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The Bull 'n Bear on a Greek default and High-yield(?)



May 11, 2011 – Comments (0) | RELATED TICKERS: NBG.DL , BRK-B , GS

In today's press:

- Martin Wolf -- one of the must-read commentatorys out there -- has a very good piece on the quandary that Greece finds itself in. With crystal clear reasoning, he shows why a sovereign debt restructuring is basically inevitable at this stage. I won't try to summarize it; here is the crux of the argument:

Assume that interest rates on Greek long-term debt were 6 per cent, instead of today’s 16 per cent. Assume, too, that nominal GDP grows at 4 per cent. These, note, are highly optimistic assumptions. Then, even to stabilise debt, the government must run a primary surplus (before interest payments) of 3.2 per cent of GDP. If Greek debt is to fall to the Maastricht treaty limit of 60 per cent of GDP by 2040, the country would need a primary surplus of 6 per cent of GDP. Every year, then, the Greek people would need to be cajoled and coerced into paying far more in taxes than they receive in government spending.

What might persuade investors that this is sufficiently likely to justify funding Greece? Nothing I can imagine. But remember that 6 per cent would be a spread of less than 3 percentage points over German bunds. The default risk does not need to be very high to make this extremely unappealing.

Difficult to argue with that. Despite suffering massive losses already, National Bank of Greece (NYSE: NBG) shareholders should be concerned that further declines are possible. The bank's exposure to Greek government bonds is roughly equal to its shareholders' equity.

Eurozone governments have not done themselves by creating a slow-motion train wreck. In addition, private creditors should rightly be concerned that they will bear more than their fair share of losses, as the official sector now owns a significant portion of outstanding Greek debt (the European Central Bank owns roughly one-fifth.)

These concerns are reflected in Greek government bond yields and the cost of insuring against a Greek default. However, owners of European bank debt don't appear to have fully internalized the risks associated with a default and the possible knock-on effects on the European banking system, according to this article from Heard on the Street at the WSJ.

- If you want proof that the Fed's interest rate policy is distorting attitudes towards risk, the FT notes that junk bond yields are now at record lows by some measures. Granted, the spread to Treasurys is still twice what it was at the height of the credit bubble, but when Treasury yields are this low, one needs to wonder if it is enough to price junk bonds on a relative basis (i.e. at a spread to risk-free Treasurys). Junk bond investors should ask themselves: Forget the yield on Treasurys, is a sub-7% yield really qualify as high-yield?

Enjoy your day!

Alex Dumortier


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