Wednesday, January 13, 2010

Greek Fire Part III

Greek fire: An incendiary weapon used by the Byzantine Empire. The key to its effectiveness was its ability to continue burning under any circumstances, even on the surface of water, making it a "wet, dark, sticky fire,".

I have been suggesting for quite some time to overweight high-grade corporate bonds of 'strong' countries at the expense of 'weaker' Eurozone sovereign issuers (see for example No easy way out for Eurozone peripherals dated October 30), most notably Greece, Portugal, Spain and Ireland. This view has paid of and by now the Markit iTraxx Western European Sovereign CDS index trades above the Markit iTraxx Europe Index (which is composed of 125 investment grade entities).
European Sovereign CDS's trade above high-grade corporate CDS
Source: Markit via Bloomberg

I see two key reasons for this development:
a) the general shift of private sector risk - most notably emanating from large corporates - onto the government balance sheet (via bail-outs, capital & liquidity assistance as well as traditional fiscal easing steps) which was reflected in the very substantial reduction in corporate bond yields over the past year.
b) the increased awareness of the structural problems facing the periphery of the Eurozone and the associated negative rating actions (most notably in Greece) which led to heightened risks of a potential funding crisis/default and in turn soaring CDS levels.

Within the sovereign realm we can build several clusters.
On the one side, we have the relatively solid sovereigns of Germany, France, the Netherlands and Finland. CDS levels are relatively close (the lowest currently is Germany with 27bp and the highest France with 33bp) and have been rather stable even though with a slight upward trend over the past months. This upward trend most likely reflects the risk that some of the weaker countries will in one form or another have to be bailed out.
The 'solid' core: Germany, France, the Netherlands and Finland
Source: Bloomberg

The second chart shows the other Eurozone sovereigns where CDS levels are available. Dispersion is much larger as is the volatility of the CDS levels. However, there are some interesting observations to be made. Ireland, Belgium, Austria and Italy have been outperforming while Spain, Portugal and Greece have been underperforming within this group. By now, both Spain (112bp) and Portugal (103bp) trade above Italian CDS (99bp).
The rest: volatile with high dispersion
Source: Bloomberg

Looking ahead, the general shift of private sector risk into the government sphere does not promise to be reversed soon and in turn I expect high-grade corporate bonds to continue their outperformance vs. sovereigns in general. However, the more interesting question at present is what happens within the Eurozone sovereign realm. Can Greece (or any other peripheral) find a solution to get out of their current mess or will the situation aggravate further, leading to an even higher risk of a funding crisis/default? Will a solution involve the transfer of Greek sovereign risk (and with that peripheral risk in general) towards the safer core issuers? Clearly, this would provide downward pressure on non-core CDS and related bond-yield spreads as well as upward pressure on core CDS levels.
By now even the European Commission has acknowledged that the Greek statistics are unreliable and not worth their paper. But that should not come as a surprise. Since having become a Eurozone member, Greece has frequently tended to substantially revise past deficit and debt data. Furthermore, if the statements in this article (Culture of Corruption Drags Greece Down) are correct, then not even 5,000 people in all of Greece report a gross annual income of more than €100,000 on their tax returns (the country has slightly more than 11mln inhabitants). Besides the unreliability of the data, the high level of corruption (it ranks 71th place in the corruption perception index of Transparency International, see here) will render a Greek-only political solution without outside help even more difficult. At least politicians seem to start acknowledging that their is a fire burning in Greece but that does not mean that they have the ability to extinguish it.
Personally, I am of the opinion that Greece should not have been allowed to join the Euro early last decade but not because the government fudged the data, rather because them joining rendered the Euro even less of an optimal currency area (it wasn't one from the beginning). But then again the Euro is more a political project than an economic one. In turn, this leads me to believe that ultimately Greece will not be left on its own and measures will be implemented to avert a default. However, when this will happen, what form the support (probably an IMF/EU combined effort) will take and what the restricions for Greece will be is hard to forecast. In light of the difficulty of the situation and the uncertainty relating to a potential solution, I do not see a favorable risk-reward for investments relating to Greek bonds for the time being and still favour to shy away from GGBs. For investors who expect to see a solution soon, I rather think that Irish government bonds would offer a more favorable risk-reward. For one, the Irish government seems to be willing to take the necessary steps while at the same time if there would be a Greek solution it might well help the periphery in general.

To sum up, I maintain my view of overweighting high-grade corporate bonds from 'strong' countries vs. sovereign bonds from 'weak' countries (most notably Spain, Portugal and Greece). However, I would be moving back to a neutral allocation for Ireland given the high spread levels, the apparent willingness to cope with the structural problems as well as the non-negligible probability that steps will be taken towards a stronger fiscal support mechanism within the Eurozone in the not too distant future.

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