Given the extent of our discussions both today and over the last two weeks of the EFSF, Moody's confirmation of all that we have said should come as no surprise. In their Weekly Credit Outlook the rating agency, that hasn't accidentally downgraded FrAAAnce recently, cites weak demand and investor's cold reception of proposals as betraying the limits of EFSF's powers. This development calls into question the ability of the EFSF to fund itself in the markets at low cost. The success of the EFSF as a tool to stabilize sovereign debt prices and the success of the current euro area-wide support mechanism comes into doubt if that ability is compromised. Clearly traders are also starting to wake up to this reality as EURUSD drops below Friday's close and given the size of sovereign issuance on deck this week, it is not surprising.
Weak Bond Demand and Investors’ Cold Reception of Proposals Betray Limit of EFSF’s Powers
Last Monday’s €3 billion, 10-year bond issuance by the European Financial Stability Facility (EFSF) was met with significantly less demand than a similar bond issuance on 15 June, and priced at 177 basis points (bps) over 10-year German Bunds, versus 51 bps in June. Investors’ cool reaction to proposals to leverage the EFSF’s lending capacity (through partial default insurance and/or a special-purpose vehicle, or SPV) contributed to the weak demand, although fundamentally, these leverage options will not affect the EFSF’s creditworthiness. Both the pricing of the EFSF’s last issuance, and the lack of progress in leveraging its lending capacity, display the limits of the EFSF’s ability to support European government bond markets.
The rise in EFSF spreads is an important signal because it reflects a rise relative to the spreads of its Aaa-rated guarantors. In theory, EFSF spreads should be below the weighted average spread of its Aaa-rated guarantors, since EFSF issuance is 100% covered by guarantees from Aaa-rated sovereigns and also benefits from guarantees from non-Aaa-rated member states and from the underlying borrower’s repayment obligation.
As shown in the exhibit below, the spread of other Aaa-rated euro area countries to Bunds has risen to 58 bps on 7 November from 20 bps on 15 June. Therefore, only 30% of the increase in the spread on the EFSF issuance (38 bps out of 126 bps) is explained by the rise in the spreads of its Aaa-rated guarantors. Further, while the EFSF bond spread remains significantly lower than the weighted average spread of all its guarantors, it has moved further away from the Aaa guarantors spread and closer to the all-member spread during the past six months.
We note that the auction took place at a time of significant uncertainty created by the political turmoil in Greece and, to a lesser extent, Italy, which inevitably depressed demand for euro area debt. Moreover, the rise in EFSF spreads mirrored a significant increase in the spread on French government bonds. In this context, the demand for the EFSF bond issuance was dampened by a lack of confidence over the credit resilience of its guarantors. Moreover, the uncertainty created by the proposed mechanisms to leverage the EFSF’s lending capacity contributed to the weak demand. So it would be wrong to draw too many firm conclusions from last week’s auction regarding investor demand for EFSF debt in an environment in which there was a clear, shared commitment to maintaining the euro area intact.
Nevertheless, this development calls into question the ability of the EFSF to fund itself in the markets at low cost. The success of the EFSF as a tool to stabilize sovereign debt prices and the success of the current euro area-wide support mechanism comes into doubt if that ability is compromised.
These concerns are amplified by a lack of progress on the two proposed leverage options as investors remain reluctant on both partial default insurance and an SPV. Against the backdrop of the proposals on Greek private sector involvement, investors expect that the suggested 20% protection (either by collateral or by an equity tranche in the SPV) will not necessarily cover them in case of a default. As a consequence, the proposals are unlikely to generate significantly greater demand for euro area sovereign debt.
With its current lending capacity (which is at about €266 billion considering commitments to Ireland, Portugal and Greece), the EFSF cannot meaningfully support the euro area’s large government bond markets. This limits the EFSF’s role as an important pillar of the euro area crisis management strategy.