Spain, Italy Bondholders May Still Trail in Writedown Seniority

Spanish and Italian bond holders may find themselves in the same place in the queue to take losses in a writedown of government debt even after European leaders renounced the preferred status of their bailout fund.

Chiefs of the 17 euro countries said after a summit today that the European Stability Mechanism will be able to recapitalize banks directly, rather than via governments, which will avoid increasing the public debt. Loans to Spain, which is to receive as much as 100 billion euros ($126 billion) for its banks, will be made through the temporary bailout fund and, when it becomes available, transferred to the ESM “without gaining seniority status,” the leaders said.

“Seniority is still with the ESM, just not for Spain’s bailout,” said Stuart Thomson, who helps oversee about $115 billion as a money manager at Ignis Asset Management in Glasgow. “Spain still has too much debt and nothing has changed to take Spain out of debtor’s prison. It’s a clever compromise.”

Spanish and Italian bond yields have surged over the past three months as Spanish Prime Minister Mariano Rajoy was forced to abandon his attempt to recapitalize banks without outside help as the country’s descent into recession obliged lenders to own up to spiraling losses. Pressure on those nations’ borrowing costs has stoked concern the currency union will break up and throw the world economy into recession.

Biggest Slide

Two-year Spanish yields fell as much as 97 basis points today to 4.45 percent, the biggest one-day slide since Aug. 8 when the European Central Bank started buying Italian and Spanish bonds to help cap their borrowing costs.

Italy’s two-year yield declined 51 basis points to 3.79 percent at 1:13 p.m. in London, after sliding as much as 81 basis points. The extra yield investors demand to hold the securities instead of German bunds shrank 55 basis points to 365 basis points.

The ESM treaty provides it with preferred-creditor status, junior only to the International Monetary Fund. The European Financial Stability Facility, which is scheduled to be replaced by the ESM this year, isn’t explicitly a preferred creditor.

Even so, what happened in Greece showed that official lenders aren’t willing to accept losses, preferring to force private bondholders to take greater writedowns. When the nation restructured this year, private investors were forced to write off more than 100 billion euros, or 53.5 percent of the face value of their investment, while official lenders -- the ECB and the European Investment Bank -- took no losses at all. As with the IMF, neither entity is formally a preferred creditor.

Words, Actions

“It’s not the words that make debt preferred, it’s the action,” said Pavan Wadhwa, global head of interest-rate strategy at JPMorgan Chase & Co. in London. “What makes bonds senior is the perception that when things go wrong and there’s a debt restructuring, the official sector will be given preferred status. The whole question about the ESM’s seniority and it saying that the ESM is now not senior any more is meaningless.”

Even if the authorities have given up seniority only as far as the Spanish bank bailout is concerned, it does help bolster investor sentiment, said Patrick Armstrong, who helps oversee $350 million at Armstrong Investment Managers LLP in London.

“Insofar as they are investing alongside you and they are protecting themselves, they are protecting you, too,” he said. “It’s useful. You’d really rather have someone taking the pain with you than not.”

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