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'Relative-Valuing' the EU Rescue Fund’s Bonds

The euro zone’s bailout fund, the EFSF, was set up to provide a backstop for euro sovereign members who get into, er...payment difficulties. To date the EFSF has issued two bonds, the first in January maturing in 2016 and a second one in June that matures in 2021. This week those bonds were trading as follows:

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2016 bond Libor + 68 basis points

2021 bond Libor + 86 basis points

This is an interesting market vote of confidence on the euro as a project that is long-term viable in its current state. After all, if we thought that the euro would not be around in 5 and 10 years, or still in existence but in some modified form, we would surely demand a higher premium for holding these bonds?

Perhaps, and perhaps not. The bonds are rated AAA/Aaa/AAA, which commands a certain spread in its own right. But two countries whose sovereign debt is currently in the firing line of investors’ credit risk concerns, Italy and Spain, are themselves EFSF backers to the tune of 18.7 percent and 12 percent respectively. Italian 10-year debt is trading at 352 basis points over Libor, while Spanish 10-year is at 299 basis points over. Germany’s on the other hand is at 69 basic points below Libor. When one factors in the French sovereign backing (21 percent), we have half of the fund being backed by countries whose sovereign debt position and banking sectors are all in danger of coming under severe pressure post a Greek default.

So how solid is the formal credit rating of the EFSF, given that a third of its liabilities are backed by two countries whose debt situation the EFSF has been designed explicitly to address? Well, possibly the implication of that question is inaccurate: one might argue that the EFSF was put in place to bolster market confidence in the peripheral euro zone countries of Greece, Ireland and Portugal. But this is disingenuous: Spain has always been viewed as being in this troubled group (hence the inelegant acronym PIIGS), and to suggest that the stability fund still has a AAA rating when 12 percent of it is guaranteed by one of this group is optimistic to say the least.

This column has commented ad nauseam on what needs to be done in order to preserve the euro project in its current state over the long term. It is far from guaranteed that we will see movement in all the required areas (centralized budgetary authority, role of the ECB as lender-of-last-resort, etc) in the coming months—so is the current price of the EFSF’s bonds a vote of confidence in the euro? It’s difficult to see how it isn’t, but current prices for euro zone debt—Germany included, its 5-year CDS price is above that of non-euro members Britain and Denmark—show just how nervous the international investor community is about the euro’s immediate prospects.

It would be easy to conclude then that the EFSF bonds are over-valued. Something has got to give, and until we get some more concrete proposals and action, one would be right to expect the credit spread on those two bonds to widen.

The author thanks his old chum Stuart Turner at Newedge Group in London for inspiring this article…

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The author is Professor Moorad Choudhry, head of business treasury, global banking and markets at Royal Bank of Scotland and visiting professor at London Metropolitan University.

The views in this article represent those of Moorad Choudhry as a private individual, and do not represent the views of Royal Bank of Scotland or London Metropolitan University.