Exotix euro crisis focus on Portugal, Cyprus and Greece

London based Exotix, a frontier market investment banking boutique, has outlined its views on the riskiest peripheral debtors in the EU.

The European authorities and IMF have revealed the solution to the European debt crisis! But it may have passed you by as there were no trumpets (neither fanfare nor the last post). The solution being implemented is to lock the euro nations together in marriage by making the divorce settlement unaffordable. Formal recognition of collectivisation of liabilities through “Eurobonds” is politically unacceptable in large swathes of northern Europe, but even so the point may have already passed at which northern Europe can cut the life support without facing an unaffordable bill.

So life support will very likely stay on, but there remains a declining tail risk of increasingly disastrous consequences that it will not. We think of it as a horrendous “3/12” type risk, named after the infamous March 2012 GGB, whose value collapsed 70% in value in 9 months. Our conclusion is that it is important for investment decisions to be based on scenario analysis which factor in extreme tail-risks.

We use this overall assessment of euro crisis policies to inform our views on Portugal, Cyprus and Greece.

In Portugal, debt composition is key because some debt is more “PSI-able” than others, and Portuguese debt is moving towards the point at which private sector involvement (PSI) alone is futile. The official sector has in Greece demonstrated extreme reluctance to share the burden of haircuts with the private sector. But official lending, ECB purchases, and LTRO-related operations have shrunk the PSI-able share to just 35% of the total. So either a Greek-style savage PSI is needed now or it is simply not worth taking the private sector to the barbers.

Our scenario analysis delivers investment recommendations for Portugal. We assume a 55% probability of a “successful” IMF programme (possibly aided by further EU financing on generous terms), a 25% probability of either euro exit or severe PSI over the next (around) two years, and a 20% probability that there is some combined PSI/OSI with moderate haircuts. We value four bonds of representative maturities accordingly. As of 24 April, we do not find market valuations hugely out of line with our own for any of the bonds. Nevertheless, on the basis of our scenarios we initiate a BUY recommendation on longer-dated bonds (2037), a BUY on medium-dated bonds (2019) and a SELL on shorter-dated bonds (December 2012 and March 2014). In short, we find the shorter-dated bonds (priced 80 or above) prone to the “picking up nickels in front of a steamroller” critique, while this affect is sufficiently mitigated by lower current prices in the longer dated bonds to persuade us that the risk is worth taking.

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