Sovereign debt crisis – a roadmap for investors

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This post is a guest contribution by Elga Bartsch, Daniele Antonucci, Arnaud Mares & Joachim Fels of Morgan Stanley.

By the end of March, European policy-makers will present broad-ranging reforms to contain the crisis. In mapping out the different policy options discussed among European policy-makers, notably in the context of the reform of the European Financial Stability Facility (EFSF), we present an analytical framework to help assess the effectiveness of the measures that will eventually be announced.

The key distinction in this framework is between measures that only provide additional liquidity and those that help to improve solvency directly. The former can easily be implemented, because they do not involve any immediate costs.  The latter is more difficult to restore, because it involves foregoing income or consumption immediately: either the borrower through austerity measures, structural reforms or asset sales; or the creditor by writing off part of the debt, lowering the interest charged or extending the maturity.

As long as emergency liquidity is available from the EFSF or other sources, countries will only default on their debt if they believe that it is in their best interest. Restructuring is a particular concern for the euro area because its member states are considered between an emerging market government borrowing in foreign currency and a developed country with its own national currency.  Yet the cost of defaulting is considerably higher for a euro area country than it is for an emerging market government. At the same time, the benefits of defaulting are also considerably smaller.

While even remote prospects of some form of default are rather disconcerting events for bond investors, markets systematically overprice such risks.  We cannot rule out an involuntary debt restructuring in the euro area in the coming years.  But we believe that the risks are more than adequately priced into government bond markets.

The restructuring hurdle in the euro area is higher than many investors appreciate, we think. Calls for a default on the debt in the euro area periphery tend to be based on a partial analysis, which just focuses on debt sustainability, but does not look at the consequences of debt restructuring across the whole capital structure to grasp the costs and benefits that a rational government will take into account in its decisions.

The impact of a sovereign debt restructuring on the euro area financial sector remains uncertain.  However, it is vital for investors to consider the impact of such a debt restructuring, especially a compulsory one, on the different layers of the bank capital structure. Together with initiatives towards bank resolution legislation and the ESM making private sector involvement compulsory in future debt restructuring, even senior unsecured bank debt has become less safe an asset.

Key Investment Implications

1. Peripheral government bonds have experienced a deterioration of some of their ‘institutional’ and ‘behavioural’ characteristics.  Investors looking for low risk, low return investments that usually characterize government bonds could continue to exclude peripherals from their portfolios, as they no longer exhibit such characteristics.  Such peripheral government-issued bonds will have to cheapen sufficiently to make them attractive within a broader asset-allocation context (e.g., versus credit such as IG & HY corporate bonds, equities, commodities, etc).

2. With country risk back as a main driver of investment decisions and portfolio performance, we think that euro area bond markets will continue to exhibit wide spreads, differently sloped yield curves and varying volatility. And, to the extent that portfolio managers’ mandates get changed to a greater extent towards AAA securities, this will further limit EMU peripherals’ financing possibilities and potentially create difficulties in euro area financial markets.

3. Implementing an EMU-wide fiscal transfer mechanism that provides for bailouts of countries in trouble by the economically stronger euro area members would certainly help to solve the current sovereign crisis near term.  However, such a move to a ‘transfer union’ creates the long-term risk of a political backlash in the countries shouldering the bill, which might ultimately even lead to EMU break-up. Clearly, leaving the euro would involve serious political and economic costs for the seceding country (or group of countries).

4. The combination of even a remote prospect of EMU break-up and the severe sovereign debt crisis in the euro area have brought the country factor back with a vengeance when it comes to portfolio performance – both in equities and in fixed income.  In our view, country allocation decisions will remain very relevant going forwards over and above sector allocation, duration decisions and credit quality. In addition, any future rally in the exchange rate will likely be capped by these uncertain but remote prospects of EMU break-up.

Source: Morgan Stanley, February 9, 2011.

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