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Post-Greece writedowns risk two-tier bond market

By Lucy Meakin

Bond changes triggered by Greece’s debt restructuring risk creating a two-tier market as investors avoid securities that adopt so-called collective action clauses to guard against potential losses in future writedowns.

Governments will be forced to include the clauses in a percentage of their euro bond sales starting in January as part of the agreement to establish a permanent rescue fund for the currency union. Bonds issued under the new documentation may be less valuable, according to Pacific Investment Management Co., which oversees the world’s biggest bond fund.

“The collective action clause bonds should trade at a marginal discount versus the ones that don’t have them because you have the scenario in which the ones which take the haircut are the ones with the CACs and not the others,” said Lorenzo Pagani, head of Pimco’s European government bond and rates desk in Frankfurt. Pimco managed $1.9 trillion of assets at the end of September.

CACs allow a majority of bond investors to approve a debt restructuring, removing the right for solitary investors to veto a rescheduling for their own holdings. Greece introduced the provisions retroactively on its debt earlier this year to impose losses of 53.5 percent on private investors who wanted to opt out of the nation’s plan to reduce its debt burden.

Greek 10-year bond yields have dropped about 26 percentage points since the debt swap in March. The yield was 17.97 percent today, with the price at 30.86 percent of face value. That’s down from a record high of 44.21 percent on March 9.

Investor confidence in the sovereign issuing the debt may exaggerate the price difference due the relative risk of a default or writedown, according to Commerzbank AG.

“For the stronger, more liquid assets it doesn’t make a big difference at all,” said Rainer Guntermann, a Frankfurt- based fixed-income analyst at Commerzbank. The greater potential risk of a credit event “would be an argument in our point of view for a somewhat more visible discount on longer-term bonds for weaker credits like Spain and other peripheral countries,” he said.

Greece lost its last investment grade rating almost two months before the nation agreed in March to the largest sovereign restructuring in history. Spain’s credit rating has come under pressure as its borrowing costs rose to euro-era records, leading to speculation the nation’s debt load may be unsustainable. Spain’s Prime Minister Mariano Rajoy is so far resisting pressure from European counterparts to seek aid.

Moody’s Investors Service assigned a negative outlook on Spain’s Baa3 credit rating, which is one level above non- investment grade, on Oct. 16. The nation lost its top Aaa level as recently as September 2010. Standard & Poor’s also has a negative outlook on its BBB- ranking and so does Fitch Ratings.

The price difference on shorter-maturity bonds may be less pronounced because of the relatively small number of securities containing CACs, Commerzbank’s Guntermann said.

Under terms of the European Stability Mechanism, CACs need only be applied on debt of maturities greater than one year and the percentage of bonds issued that must contain CACs is scaled over time. Sovereigns may choose to apply them to more or all of their issuance, as opposed to just the required amount.

The inclusion may make the bonds more attractive to investors, according to Helen Haworth, head of European Interest Rate Strategy at Credit Suisse Group AG in London.

“Naturally you might think the ones with the CACs might be worse to hold,” she said. “I actually think the opposite is true. As a bondholder, you have slightly more rights with collective action clauses. If there’s no collective action clauses in the bonds, the question is if they then do a restructuring, do they just introduce them retroactively like they did for Greece or not?”

Greece achieved a 96.9 percent participation rate in its 206 billion-euro ($262 billion) bond exchange after the government legislated to insert CACs into notes governed by Greek law retroactively.

While a price difference between the type of bond remains a likely scenario, the possibility of other distressed nations following the Greek example could remove any benefit of holding either type, Pimco’s Pagani said.

“When bonds are governed by domestic law there is the possibility to introduce CACs retroactively,” he said. “In that case, the difference in value between new-CAC bonds and old no-CAC bonds disappears.”

[Bloomberg]

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