re money good is just nuts. That will not happen.

My conclusion is that the new enhanced debt has to trade cheap. There is a massive amount of this story paper coming our way. That mountain of supply has to mean the bonds have to have a high yield. If one wanted a litmus test for this I would ask the Swiss National Bank. They have E200b in reserves. I bet they would not put a dime into these new securities. Neither would Singapore, Venezuela, Kuwait, Hong Kong or Saudi Arabia.

It’s quite possible that the new paper does very little for Italy. If that were the result for Italy (a relatively strong borrower) it would be the kiss of death for the weaker ones like Spain and Ireland.

What I find fascinating about this is that the deep thinkers in the EU are relying on the global bond market to price the new securities in a way that would produce the desired results. The deciders are going to trust Goldie, Citi and good old JP to price this swill on the rich side? Not a chance in the world.

After four agonizing years the inescapable conclusion is that complex derivative securities were at the heart of our problem (they hide risk). The response by the EU is to give us the largest derivative transaction that has ever been created. Talk about a sign of weakness.

The most amazing thing is that the global markets are lapping this up. Any confirmation (the silly Guardian story) that the Mega Monoline is in our future is a cause for celebration.

Wait and see how these new bonds trade. I think they will trade on the cheap. If I’m right, then you can kiss off the possibility of an EU soft landing.

If the markets give the new bonds a thumbs down it will be the final act in the story. There’s an "event risk” to look forward to.

Note: The only way the new enhanced bonds can trade rich is if the ECB stands ready to buy them such that the spreads are very narrow to German paper. I see a very small chance that this would happen. But if they did step up, the markets would see through the charade in a NY minute. The lights would start to go out shortly after they started buying.