Pimco warns euro debt holders to ‘check the fine print

Pimco is urging investors in European fixed income to check the fine print on their debt holdings to see which law governs the bond in cases where a country leaves the eurozone.

Bond holders must know which national law governs their holdings, to know how likely it is their bonds will be re-set in the new local currency once the issuing country has abandoned the shared currency, says portfolio manager Myles Bradshaw.

His note published today is the latest sign of asset managers making contingency plans for at least one heavily indebted country to abandon the currency bloc.

Bradshaw considers Greece leaving with Ireland and Portugal – all now on European Union / International Monetary Fund support – or the eurozone dividing into northern and southern blocs, or a complete break-up.

In any such case, capital would probably rush out of the affected countries as they exited, causing sharp devaluation, and pain to investors with holdings denominated in that currency, Bradshaw notes.

The fixed asset specialist unit within German insurance giant Allianz highlights historical examples of such crisis devaluations. Iceland’s kroner lost half its value versus the US dollar after its troubles in 2008, while Argenitina’s peso slumped 70% after its 2002 crisis. Inflation peaked in those nations at 22% and 40% respectively.

Holding bonds denominated in these currencies obviously hurt.

Pimco says: “But having a bond issued under English or New York governing law does not unambiguously address these risks. If the bond documentation gives jurisdiction to local rather than foreign courts, the bond could be redenominated.”

If it is not clearly stated that coupons are paid in euros, foreign courts could use the ‘place of payment’ to decide whether or not the bond should be redenominated.

And if the euro exit is politically negotiated, “it may be accompanied by an EU directive that compels all EU courts to give primacy to local redenomination law”.

Ultimately, Pimco says the way to mitigate these risks is “hold fewer assets in the country at risk of euro exit. In cases where this does not make sense – for example because valuations are attractive while the perceived risk of euro exit is very low – investors should think about diversifying the location of their liquid assets as well as holding higher than usual liquidity buffers.”

Rotating from sovereigns to corporates in the affected country may not help much.
Default risk could rise sharply for firms with local revenues but euro liabilities, whereas globally focused companies could face governments taking assets, or taxing heavily.

Pimco says European fixed income investors should look to alternatives to sovereigns and consider also agency, regional government and covered bonds.

“These have characteristics similar to government bonds but typically offer higher yields. The absence of a credible eurozone policy response means we should expect more eurozone sovereign debt to behave like credit rather than interest rate risk. German Bund yields might initially fall as the crisis intensifies but Bunds’ credit quality could change quickly, irrespective of the macro economic backdrop if a credible policy response finally emerges.”

Bradshaw also suggests investors increase the duration risk in other developed sovereign markets, and reduce exposure to the euro, which already fell sharply against other major currencies in the latest eurozone crisis.

And finally, diversify and increase cash or cash-like instruments.

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