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Planned Portugal debt swap may be too costly for lasting relief

Marius Zaharia and John Geddie
Wednesday, 23 Oct 2013 | 5:36 AM ET

* Portugal plans debt swap to ease refinancing burden

* Market prices suggest debt swap may come at high cost

* Concerns Lisbon needs new bailout seen capping debt rally

LONDON, Oct 23 (Reuters) - Portugal aims to replicate Ireland's path out of a bailout with a debt swap later this year, but the likely high cost may sow doubt among investors that it can stand on its own feet.

An exchange of short-term for longer-term bonds would ease Portugal's immediate refinancing burden and is seen as a crucial step in its plans to replace a 78 billion euros ($107 billion)EU/IMF bailout with a precautionary credit line (PCL) next year.

The PCL would be easier to sell to an austerity-fatigued population as the terms would be less strict than the second bailout that might otherwise be needed. But Lisbon must prove it can finance itself to gain access to the facility, which only provides emergency funds.

Bond swaps in Ireland in January and July 2012 helped drive its borrowing costs below those of Spain and Italy and put Dublin on track to complete its bailout and return to markets.

But for junk-rated Portugal, bailed out in 2011, it will be more complicated.

Based on current market prices, foreign investors would have little incentive to take part in any debt exchange.

The government has said it plans a swap but not which bonds would be included But swapping 2014 and 2015 bonds for paper maturing in 2018, when Lisbon faces lower repayments, would give investors 120-220 basis points of extra yield in exchange for putting their money at risk for longer.

An equivalent switch in investment grade-rated Spanish or Italian debt would offer similar returns.

While local banks and pension funds might accept that because a funding problem for the government might create troubles for them as well, foreign investors - who own about 53 percent of tradeable Portuguese debt - may not be so keen.

To lure them, Portugal will have to pay up.

"They intend to lengthen the duration and they need to do it whatever the price," said one senior trader at one of the 19 primary dealers of Portuguese debt - banks which play a key role in ensuring government debt sales go well.

"The terms would (have to) be very appealing," he added, in comments echoed by a senior official at another primary dealer who also asked not to be named.

The more Portugal pays, though, the bigger the concerns over its longer-term debt sustainability. At 215 billion euros, its public debt is already 1.3 times economic output, just above what the International Monetary Fund deems as sustainable.

Natixis Asset Management fixed income strategist Axel Botte said his firm might participate in the debt swap if the yield rewards were "interesting" and that the exchange could still see sufficient demand even if other foreign investors stay away.

But as long as the Portugal's overall debt does not shrink to sustainable levels, Natixis was likely to keep its underweight position in Portuguese bonds, he said.

The planned bond swap will not be Portugal's first attempt to follow in Ireland's footsteps. A year ago, it exchanged 2013 for 2015 paper. It has also sold bonds, of up to 10-years maturity, via syndication.

These moves were welcomed by the market but failed to quell talk of a second bailout. At 6.3 percent for 10 years and 5.3 percent for five, analysts say Portuguese borrowing costs are unaffordable. Ireland's are 3.6 and 2.2 percent, respectively.

"I don't believe that they can fund at the moment, not with the uncertainty of a potential (second) bailout," a third senior primary dealer official said.

TOUGH TASK

Analysts and traders say a swap out of 2014 and 2015 bonds into 2018 paper is the most likely. While it needs to repay 14 billion euros of debt in 2014 and 15 billion in 2015, it only has to repay about 10 billion in 2018.

Ireland had it easier. Its not-so-packed near-term repayment schedule allowed it to swap 2014 for 2015 paper for only a 25 bps cost in January 2012, in line with secondary market prices.

Its second debt swap was perfectly timed. It came on July 26 - the same day European Central Bank President Mario Draghi pledged to do "whatever it takes" to solve the euro zone crisis.

The swap was a minor part of a 5.2 billion euros long-term debt sale, whose success was seen as decisive in taking Dublin off official support.

Portugal also faces more problems than Ireland did at the time. Investors are still not confident its government can survive many more austerity protests as it tries to cut the budget deficit to 4 percent of GDP next year from 2013's 5.9 percent. Concerns remain about the country's growth potential.

"We might be looking to invest in that market in the near future," said Fadi Zaher, head of bonds and currencies at Kleinwort Benson. "But they need to bring fiscal discipline on track and show the austerity is working." ($1 = 0.7260 euros)

(Graphic by Vincent Flasseur, editing by Nigel Stephenson, Ron Askew)