October 21, 2011 / 3:35 PM / 8 years ago

REFILE-EFSF leverage plan may limit states' borrowing options

* EFSF insurance may split investor base, sap liquidity

* Insured debt to trade at 80-100 bps discount - JPMorgan

* 20-30 pct insurance may not be enough for bond investors

By William James

LONDON, Oct 21 (Reuters) - Proposals to insure the first slice of losses on new euro zone sovereign debt could create a two-tier bond market for Italian and Spanish debt that would severely limit the countries’ borrowing options.

Policymakers are scrambling to agree on a way to leverage the existing European Financial Stability Facility (EFSF) to give it enough ammunition to fend off the threat that rising borrowing costs push Spain or Italy to the brink of default.

One proposal gathering momentum, in spite of political and legal hurdles, is for the EFSF to issue guarantees on new sovereign bonds that would protect holders from the first 20-30 percent of losses in the event of a default.

This would create a division between insured and non-insured debt, that could split a country’s investor base and suck liquidity out of the market unless new bonds were carefully constructed to allow them to trade on a par with existing debt.

“The issuer would have to create a new curve of insured debt, limiting the liquidity in both curves with risks that investors would dump the old non-insured bonds,” said Commerzbank rate strategist Christoph Rieger.

Based on a 20 percent insurance model, JPMorgan estimates that insured bonds issued by Italy would trade at a yield around 100 basis points below existing debt with new, insured Spanish debt likely to be priced 80 bps lower than existing bonds.

“If Italy is trading at 6 percent in the uninsured market, then the insured structure would be trading at 5 percent, roughly speaking,” said Pavan Wadhwa, global fixed income strategist at JPMorgan.

Reducing the liquidity in existing debt could further limit the funding options available to Spain and Italy, with investors preferring to hold assets that can be easily traded. Both Italy and Spain frequently sell new tranches of existing bonds to raise funds but this paper would become less attractive without the guarantee.

Funding toolboxes have already been diminished by the interim support from European Central Bank’s bond-buying programme, which has focused on short-term, fixed-coupon debt, effectively ruling out fresh long-term and inflation-linked issuance.

“Tapping off-the-run lines would be becomes less likely in such an environment and issuers should retreat towards the short end of the curve, where an insurance scheme would offer better protection,” RBC’s Norbert Aul said.


However, the insurance plan could tempt investors back into buying Italian and Spanish bonds, tempering the rising cost of raising money seen after the spreading euro zone debt crisis threatened both countries earlier this year.

“The positive elements of an insurance scheme would be to keep the financing and re-financing access for countries like Italy and Spain open,” said RBC Capital Markets strategist Norbert Aul.

“But on the negative side this won’t be the masterstroke in terms of resolving the euro zone debt crisis because it basically just buys more time.”

More time would allow Italy and Spain some breathing room to get their public finances in order and implement structural reforms to invigorate growth.

Even the newly insured debt was not guaranteed to receive a warm welcome from investors, analysts said, and risked sending the wrong signal to markets already sceptical that the guarantees would be large enough.

“What the market is saying is, if Italy were to default then the loss on those bonds would be 60 cents on the dollar and if you’re only covered for 20 of those 60 cents, it’s not enough,” Wadhwa said, citing prices from the recovery rate swaps market.

But higher guarantees would mean less overall firepower, with the EFSF’s ability to offer guarantees firmly capped.

“It’s a trade-off between having a high headline number and a high enough guarantee where the market believes that they won’t be incurring huge losses on Italian paper given a default.”

Perversely, for an investor base stuck on the notion that sovereign debt carries the lowest risk, the insurance could be seen as acceptance that in the future even government will be allowed to default.

“Generally I think investors will be cautious, due to the fact that they know now that a sovereign default in the euro zone is a possibility ,” Commerzbank’s Rieger said.

“If we see a few hedge funds or emerging market players who are now willing to look at this debt, that won’t be enough. You need the traditional conservative type government bond investors to regain confidence in the type of product.”

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