Espirito Santo Threatens Flight From Risky Debt, Citigroup Says

Banco Espirito Santo SA’s woes are shaking complacency in the riskiest segments of debt markets that have lured investors seeking higher yields, according to Citigroup Inc. (C)

Credit-default swaps insuring the debt of Portugal’s second-biggest bank by market value for one year climbed as high as 692 basis points this month from 53 basis points in April after a company in the Espirito Santo group missed payments on short-term debt. The increase was partly driven by investors hedging their holdings of so-called equity tranches of a credit-default swap index, said Abel Elizalde, an analyst at Citigroup in London.

Investors had been buying these segments, which pay the highest returns but are the first to absorb losses, as bond yields held near record lows. While Portugal’s central bank has said that Banco Espirito Santo’s solvency is “solid,” investors may demand a higher premium or exit the trades, driving up the price of more senior portions.

“BES is a wakeup call to investors in the tranche market,” said Elizalde, who recommends investing in safer portions of the benchmark. “It’s a reminder that unexpected stories can happen, which means that the willingness of investors to keep selling equity protection is going to change and they’ll be keener to sell super senior protection.”

Lisbon-based Banco Espirito Santo will probably raise private funds to boost capital, Central Bank Governor Carlos Costa said on July 18. He said the option of tapping a fund reserved for recapitalizing banks under the country’s 78 billion-euro bailout ($105 billion) is a “last resort.”

Creditor Protection

Espirito Santo Financial Group SA sought protection from creditors last week after saying it was unable to meet some of its debt obligations, the Luxembourg-based company said in a regulatory filing. It was the third such request in a week from a company in the Espirito Santo group.

A flight from equity tranches could echo the credit selloff in 2005, when General Motors Co. and Ford Motor Co. lost their investment-grade ratings, according to Elizalde. That triggered losses for banks and hedge funds holding the riskiest part of collateralized debt obligations, securities that package bonds, loans and credit-default swaps and use the income to pay investors.

“The GM and Ford downgrades caused a correlation crisis as investors woke up to the fact that investment-grade companies could become distressed and even default,” Elizalde said. “The BES story can do something similar.”

To contact the reporter on this story: Abigail Moses in London at amoses5@bloomberg.net

To contact the editors responsible for this story: Jennifer Joan Lee at jlee176@bloomberg.net; Shelley Smith at ssmith118@bloomberg.net

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