Investors see default risks in Cyprus despite bailout

Thu Apr 4, 2013 7:54am EDT

Related Topics

* Investors expect that Cyprus may soon need more money

* Cypriot bonds, CDS prices point to high default risk

* June 2013 bonds seen attractive

By Marius Zaharia

LONDON, April 4 (Reuters) - Investors are still shunning Cypriot bonds despite the country's bailout, fearing the terms of the deal could lead to an unbearable recession that may impair the island's ability to repay its debts.

Cyprus's 10 billion euro ($12.9 billion) bailout, agreed with its euro zone partners on March 25, is the first in the region to impose losses on major bank depositors. This is expected to further undermine its oversized banking system - the island's main industry.

The measure, coupled with capital controls imposed to prevent bank runs and the usual medicine of budget austerity, is likely to condemn the economy to years of recession that some analysts say could be more painful than Greece has endured.

If the economic contraction in coming years is deeper than initially estimated, as in Greece, the troika of international lenders and Cyprus will have to come up with fresh funds to plug the gap.

That raises the risk that they would eventually try to impose losses on government bond holders, analysts say.

The price on the 2020 Cypriot bond was 64 cents in the euro on Thursday, only a tad higher than the 61 cents close on the day the bailout deal was agreed, having fallen to as low as 55.75 last week.

"If you're contracting your banking system in such a dramatic way then it's unlikely your economy will be growing any time soon," said a buy-side investor active in distressed sovereign debt markets.

"That view is now being reflected in people saying: Hold on. If you're going to have a bailout now it doesn't necessarily mean that it's going to be enough. So further down the road you can't be sure that they're going to be able to repay (debt)."

Prices of a benchmark Greek bond sank to around 60 cents before Athens agreed its first bailout deal in May 2010 and, after a few ups and downs, eventually fell below 20 cents before the country restructured its debt last year.

Analysts say prices of Cypriot bonds are unlikely to hit the lows seen in Greece because they are issued under international law, which offers better protection to bondholders.

INVERTED CURVES

The yield on the 2020 bond stood at 12.5 percent, less than the 16.7 percent yield offered by the 2015 bond. An inverted yield curve - when short-term yields are higher than long-term yields - is a sign of increased fears of default.

"The current yield curve is saying if in a year's time the recession is deeper than expected then maybe the remaining sovereign bonds are at risk," said Sohail Malik, lead portfolio manager for the ECM Special Situations hedge fund.

"Longer term, markets ask themselves: 'Is Cyprus going to stay in the euro?'"

Credit default swaps, used by investors to protect themselves against default, traded upfront - a phenomenon which occurs when governments or companies are seen close to bankruptcy.

Five-year CDS were last quoted 36 basis points upfront, higher than the 28 bps seen immediately after the bailout deal, meaning investors had to make a $3.6 million initial payment to insure $10 million of Cypriot debt for five years.

The CDS curve was also inverted.

JUNE BONDS

Wednesday's announcement by the International Monetary Fund that it will contribute to the bailout package lifted bond prices by a relatively modest 3-5 cents across the curve. Analysts warn the rise could be short-lived.

"I'm still happy with my sell (recommendation) on Cyprus," said Gabriel Sterne, chief economist at distressed debt brokerage Exotix. "Longer-term there is a risk that the programme goes off-track ... I wouldn't think the bonds are worth more than 30 (cents) if they leave the euro."

Sterne has a different opinion though about bonds worth 1.4 billion euros due to mature in June 2013, saying the IMF's statement "considerably raised chances" that issue will be repaid.

Its price has still not fully recovered since the bailout agreement, last trading at 94.5 cents in the euro compared with last month's lows of around 80 cents. For many, this is a chance to make hefty profits in a very short time.

"They've done the pain with the banks, they've done the pain politically - are they really going to let it default in two months' time? It's not going to happen," one senior bond trader in London said.

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