Greek rescue package is no long term solution, says HSBC’s Willem Sels

Willem Sels, UK head of Investment Strategy at HSBC Private Bank comments on the investment strategies that may be required in the wake of Greece’s second bailout.

Markets rallied ahead of the European summit in the anticipation of a Greek rescue package, but after the agreement was struck, the positive momentum
faded and markets were more mixed: the euro was up, but credit markets and most stock markets were relatively flat. The equity market reaction may have
been a case of ‘buy the rumour, sell the fact’. But it probably also reflects markets’ doubts that this package fundamentally changes Greece’s problems, even if it will probably stave off any risk of an immediate default. Indeed:

1) the debt load remains unsustainable at an estimated 168% of GDP in 2013 and around 120% in 2020, even after the private sector debt swap (PSI).

2) In addition, the success of the austerity programme critically depends on the ability of Greece – and the rest of the Eurozone – to lift economic growth and competitiveness, as well as the fragile social fabric in Greece. The violent demonstrations in Athens in past weeks show that there is strong opposition to the programme already, and markets hence worry whether the commitment to austerity will hold for the many years that are needed to bring the debt back down to more sustainable levels. If not, further haircuts for private bondholders are possible in the future, and we believe markets will thus continue to price in a high probability of default.

What was announced last week?

EU leaders (and the IMF) ‘finalised’ the agreement on the bailout for Greece and trashed out the details of the Greek private sector debt swap (PSI).

1. The bail-out package

In spite of much opposition in Greece, EUR 325 million of additional spending cuts and agreeing to permanent monitoring by the European Commission
were probably worth the price paying to pull core Eurozone countries over the line and agree on EUR 130 billion of aid. Greece will also set up a facility that
prioritises payments to bondholders over internal spending, which lowers short term default risk. Importantly, this agreement had to be struck well ahead of the 20 March deadline, when a EUR 14.5 billion bond expires, for Greece to receive the funds to pay back bondholders.

Some uncertainties remain, including what percentage of the funds will be provided by the IMF. This weekend’s G20 meeting made it clear that an expansion of IMF fire-power will depend on whether European leaders first agree to expand their own rescue funds. German finance minister Schaeuble has already stated a parliamentary vote on this issue is likely to take place in March and that he is hopeful that it will pass.

2. Private sector bond exchange

European leaders had been talking about the PSI for a long time, and they may regret not having acted sooner. Since they introduced the idea of a haircut, several bonds have expired. As a result, the pool of bonds held by private investors has progressively shrunk, and they therefore needed to apply more and more drastic haircuts on the remaining bonds to achieve the EUR 107 billion of desired reduction in the debt load.

This has two unfortunate implications. First, a broader range of bonds will likely be included in the swap, potentially including inflation linked bonds and very long dated bonds (money market instruments with an initial maturity below 12 months will still be excluded). Second, if needed, the bond exchange could become forced rather than voluntary: if not enough bondholders participate voluntarily, Greece has stated that it is willing to introduce collective action clauses in the bond documentation, which makes it possible to force any investor (including retail investors) to participate in the exchange, as long as a qualified majority (66%) of all investors agrees to the swap.

So what will bondholders get? For any 100,000 of bonds, investors will be getting

   – 15,000 worth of bonds issued by the European rescue vehicle EFSF, and
   – 31,500 worth of bonds issued by Greece, with maturities between 11 and 30 years, and coupons between 2% and 4.3% (depending on the maturity), and
   – GDP-linked securities, which could (or not) pay out some coupon when growth exceeds pre-determined levels. Needless to say, many investors are sceptical about the value of this third component.

The combined notional value of 46,500 notional value implies a haircut of 53.5%, but given that the coupons on the Greek government bonds are well below current yields, they should not be trading at par, and the total actual haircut is therefore close to 70% in our view.

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