Last week, looking at Third Point's best performing positions we noticed something odd: a big win in Portuguese sovereign bonds in the month of April. We further suggested: "We suspect the plan went something like this: Loeb had one of his hedge-fund-huddles; the cartel all bought into Portuguese bonds (or more likely the basis trade - lower risk, higher leverage if a 'guaranteed winner'); bonds soared and the basis was crushed; now that same cartel - facing pressure on its AAPL position (noted as one of Loeb's largest positions at the end of April) - has to liquidate (reduce leverage thanks to AAPL's collateral-value dropping) and is forced to unwind the Portuguese positions. A quick glance at the chart below tells the story of a Portuguese bond market very much in a world of its own relative to the rest of Europe this last month - and perhaps now we know who was pulling those strings?" Since the end of April, both AAPL and Portuguese bonds have tumbled, and Portugal CDS is +45 bps today alone, proving that circumstantially we have been quite correct. Today, we have the full Long Portugal thesis as explained by Loeb (it was a simple Portuguese bond long, which explains the odd rip-fest seen in the cash product in April). There is nothing too surprising in the thesis, with the pros and cons of the trade neatly laid out, however the core premise is that the Troika will simply not allow Portugal to fail, and that downside on the bonds is limited... A thesis we have heard repeatedly before, most recently last week by Greylock and various other hedge funds, which said a long-Greek bond was the "trade of the year", and a "no brainer." Sure, that works, until it doesn't: such as after this past weekend, in which Greece left the world stunned with the aftermath of what happens when the people's voice is for once heard over that of the kleptocrats, and the entire house of cards is poised to collapse.
End result for Greylock: the trade of the year is down 20% in one day. In other words: lots and lots of fancy talk to merely explain yet another episode of knife catching. Which sadly, is how we would classify Loeb's trade as well... And he knows it. Which is why the long Portugal thesis is now most likely dead and buried as the Third Point hotel has come and gone, selling its holdings to other, far more hapless gamblers.
From Third Point:
Credit: Long Portuguese Sovereign Bonds
We initiated a long position in Portuguese sovereign bonds during the First Quarter. While we have studied Portugal since last year, it was not until the country’s February downgrade to junk by all three rating agencies that we found a truly asymmetric investment opportunity. Many investors liquidated their holdings after the downgrade, causing bonds to decline from the high 50s to the low 40s. Following the playbook that has generated numerous successful investments for Third Point we provided liquidity to sellers when others would not. There were few natural buyers as “real money” was ratings? constrained and most distressed investors shied away from an opportunity not analyzable via traditional corporate balance sheet and earnings metrics.
As investors know, our framework flourishes in situations characterized by extreme market uncertainty and compressed time frames, and we initiated our position confident that the odds were solidly in our favor. The timing of our catalyst is often the one piece we cannot predict with any certainty, and in this case, the bonds experienced a sharp rebound very quickly. Our credit analyst met in Lisbon with government and IMF officials immediately following the downgrade, rigorously reviewed the country’s quarterly IMF reports, spoke with current and former ECB officials, and analyzed Portugal’s historic fiscal and economic position. Despite the recovery off the lows subsequent to our purchases, we believe Portuguese debt remains a very attractive investment opportunity and continue to own the position in meaningful size.
Portugal’s 5?year CDS currently prices in a 65% probability of default and assumes a recovery of ~33%, roughly equivalent to Greek levels. Both the probability of default and recovery appear mispriced to us and marginal improvements in either should yield substantial upside. Under the current IMF/EU program, Portugal must re?enter public markets with a ~€10B bond issue in September 2013. Given IMF budgeting guidelines however, the Troika must assess that possibility by September 2012, a full year in advance. As this deadline approaches the IMF/EU will begin analyzing the merits of extending more funding to Portugal. Markets fear an extension denial will leave Portugal twisting in the wind. We believe this probability is materially overstated and the most likely outcome involves Portugal being funded by official channels until it can tap bond markets.
First, neither Portugal nor the Troika has an incentive to force a restructuring. Creating Spanish and Italian contagion risk from a Portuguese PSI would represent a massive “unforced error” by the Troika. Portugal's ~€185B debt stock is incredibly small compared to either Italy’s (~€2,000B) or Spain’s (~€850B), and funding requirements for a one to three year extension would likely not exceed ~€40B compared to a potential ESM size greater than €500B and new IMF resources of $400B. From Portugal’s perspective, the Official Sector’s large and growing debt ownership (~60% by year end 2013) severely blunts a restructuring’s effectiveness without their participation. Attempting to force a PSI could severely damage the economies of Portugal’s main trading partners (exports represent ~35% of GDP) and potentially offset the benefits of marginal deleveraging.
Second, Portugal is not Greece and is actually more akin to Italy and Spain. The Greeks distinguished themselves from other PIIG nations both fundamentally and politically. Greece remains hopelessly over?levered even post?PSI and has continued, in our opinion, to act in bad faith. Portugal’s debt profile is more consistent with Italy’s than Greece’s, its banks are substantially healthier than Spain’s, and its government has enacted more aggressive labor reforms and is more stable than regimes in both countries. Bond vigilantes did not immediately jump from Greece to Italy or Spain, but with banks’ LTRO buying power close to fully expended, officials know creating avoidable contagion risk would be highly irresponsible.
Finally, if given the opportunity to right its own ship, Portugal could validate the efficacy and necessity of reforms being demanded of Spain and Italy and represent a political homerun for the ethos of austerity being championed by Northern Europe and the ECB. Portugal’s debt to GDP is forecast to peak lower than Italy’s current levels, its budget deficits are already materially lower than its neighbors (and even the US or Japan), and its economy is showing encouraging signs of market reforms through a rapidly improving current account deficit and expanding export growth for the last 18 months. The Portuguese economy’s structural issues will require many years to correct, and it likely lacks key building blocks to ever exhibit above average growth trends. However, Portugal only needs a 1.5% GDP growth trend to achieve IMF?defined debt sustainability. Given their starting point and the presence of small green shoots, Portugal is not a lost cause but rather an incredible opportunity for IMF, EU, ECB and German validation. Furthermore, international investment has already returned to Portugal. Chinese power companies won two Portuguese privatization auctions featuring numerous international bidders and Banco Espirito Santo even increased its mid?April equity raise due to investor demand. If economically rational international corporations and equity investors are willing to bet on Portugal, why wouldn’t the Troika?
We view a one to three year program extension during Q3 2012 as the most likely outcome. In that scenario our holdings would likely receive interest for at least 18 months before a potential restructuring if Portugal ultimately faltered. Most of our holdings carry coupons of nearly 5%, which will reduce our cost basis and limit downside from current market prices in the mid?50s. The Troika’s awareness of the inverse relationship between recoveries and contagion risk supports our belief that any restructuring would include recoveries at a premium to Greece or even premiums to market prices. We view a realistic worst case outcome (other than a full Eurozone implosion which would likely trigger our tail hedges) to have downside of ~15% to 20%. In a positive outcome, however, it is possible that an extension and continued reform result in Portugal being viewed similarly to Ireland, whose debt carries yields of 6.5% or less as compared with similarly dated Portuguese bonds yielding 13% to 15%. If over the next year Portugal’s spreads compress to within 100 basis points wide of Irish yields, total returns on most of our holdings would exceed 55%, and if spreads come completely in line with Ireland those returns would reach 65%. We believe our holdings carry ~3:1 upside to downside probability and better than 50/50 odds of a positive outcome.
Of course, Portugal’s debt carries a myriad of risks and has extreme volatility. The largest and most commonly cited risk is subordination to the Official Sector in a restructuring, a dynamic that only gets worse the longer Portugal stays in an IMF/EU program. Third Point estimates by year end 2013 Official Sector holdings will represent nearly 60% of total Portuguese debt outstanding. Most investors are automatically assuming high levels of Official Sector holdings equate to lower private investor recoveries. We believe, however, these holdings ultimately provide a massive disincentive to a restructuring and would possibly force Official Sector participation in order to achieve any meaningful debt relief. Official Sector participation would significantly reduce contagion risk in Italy and Spain given large and possibly expanding ECB holdings of their debt and would likely enable recoveries higher than current market prices.
Ultimately, whether Portugal’s reforms can reengineer its economy to necessary growth levels is difficult to predict and will not be known for many years. What we do know is that before the world gets the answer to that question, the Troika and Portugal must make very difficult decisions. Their alternatives are limited and generally point to one solution that is best for all parties, including bond holders.