Irish woes small part of firms' European fears

An expected bailout of the Irish government and its moribund banking system has done little to quell bond managers' uneasiness about risks in the European periphery, and bond managers view the Irish problem as a mere distraction from the main event: Spain.

As a result of the crisis, European bond managers are shunning investments in the peripheral nations or making very limited, opportunistic bets on bonds of individual countries or companies.

“(An Irish bailout) doesn't really draw a line under the whole peripheral crisis,” said Richard Dryer, head of EMEA credit at Aberdeen Asset Managers Ltd., London. “In reality, the next big issue is Spain.”

“(Spain) causes us a greater loss of sleep” than other peripheral European countries, agreed Ralph Frank, head of solutions for investment consultant and discretionary manager Cardano Risk Management BV, London.

Spain is important because of the size of its economy, which towers over the fellow peripheral countries of Portugal, Ireland, Italy and Greece.

The European Financial Stability Fund — a €750 billion ($974 billion) safety net set up by the European Union and International Monetary Fund in May — can prop up Greece, Ireland and Portugal, but a sinking Spain is widely thought to be too big for the fund to rescue.

While bond managers and economists view the European debt crisis as far from over, the good news is that Spain looks relatively healthy, unencumbered by the policy shortcomings of Greece, the oversized banking sector debts of Ireland and the dismal economic growth of Portugal.

“Spain is doing everything it should, and it doesn't start from as bad a position as Ireland ... or Greece,” said Jacob Funk Kirke-gaard, research fellow at the Peterson Institute for International Economics, Washington. “So, I'm pretty optimistic.”

The Spanish government has been aggressive on fiscal tightening and structural reforms, and Spain is increasingly less dependent on foreign financing, Willem Verhagen, senior economist at ING Investment Management, The Hague, Netherlands, said in an e-mailed response to questions.

Plus, Spain's “banking sector has made some real progress. ... Exposure to property developers and construction companies has been reduced severely while, contrary to Ireland and Portugal, dependence on (European Central Bank) financing has fallen since early summer,” Mr. Verhagen noted.

Spain still remains susceptible to contagion effects, both from problems in sovereign debt and banking sectors of other countries, he said. “The contagion effects are self-fulfilling in nature and therefore not that much related to the fundamentals. If this should happen, Spain may well need assistance,” Mr. Verhagen said.

But the crisis has European bond managers worried.

“There's still a lot of concern about the overall debt profile of these European peripheral countries,” said Ranjiv Mann, chief economist at bond manager Rogge Global Partners PLC, London. “The problem with all of these countries is they're being forced into (adopting) massively deflationary (policies). The problem is, how do they generate growth in this environment?”

Rogge has “continued to prefer to own core European (sovereign) debt” from countries such as Germany and the Netherlands, while focusing on credit investments from “well-diversified corporate issuers” that don't have a lot of exposure to peripheral countries, Mr. Mann said.

Newton Investment Management Ltd., while also leaning toward the debt in the core European states, has bought some Irish sovereign debt — specifically that which would be backed by the EFSF rescue fund, said Paul Brain,investment leader, fixed income.

However, Mr. Brain said the European stability fund is structurally flawed, and weakens with each bailout as the burden of funding falls on fewer countries' shoulders. “That brings forward (the fund's) demise pretty quickly,” he said.

Ben Bennett, credit strategist at Legal & General Investment Management Ltd., London, said location doesn't matter for credit investments: “What matters is where the cash flows come from.” LGIM has bought and sold individual securities in peripheral countries when they are underpriced, being careful to pick companies whose cash flows aren't concentrated in peripheral states.

Aberdeen's Mr. Dryer said the outlook for corporate credit market in Europe overall is decent. “Everything else is stacking up to be pretty positive, it's just this peripheral issue,” he said.

Aberdeen has taken only small positions in Irish banking debt. “The senior banking (sector debt) risk is attractive at these yield levels, but it's a very political and uncertain situation,” Mr. Dryer said.

While holders of Irish sovereign debt likely would be protected by a bailout, some experts doubt the same protections will be offered to holders of Irish bank debt, whether senior or subordinated.

In trying to prop up the nation's banks, the Irish government flooded itself with liabilities — to the tune of 176% of its gross domestic product, according to the Peterson Institute's Mr. Kirkegaard. Given the political choice of honoring those commitments or minimizing the burden of the bailout shouldered by Irish taxpayers, the decision is easy, Mr. Kirkegaard said.

“Even all of the senior creditors in the Irish banks won't see all of their money,” he predicted.

Philip Shier, senior actuarial consultant at Aon Hewitt in Dublin agreed. “There seems to be a growing expectation that bondholders will have to take some of the pain — that taxpayers can't take it all.”

Investors' overwhelming approval of an 80% write-down on subordinated debt from Anglo Irish Bank Corp. Ltd. last week shows that the market is expecting further pain, Messrs. Kirkegaard and Shier said.

“I think that it is moving in that direction,” Mr. Shier said.

Kathleen Gaffney, vice president and portfolio manager at Loomis, Sayles & Co., LP, Boston, said it's only a matter of time before bond investors see sovereign defaults in the European periphery. Still, she's betting that prices on debt of beleaguered states fall below the amount of the “haircut” that bondholders will have to take on the investments. “We're looking at the entire (peripheral) area and looking for where discounts in sovereign debt are the largest,” Ms. Gaffney said.

The latest turmoil shouldn't have much impact on Irish pension funds, as they have diversified away from home country bias during the past decade as part of the move to adopting the euro. Major pension funds hold little Irish debt or stocks, Mr. Shier said.

But that could change under new legislation the Irish government plans to introduce, according to the recovery plan announced last week.

Irish pension funds and the €24.5 billion ($31.5 billion) National Pensions Reserve Fund, Dublin, could be encouraged or required to buy Irish sovereign debt next year, the 140-page “National Recovery Plan 2011-2014” said. Just 15% of Irish government-issued bonds are owned by domestic investors, the plan said.

One proposal being discussed among pension and government officials is a move to sovereign annuities, or annuities based on yields of Irish sovereign debt. That would lower liabilities, as Irish debt yields are typically greater than those on German bunds, which are now used to calculate liabilities.

“That clearly in itself would incentivize trustees to hold (Irish debt to match liabilities),” Mr. Shier said.

The plan also states that the NPRF's resources will be made available to support the Irish government bond market. “Such a step would be very beneficial to the markets and would demonstrate the government's willingness to ensure (its own) funding.”

The NPRF's €6.6 billion of investments in Irish banks, made in 2009 as part of a bailout of the sector, would not be affected by the new proposals.