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Would a EuroBond Just Make Things Worse?

November 25, 2011

by Curtis Bergquist

Here is the latest update and some conjectures regarding Germany's "failed" auction of 10-year bunds on Wednesday.

First, recall that for some time now one, if not the only, posited solution to the European Sovereign Debt Crisis has been the issuing "euro-zone bonds". These would be offered by the EU or ECB in some fashion to provide funds to solve the crisis. Some details have not yet been ironed out. One such is the question of "backing". Who would stand behind the new bonds? Would all 27 members of the European Union stand behind this new creation? Or, would perhaps the backing come from only the 17 EU countries which are also part of the European Monetary Union (the Euro-zone)? From what I have read and heard it seems that the answer is most likely the latter.

From that point we immediately are faced with another question: to what degree would each of the 17 Euro-zone countries be obligated to back the new debt? Also, how would the pricing of the joint euro-bonds be affected by the answer to that question?

One option is to limit each country's potential liability to a pro-rata share of the bonds outstanding based upon the ratio of that country's GDP versus the total GDP of the Euro-zone. This means each country would be on the hook for only a portion of the debt should a default or restructuring occur. Numerous further problems from this approach immediately come to mind. In the case of a default would 17 separate "recovery" operations or claims be required. Would the new Euro-bonds effectively be treated similar to the CDO tranches we all were forced to learn about a few years ago? How would this form of support shift and be altered as a given country's own credit standing changed?

I'm certain we could all come up with many more questions and areas of concern. The fact that we could clearly points out how complicated this idea actually is.

The second option regarding the backing of the bonds would involve some form of "joint and several liability" option. The problem here, in my opinion, is glaringly obvious. The Germans would be on the hook for the entire deal. I'm going to go out on a limb and suggest that the German voters may have a problem with this.

OK, so actually getting to the point where some European entity would, in some fashion, issue bonds which are supported in some manner by some as yet undetermined number of European Union countries, is likely still a good ways off in the future.

But let's assume that the major players will eventually (perhaps soon) resolve the problems, and/or at least their own differences, and that Joint Euro-bonds will soon be the "new toy" in under the "bond market Christmas Tree".

That brings us to some interesting thoughts and speculations regarding Germany's 10-year bund auction held yesterday.

It would be reasonable, I believe, to say that those players (traders and investors) who operate in the bond market arena are beginning to factor in the possibility of joint Euro-bonds being issued. One part of the new "modeling" would almost certainly be to estimate what the yield might be on said Euro-bonds.

One method that I have seen arrives at an estimated yield on 10-year Euro-bonds of as high as 5%. This is based upon the current yield of each Euro-zone country's 10-year bonds, weighted by that country's GDP. Perhaps the whole is greater than the sum of the parts. In that case the yield on 10-year joint Euro-zone bonds would be lower; perhaps 4%. Maybe 3.5%. Possibly even as low as 3%. Since Greece, Ireland, Portugal, Italy, Spain and Belgium (Dexia) are part of the 17 countries that would be backing the new paper I feel comfortable in assuming that a 3% yield represents the low end of the range of possibilities.

And now the key point.

Let's assume you are a potential bond buyer. You have funds to invest. There's an auction of new German 10-year bunds scheduled for Wednesday (yesterday). These are highly regarded bonds. So highly regarded that recently the 10-year bund rate was in the 1.60% - 1.70% range.

But you've heard that those new joint Euro-zone bonds may actually become a reality.

If the yield on those could be 4.00% or so, why not hold off on the German auction (at least a little) and pick up roughly double the interest rate on debt that is still backed by Germany?

Thus, once again, the Law of Unintended Consequences may be making its presence felt. Everyone wants joint Euro-bonds to be issued to "save Europe". But the possibility that such will actually occur drives buyers away from the German auction. That leads to "headlines" of a failed German bond auction. And that leads to a huge sell off in the equity markets.

Gotta love that L.U.C.

Have a great day!

Curtis Bergquist
Editor: Daily Decision-PRO

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