Three weeks ago, Zero Hedge [10] was the first to bring the world's attention to the legal (and explicit trading/risk) ramifications of European sovereign bonds. We noted the ECB/IMF's subordinating impact on unsuspecting sovereign bond holders but much more explicitly showed the huge gap in market perception between domestic- and foreign-law bonds (and the fact that they have very different ramifications given the rising tendency for retroactive CACs or simply local-law changes to accommodate restructurings). The arbitrage of "dumping all weak protection bonds and jumping to the 'strong' ones" which we preached is indeed occurring and now three weeks later, JP Morgan is suggesting its clients take advantage of this same arbitrage strategy (citing the very same thesis and legal justifications as we did) as domestic law bonds offer significant advantages to the sovereign (and therefore implicit disadvantages to the lender or bond holder just as we said) relative to foreign law bonds. While we are flattered that our analysis is deemed worthy of mainstream sell-side research regurgitation, we caveat the celebration with the concern that perhaps JP Morgan already took advantage of the information a 'fringe blog' provided to the world (as we know many funds did given the requests for more explicit bond details) and is now looking to unwind the profitable (though modestly illiquid) positions it has been accumulating for the past three weeks.
JPMorgan: CACs and foreign vs. domestic law issues in Greek bonds
Collective action clauses (CACs) make it easier to restructure distressed bonds. If a super-majority of bondholders vote in favour of a modification to bond terms, that modification is applied unilaterally. This can limit the hold-out problem in distressed exchanges. Sovereign bonds issued under foreign law (e.g. English) typically contain CACs already, and the issuer can only change bond terms by garnering enough investor consent.
By contrast, bonds issued under domestic law usually lack CACs, and the sovereign can retroactively change contract terms merely by changing domestic law. Thus, domestic law bonds offer significant advantages to the sovereign relative to foreign law bonds.
In particular, in the case of Greece, Greece could retroactively insert CACs into domestic law bonds and could choose to include unusually flexible terms.
For instance, in Greece’s existing foreign law bonds, the super-majority required to pass a resolution on “reserved matters” appears to be 75% of principal outstanding (and less commonly, 66.7%).9 Also, Greece’s foreign law CACs generally apply to the single bond issue or at most, a common issuance platform. By contrast, if Greece were to retro-fit its domestic law bonds with CACs, it could set a lower voting threshold and/or insert “aggregation” clauses which permit aggregation across distinct bond issues. The latter makes it harder for small bond issues to hold out, as large bond issues can dominate the voting. The main deterrent to such behaviour from Greece is that anything perceived as unfair or overly draconian is more likely to prompt legal challenges and to worsen investor sentiment.
[11]
Greece is fortunate in that over 90% of its outstanding debt appears to be issued under domestic law (Exhibit 3). Amongst peripheral countries, this is the lowest such percentage; Portugal is the next lowest with an estimated 96% of domestic law bonds outstanding. Ireland, Spain and Italy all have fairly de minimis levels of foreign law bonds outstanding.
However, this still leaves about 9% of Greek bonds outstanding which are foreign law. These will be harder to coerce into a deep restructuring, given the predefined super-majority voting thresholds. This is why, in Exhibit 2 above, we assume that Greece is able to successfully use CACs only on its domestic law bonds. Obviously, any voluntary participation from foreign law investors would be an added benefit to the PSI exercise.
[12]
An interesting question, given that foreign law bonds are harder to manipulate, is where they price vis-à-vis domestic law bonds. Although international bonds tend to be smaller issue sizes or private placements, and thus many lack or have unreliable price data, those that are marked more regularly tend to price about €3-€10 points above similar maturity domestic law bonds (Exhibit 4).
[13]
Finally, we do a similar exercise for Portugal. Portugal only has a limited number of international bonds outstanding, and just a few have realistic pricing data on Bloomberg. Out of these, an admittedly small sample with wide bid-offers, there appears to be relatively little pricing premium currently given to foreign law vs. domestic law bonds (Exhibit 5). The lack of a pricing premium is striking given the high probability of a Portuguese restructuring over the next one year, as implied by CDS markets (roughly 1/3). Liquidity permitting, we recommend overweighting Portuguese foreign law vs. domestic law bonds going forward.
Of course we agree with JP Morgan's perspective, since we came up with it, and in the case of Portugal there has indeed been less differentiation so far but extreme amounts of volatility in the last few weeks. While the market is indeed mis-pricing the legal differences between bonds as the 'option' to retroactively 'adjust' domestic law becomes worth more and more to the sovereign (and reduces value for the bond-holder) and so during this volatility we would remain vigilant for the ability to pairs trade - selling domestics into strength and buying foreigns - as bid-offers will compress if we see more LTRO-driven exuberance in the peripherals.