EFSF feels the heat

* Moody's negative outlook weighs on investor sentiment

* Funding costs rise, capacity for further rescues in doubt

* Bank research questions when ESM will come into force

By John Geddie

LONDON, July 27 (IFR) - The European Financial Stability Facility could be left with just one precious Triple A rating after Moody's changed its outlook to negative this week, putting the issuer under yet more pressure just as concerns escalate around how much firepower it has left.

Back in January S&P cut EFSF's rating to AA+ and now Moody's threatens to follow suit after also shifting the outlook on some of its remaining Triple A guarantors - Germany, Luxembourg and the Netherlands - to negative.

The moves have exacerbated investor concerns about the credit.

"The EFSF is a flawed concept, and investors are very wary of that," said Peter Allwright, co-head of the absolute return bond and currency team at RWC Partners.

"Now, with the possibility of further ratings downgrades, there is just too much risk," he added.

While the EFSF's credit strength is based on a 165% overcollateralisation by its Triple A rated guarantor countries, these include France and Austria, both of which are AA+ by S&P and already on negative outlook with Moody's.

"We just don't know what the long term future for this institution is, what its potential borrowing needs are, or what the credit quality of the countries that back it will be," said Sandra Holdsworth, investment manager for global government bonds at Kames Capital - a fund with over GBP50bn of assets under management, mainly in the fixed income space.

Investor concerns about the institution have been reflected in its spreads, which have widened out dramatically since its inception in early 2011, although recent fundraising efforts have proved it does have market access - as long as it pays for it.

A five-year trade priced in early July came at 50bp over mid-swaps, 12bp back from where it priced a trade in the same maturity in March. Both of those are well wide of its inaugural offering in early 2011 - another five-year - that priced at mid-swaps plus 6bp.

RISK AND REWARD

A senior DCM official at one of the largest SSA debt houses told IFR that as yet, no investors have told them they would stop buying EFSF, as long as it continues to offer sufficient returns.

Allwright at RWC Capital is, however, one investor for whom, as far as Europe is concerned, returns on investment come second to risk mitigation.

"It's not about return on capital any more; it's about return of capital," he said.

"If you buy the EFSF, you are a buy-and-hold-to-maturity investor, and you've got to believe in the whole concept," he added.

And it is the whole concept that seems out of sync, agree SSA bankers.

There is a fundamental flaw in the growing expense the EFSF faces in raising funding for Europe's indebted countries.

"Is it really efficient for eurozone leaders to transfer expensive money to the countries in need?" said the DCM official.

The solution Europe's leaders have come up with is the European Stability Mechanism, a permanent intergovernmental organisation expected to take over from the EFSF in September 2012.

The ESM will have paid-in capital, but what its credit rating will be and how much it will have to raise in the public markets remain uncertain.

SWEAT IT OUT

What is clear is that until the ESM comes into operation, it is the EFSF that must shoulder the burden of Europe's woes - and bankers are already concerned that it just does not have the capacity.

EFSF's investor presentation, updated on July 16, states that its remaining lending capacity excluding Spain's bank recapitalisation programme is EUR248bn.

A research note published last week by Bank of America Merrill Lynch stated that the EUR150bn EFSF would be left with after a commitment to Spain would not be enough to service proposed secondary market intervention for Spain and Italy.

Over the last few years Spain has, on average, issued EUR10bn a month and Italy EUR20bn a month; Spain's stock of outstanding (state) debt is less than EUR600bn, Italy's is about EUR1.6tn.

That note was published before a full EUR300bn sovereign bailout appeared firmly back on the cards, with Spanish 10-year yields driven out to an historic high of 7.66%.

Factoring in EFSF support for Cyprus, secondary market intervention, and the potential for a full Spanish bailout, the EFSF looks decidedly strapped for cash.

"It can only service a public policy role of a certain size, and if they go beyond that they will be squeezed," said one SSA official.

Its role would be further stretched if legislative approval for the ESM is delayed in the German constitutional court.

BofAML's research note says that if a similar timeline to the approval for the EFSF is applied, a decision on the ESM could be as late as November.

A research note distributed by Barclays last week states that, in principle, if any articles of the ESM Treaty need to be changed, a renewed ratification of those changes by all eurozone members would be necessary, further delaying proceedings.

Finally, the commitments EFSF cannot push on to the ESM are long-term funding funding programmes for Greece, Portugal and Ireland, of which EUR117.5bn must still be raised out to 2014, according to EFSF's investor presentation.

Taking all this into consideration, it is a mammoth task for an increasingly tired-looking institution. (Reporting By John Geddie; editing by Helene Durand, Julian Baker)