A Sneak Preview Of The Tranching & Subordination Of Eurozone Government Bonds

Greece: The kiss of death for pari passu

A sneak preview of the tranching & subordination of EZ government bonds

While we are aware of politicians' repeated vows about the uniqueness of the Greek case, we remain deeply skeptical. After all, hasn't it been a winning investment strategy to assume that the exact opposite of whatever Europe's elite says will become fact? The recently overheard and filmed conversation between Germany's and Portugal's finmins (http://t.co/iDA9HJPo) points in the direction of an imminent review of the Portuguese case and might be a harbinger of PSI, OSI etc à la Gréce. And why stop there? Why not relieve the Italians, Spaniards, Portuguese etc. of their troublesome load? Wouldn't it be nice to pull a Greek and finally make it for those pesky Maastricht criteria?

But regardless of one's view on the ongoing crisis, it makes perfect sense to go where no investor has gone before. We did the unthinkable, read the unreadable and made it back alive to tell the tale: we ploughed through all of the individual bond prospectuses of our favorite list of countries in peril and actually found a lot of useful information for the investor. Given that the sovereign bonds of the Eurozone used to be looked at as riskless assets, it is safe to assume that the exercise hasn't been done by a lot of investors on a regular basis. Judging by the difficulty to even obtain the information, both the interest of investors to obtain it and that of issuers and underwriters to provide it has been and remains extremely limited.

Countries we looked at:

Greece, Portugal, Italy, Austria, Hungary and Spain

Criteria we applied:

Governing law (local vs. foreign) and debt covenants.

Metrics we applied:

We compared yields or ASW levels of similar maturities, to account for the various currencies.

Conclusions we came to:

While there is already a significant markup for certain Greek government bonds that are issued under a foreign law jurisdiction (see Graph 1), there is no clear distinction in any of the other countries' bonds.

Graph 1

Table 1: Foreign Law bonds of Greece, Portugal, Italy, Austria, Hungary and Spain

Relative illiquidity and low issuance sizes distort yields and spreads. Investors traditionally shunned foreign law bonds and piled into local law issues. This may seem puzzling at first glance, given the duration and severity of the crisis. We attribute this to the investor base: their thinking remains entrenched in traditional categories, namely interest rate risk as opposed to credit risk. Only when the threshold is clearly crossed -as in the case of Greece- does duration-based pricing make way for default-based pricing and a different investor base takes over. When Greece lost its last IG rating, it disappeared from the universe of EZ government bond managers and entered the realm of HY bond investors. Thus credit criteria began to matter and were being priced in. In our view, the state of the crisis warrants a broad-based significant markup for investor-friendly prospectus language and we see trading opportunities in most of the countries we analysed.

Graph 2

No distinction yet- amazing, given the yield levels.


Graph 3

No visible distinction yet.

Graph 4

Some mispricings, else no distinction so far.

Graph 5

Small markup vs. HUF swap rates for the local bonds, FX bonds mostly trade north of HU CDS; given the illiquidity and unreliability of BVAL pricing, the situation is clouded.

Graph 6

Foreign law bonds receive no love from investors, yet.

Our general recommendation: Establish selective long/short pair trades in maturity-matched foreign/local bonds, or go long foreign law bonds and hedge via CDS.