With all eyes firmly planted on Spain, the little-Escudo-that-could has quietly slipped off the heading-into-the-abyss list of the mainstream media. Little was made this week of the fact that 10Y Portuguese bond yields dropped to seven-month lows - except by us of course where we explained that this is almost entirely due to the CDS-Bond basis trade 'arb-du-jour' that has placed a technical bid under Portuguese bonds. Between the help from LTRO and the fact that ISDA is under-pressure to improve/amend CDS rules to 'honor the spirit of the CDS contract to the fullest extent' which implicitly reduces the massive 'event' premium uncertainty between CDS and Bond risks for distressed-names (thanks to the ECB's actions in Greece), every bond in the short- to mid-term maturity of Portugal appears notably rich - with only the longest-dated bonds reflecting the crisis that remains. As we described in detail here, the real Debt/GDP of Portugal is around 140% (notably higher than the EC estimates of 111% once contingent liabilities are take account of) and the issues that face this small nation are entirely unresolved with bank recapitalization needs of at least EUR12bn and a highly indebted private sector. The bottom-line is that optically-pleasing bond improvements recently have been entirely due to synthetic credit arbitrage and, as Morgan Stanley notes, the nation remains mired in the three risks of contingent liabilities, bank recap needs, and a grossly indebted private sector; leaving a second bailout very likely by September 2012 and the challenging debt dynamics likely to mean a restructuring.
The rally in Portuguese bonds has been impressive (though interestingly un-covered by bullish leaning media who are always looking for a good-news story). However, given the illiquidity of Portuguese bonds in general and the massive premium difference between the bonds and CDS (as seen below), the emergence of hope that ISDA will make more 'honorable' decisions with regard to CDS triggers and with some help from LTRO, the basis (the spread between bonds and CDS) has begun to normalize though we note 5Y CDS still trade around 1000bps...
This chart shows the spread between CDS and Bond spreads (in fact it is CDS spread - Bond spread both adjusted for systemic 'German' risk) - a negative point on the chart means bonds are trading 'cheap' to CDS. A rising trend in the chart means bonds are outperforming CDS.
Morgan Stanley; Portugal: Bail-Out Now, Bail-In Later
1. Further Rescue Package Likely – Risk of Debt Restructuring Later on
Risk One: Contingent Liabilities
Up to €21bn from SOEs
Up to €12bn from PPPs
Up to €6bn from local government arrears
Risk Two: Banks’ Recapitalisation Needs
At least €12bn
Risk Three: Highly Indebted Private Sector
2. What’s Priced in? Putting the Bond Curve in Context
The Portuguese credit story is at a crossroads, when compared to Ireland and Greece
LTROs Have Caused a Significant Curve Steepening
- The front end is pricing in some sort of normalisation...
- ...but this seems to be mostly the result of recent LTRO operations and expectations of the second bailout package
- The long end is still pricing in caution
Morgan Stanley sees the front-end and the belly looking rich while the long-end appears more fairly priced. We tend to agree - especially with the debt dynamics in the CDS curve and think their recommendation of a curve flattener (with the belly to underperform the long-end as the curve inverts into distress and restructuring) is a worthwhile trade...
What is most notable is the 'richness' of the belly of the curve (over the short- and long-end) which likely reflects this odd technical that we have discussed from the CDS-Bond basis traders. As that basis normalizes, this technical demand for bonds will drop (i.e. at a 200bps carry - with all the uncertainty around restructuring triggers - the 'easy carry' trade is a lot less attractive than at 600-700bps). In fact, we would not be surprised to see profit-taking on Portuguese basis-trades sooner rather than later as opposed to letting them run into the actual event - also likely to put pressure on Portuguese bonds.
All-in-all, Portugal remains totally unresolved as a nation mired in unsustainable debt, is likely to need a second bailout very soon and probably a restructuring and while bonds may appear to have rallied, this is entirely due to LTRO and Basis-trade effects and only the long-end (less affected by these technicals) reflects the considerably less sanguine state of this nation's future.