Sunday 15 December 2019

Euro stragglers may be tempted to borrow their troubles away


Faced with a turbulent decade for family finances, if you could fix the interest rate on your massive mortgage debt at 3.5-4 percent for the next 10 years, you might well be tempted to grab it with both hands.

In some senses this is the choice facing debt managers for the euro zone's vulnerable southern members after six months in which long-term interest rates have fallen to implausibly low levels, the likes of which they may not see again.

Why not issue hundreds of billions of euros of long-term debt at current rates and pass the whole problem on to the next generation?

It may be just a tempting mirage, and likely only to remain that given the structure of the bond market, politics and the inherently conservative nature of national debt managers.

But it underlines the nature of this golden moment for debt managers in places like Italy and Spain, and begs the question of whether they should take more advantage of it now to avoid another Greek-style default in years to come.

"If I were an issuer - public sector or private sector - and someone said you can wait to pay a chunk of your debt for a generation at record low interest rates, I would be willing to pay slightly above current market prices now," said Håkan Wohlin, global head of debt origination at Deutsche Bank.

Wohlin and other senior figures at the world's biggest banks are the experts advising debt managers in Rome, Madrid and other capitals on where to go from here. The consensus is firmly in favour of arresting, and if possible, reversing a slide in the average duration of the loans countries have taken from global markets over the last five years.

That is happening slowly.

Spain and Italy both issued their first 30-year bonds since 2009 last year, and this week Ireland offered investors the chance to switch out of shorter-dated bonds for longer-dated ones - an exercise which is becoming routine for the bloc's most indebted states.

But having just emerged from a crisis where cautious investors were only prepared to trust them over short horizons, many of the euro zone's most fragile states are still faced with a mountain of debt repayments in the coming years.

Almost half of Spain and Italy's combined 2.7 trillion euros in public debt has to be refinanced over the next five years. With debt-to-national output ratios still very high and prospects for growth and a rise in prices that would reduce the value of the debt still uncertain, there is no guarantee that refinancing will be easy - or, at least, as cheap as it is now.

"Some public sector borrowers may not be able to repay a significant part of their debt load in the near term," Wohlin says. "Economists don't see sufficient growth for them to do it. Where is the cash going to come from? Perhaps monetization of dormant state assets, but still..."


One big barrier is the suspicion that current market pricing of the relevant governments' debt would not hold under the pressure of an avalanche of new bond sales.

"On one hand someone who's rational would want to issue debt for as long as possible, at the lowest interest rates," said Alessandro Tentori, global head of rates strategy at U.S. bank Citi. "But on the other hand you need to have demand."

Norway's huge national oil fund - one of the largest bond investors in the world - voted with its feet last month, saying it would steadily scale back the share of its holdings in bonds in traditional markets in Europe.

It says its expectations of both nominal and real - adjusted for inflation - returns are much higher than those now on offer.

"We have a 4 percent real return expectation from the government. If you add in 2 percent inflation, then that's a 6 percent nominal return," chief executive Yngve Slyngstad told Reuters last week. "You will not get that in the bond market in the foreseeable future ... We now have a real return in the bond market that is uncomfortably close to zero."

German 10-year bond yields currently yield around 1.27 percent, but with year-on-year inflation of around 1 percent, real returns are scant. In Spain, where inflation is zero, 10-year yields of 2.7 percent look a bit more palatable - but not enough to tempt the Norwegians.


There is also the problem that unlike a mortgage, raising a surplus of funding for ongoing needs can come at a cost.

If a country borrows more money than it needs to finance the state budget or pay back redemptions, then it has to re-invest that cash somewhere else until it is ready to spend it. Given the inherently conservative nature of debt managers, this is likely to be in short-term money market instruments that offer meagre returns - and a net loss.

"It can't just sit there making bigger and bigger losses," said Allegra Berman, global head of public sector banking at HSBC, pointing instead to the very low cost of borrowing over the short term for all these countries.

Any added cost is also a hard sell politically, and carries with it risks to already stretched debt-to-GDP ratios and budget targets being closely watched by Brussels.

"In the periphery, credit curves are still quite steep, and governments will not be prepared to pay up that much (for longer-term money)," Berman said.

"They could just be building up a problem that hits in 10 years time."

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