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Loss Clauses May Not Dent Demand for New Euro Government Bonds

By Neelabh Chaturvedi and Tommy Stubbington

Euro-zone governments are set to start selling bonds with clauses that make it easier for countries to impose losses on bondholders, but analysts doubt that these provisions alone will make this new slice of government debt trade at a sharply lower price than existing bonds, at least for now.

Collective action clauses, or CACs as they are known, bind bondholders to a change in the terms and conditions of a bond contract if a predetermined majority approves of the changes. In the event of debt restructurings, such as the one in Greece earlier this year, that can leave some investors forced to incur losses.

Very few euro-zone government bonds have these clauses at the moment, but under European Union rules first revealed in 2011 from next year, all new government bonds sold by euro-zone countries will have them. Countries will have to ensure 55% of the bonds that they sell in a given year will be new bonds with CACs, so countries will be unable to meet more than 45% of their funding needs by re-opening old bonds issued before 2013.

That raises the specter of splitting this market, which lies at the heart of Europe’s debt crisis, into two, with one category of bonds more attractive to investors than the other, purely by virtue of carrying a lower risk in the case of a debt restructuring.

Other things being equal, that could threaten to disrupt liquidity in each of those markets, making them harder to understand and trade, and leading investors to ask a higher price for holding them.

Those concerns are pressing for some. But many suspect any impact will be modest at most, in the short term at least.

“Markets are likely to focus on such issues with far more scrutiny in periods of market stress than the prevailing calm, which has been witnessed in the past two months,” said Mark Dowding,co-head of investment-grade debt at fund manager BlueBay Asset Management, which has more than $45 billion in assets under management.

“We don’t see this issue having a big market impact,” he said.

Euro-zone government bonds have been on their best behavior in the last few months and yields on Spanish and Italian bonds have eased back to more manageable levels. That is mainly due to the European Central Bank’s promise to keep bond yields under control for countries that ask for aid and make the adjustments that are required of them. The risk of loss in a restructuring may rise, but for now, the likelihood of that a restructuring happening in the first place has shrunk.

Some market-watchers are concerned, as the looming changes imposed by European authorities have fuelled concerns that government bonds issued by a euro-zone country may suddenly not be considered the same. As the new bonds have clauses that make it easier to force a hefty loss on an investor without his or her consent, investors might shun them in favour of old bonds that are perceived to be more difficult to restructure. That could prove costly at a time a majority of these bonds are supposed to be these new bonds.

“Investors may become reluctant to buy long-dated CAC bonds and may opt for either shorter maturities or the existing lines,” said interest rate strategists at Commerzbank in a note to clients.

Still, even if the debt environment in the euro zone suddenly turned sour and a country had to restructure its debt, no restructuring that focused only on CAC-plated bonds would achieve a meaningful reduction in the debt stock, simply because there wouldn’t be enough of them.

And as the Greek debt exchange has shown, countries can retroactively insert CACs in their old bonds if they want. All of a sudden, the difference between old bonds and new CAC-embedded debt may disappear.

“Holding a domestic law bond without a CAC does not make it immune from restructuring,” Citigroup Global Markets interest strategists said in a research note.

“More broadly, all restructurings inevitably involve complex legal proceedings which are unique and hard to predict. As such, pricing differentials between domestic law issues are likely to be very small,” the bank’s analysts added.

BlueBay’s Dowding agrees that the Greek example showed that the absence of a CAC is no guarantee a bond won’t be restructured, provided it is governed by domestic law.

That’s not to say that countries with particularly shaky finances will be immune from investor speculation over the long term. But for the immediate future, the new and old government bonds issued by a euro zone country with stable debt dynamics look set to live in harmony.

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