The New European Sovereign Debt Market Threatens International Bond ETFs

Includes: IGOV
by: David Urban

Back in October when the European Union crafted the agreement to rescue Greece it told private creditors during the restructuring that the package would amount to a 50% write down of Greek debt.

Never mind that this backroom deal was crafted by strong arming the private creditors into the agreement and it was this action that caused the bond market rout last year in Europe.

The EU, International Monetary Fund, and pension funds sent a clear message to the private holders telling them that their bonds were not on par with the public sector holdings. No matter that they shared the same prospectus, trading floor, settlement instructions, and cusip. The private sector was to bear the brunt of the write down.

Then to rub salt in the open wound, it strong armed the ISDA into calling the event a voluntary restructuring, which would not trigger a credit event under CDS contracts.

European debt across the board was rerated including a failed bond auction in Germany. If sovereign debt has different risk profiles for the public and private sectors investors need to realize the risks involved.

Negotiations are now focused on the interest rate the new bonds pay. At stake is the amount of loans the EU and IMF are to front as a condition for the swap.

The lower the interest rate the less money that needs to be fronted by the EU and IMF as per the October agreement so the EU and IMF have an incentive to push the rate as low as possible.

If a settlement cannot be reached, the Greeks are talking about forcing through a settlement on the bondholders. If the EU and the IMF believe this is a solution to the problem then they need to wake up to reality.

Banks are already shunning the European sovereign debt markets as seen by the amount of cash redeposited back with the EU borrowing through the swap program. No bank wants to take the risk of holding European sovereign debt at a time when it may be facing 50-80% haircuts. Once Greece concludes everyone will move over to Italy, and Portugal, which face daunting repayment schedules in 2012.

If the EU and IMF are set to put the brunt of the restructuring on the private sector then the risk profiles for those bonds change. No longer can a holder in the private sector count on receiving 100% of par at maturity. Repayment risk has reared its ugly head across bond portfolios as risk managers need to determine the possibility that their holdings may not be looked upon as pari passu with public holders of the same debt.

Investors who have diversified into International bond funds looking for value like iShares S&P/Citigroup International Treasury Bond Fund (NASDAQ:IGOV) should review their current holdings for Greek, Italian, and Portugese exposure. As of December 31, 2012, the three countries had a combined exposure of 15.29% of the fund.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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