The biggest news in the sovereign debt world this week has come from Greece, which managed to sell some €3 billion in new 5-year bonds at a yield of just 4.95%. This is not what you might expect, given the macroeconomic situation:
Greece's debt currently stands at about 320 billion euros, or 175 percent of GDP. It is rated nine notches below investment grade at Caa3 by Moody's. Standard & Poor's and Fitch rank Greece six notches below investment grade at B-.
So, how does one explain investors' appetite to buy this debt at such low yields? Here are the top five reasons:
1. This is just part of a momentum trade.
The Greece trade has been astonishingly lucrative for the past two years. Here's the chart, from the WSJ:
You could have bought post-restructuring Greek debt in May 2012 at a yield of 30%; it's now down to 5%, and there's no particular reason to believe that the trend is over. After all, Portugal, which hasn't even had a restructuring (yet), has five-year bonds trading at a yield of 2.6%. As a result, so long as the "go long Greece and make lots of money" trade is working, there are going to be investors who are happy to jump on the bandwagon.
2. The yield is reasonably juicy.
4.95% might not seem like a lot on its face, but Greece has been suffering from deflation for the past year. Right now the inflation rate in Greece is about -1.5%, which means the real yield on this bond, for a Greek investor, is actually closer to 6.5%. Given that Europe is going to have a zero interest rate environment for the foreseeable future, that kind of real yield is undeniably attractive.
3. There's potential for significant price appreciation.
With a coupon of 4.75% and a yield of 4.95%, you can buy €1,000 face value of bonds today for €991. Let's assume that you hold this bond for 18 months, and that at the end of that period the yield has dropped to Portugal's 2.6%. In that case, you would get three coupons along the way, totaling €71.25, even as the value of the bond itself would have risen to $1,071. If you sell the bond at that point, you're not just getting your €71.25 in coupon payments, you're also getting €80 in capital gains - for a total profit of €151.25. Which is a 15.3% return in 18 months. Not too shabby, in a world of zero interest rates.
4. The chance of default is slim.
Greece has an unsustainable debt load, and will certainly default again in the future. But the key question for anybody buying this bond isn't whether Greece will default. Rather it's when Greece will default, and what instruments Greece will choose to default on. So long as Greece continues to pay the modest coupons on this modestly-sized bond for the next five years, it can prove to be a perfectly good investment even if the country is defaulting elsewhere. Similarly, if Greece defaults on its public bonded debt but does so after April 2019, again this bond will be unscathed.
The degree of pain inflicted on Greece's private-sector bondholders in 2012 was so enormous, and the amount of privately-held debt which is still outstanding is so small, that it's going to be the official sector's turn to take a big haircut next time round. In other words, buying this bond does not constitute a bet that Greece, as a sovereign, will not default. It's just a bet that this particular bond will not default. And that's actually a bet I'd be willing to take.
5. Mario Draghi is going to do QE.
The worst thing that can befall Mario Draghi, the ECB president, would be deflation across the eurozone. And the German constitutional court notwithstanding, the markets are now convinced that if Draghi needs to implement some kind of quantitative easing in order to prevent eurozone-wide deflation, he will do so. And that no one, including the German constitutional court, will be willing or able to stop him.
Quantitative easing, of course, means buying bonds. And while no one can know exactly which bonds the ECB would buy, one easy and obvious option would be to simply buy the sovereign debt of all eurozone member governments. Including Greek debt. If that happens, Greek bond prices would surely rise, possibly quite substantially. After all, there's not much point in Draghi doing QE unless he's going to do it at serious scale.
I'm at the INET conference in Toronto this week, where there's a lot of talk about "overt monetary financing" in the eurozone. Basically, the euro crisis isn't over, and there are only three ways to resolve it. One is a pan-European fiscal authority; the second is a breakup of the eurozone. Since neither of those two things is politically possible, the third option becomes a necessity. Which, essentially, is that the ECB swoops in to save the day by printing money. Most of the people I've talked to here think that Draghi is bound to do that at some point. Which in turn helps explain those low bond yields in peripheral Europe.
None of these reasons, individually or collectively, are particularly good reasons to buy Greek bonds at 4.95%. It has always been very easy to lose a lot of money buying junk-rated sovereign debt at low single-digit yields; that hasn't changed. But if you're a bond investor, there's a surprisingly large number of ways that you could end up making money after buying Greek debt at these yields. Which in turn explains why Greece found it so easy to sell €3 billion in bonds.