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Spain Regional Rescues Hurt Existing Debt Holders: Euro Credit

Spain Regional Rescues Hurt Existing Debt Holders
Spain is bailing out its regions even as the European Union’s highest unemployment rate and the nation’s second recession since 2009 drove its borrowing costs to records this month, and the government implements 110 billion euros of budget cuts. Photographer: Angel Navarrete/Bloomberg

Spain’s rescue of Catalonia and Valencia risks diverting the taxes those regions need to pay their debts, disadvantaging holders of more than $150 billion of regional debt.

Spain collects income, sales, gasoline, tobacco and alcohol taxes on behalf of its regional governments, excluding the Basque country and Navarra. More than half of the 65.9 billion euros ($81 billion) gathered in the first six months of the year was then assigned to local states, according to budget ministry data released today.

The government is doubling loans to 17 semi-autonomous regions to as much as 41 billion euros after the local authorities lost access to capital markets to meet debt redemptions, pay suppliers and finance their deficits. Terms of the backstops say that the regions’ tax share can be seized in the event of default, meaning the government would rank ahead of existing bondholders for repayment.

“The potential subordination is an element, which is implicit in the way the rescue mechanism has been designed,” said Fernando Mayorga, an analyst at Fitch Ratings in Barcelona. That subordination risk will become increasingly important in the event of rating cuts, he said.

Catalan Spread

Catalonia’s 850 million euros of 3.875 percent bonds due April 2015 yield 14.2 percent, up from about 3.9 percent when the securities were first sold in March 2010. That’s higher than the 11.3 percent investors demand to lend to European companies rated B, five levels below Catalonia’s BBB- rating at Standard & Poor’s, according to the Bank of America Merrill Lynch Euro High Yield index.

A default is very unlikely scenario, since Catalonia is committed to honor all its debts, said a Barcelona-based press officer of the Catalan government, who declined to be named. In any case, the central government will assume the maturities that regions can’t repay, she said in an e-mailed statement.

The Spanish regions had 123.2 billion euros of long-term debt in the first quarter, with 65.4 billion euros of bank loans and the remainder mostly bonds, central bank data show. The threat of subordination may mean local governments are unable to sell additional debt for even longer, according to Leef Dierks, a credit analyst at Morgan Stanley in London.

Subordination Concern

“As loans granted to the regions will be backed by their very own share in the centrally collected tax revenues, the element of subordination of already outstanding paper could come to the fore again,” Dierks said. “It could make it even harder for regions to return to the capital market anytime soon.”

Loans organized by Spain’s central government with the nation’s major banks and the state-owned Instituto de Credito Oficial include 17.7 billion euros to repay commercial bills, 5.4 billion euros for first-half bond redemptions, and an 18 billion-euro fund set up this month to cover bond redemptions in the second half of the year, as well as deficits.

The regions need about 16 billion euros during the next six months to roll over debts and meet anticipated budget deficits, according to Fitch data. Valencia, Catalonia and Murcia have combined short-term financing needs of 9 billion euros, Fitch said. Valencia said July 20 it will seek a rescue from the government, adding to at least 4.35 billion euros raised from Spain earlier this year to cover unpaid commercial bills, more than any region. Catalonia, which took 2 billion euros of aid to pay commercial creditors, may also request more cash.

Record Joblessness

Spain is bailing out its regions even as the European Union’s highest unemployment rate and the nation’s second recession since 2009 drove its borrowing costs to records this month, and the government implements 110 billion euros of budget cuts. The country’s 10-year yield rose to 7.75 percent on July 25 and dropped to about 6.6 percent today on speculation the European Central Bank will resume its bond-buying program.

The central government’s budget deficit for the first half climbed to 4.04 percent of GDP, topping its 3.5 percent full-year target due to transfers to administrative units including the regions, Deputy Budget Minister Marta Fernandez Curras said today in Madrid.

Spain reformed its constitution last year to include a commitment to restrict budget deficits and prioritize repayment of debt over other public sector expenses.

“The most important issue now is that the central government is aware of the regions’ lack of liquidity and that it’s tackling the problem,” said Jose Sarafana, a credit salesman at brokerage firm Aurel Bgc in Paris. “The potential subordination that the central government program involves is a longer-term issue, but the important thing is to solve the immediate liquidity problem.”

Basque Debt

Basque Country’s 700 million euros of 2019 bonds, which are rated A, Fitch Ratings’ sixth highest investment grade, yield 9 percent. The bonds from Basque Country, which hasn’t used the Spain rescue funds, yield 262 basis points more than debt with a similar maturity issued by Spain, which is rated three steps lower at BBB.

“I prefer to go for bonds of regions, which aren’t being bailed out since the rescue programs are very good news for the regions’ short-term creditors, but not necessarily for long-term debt holders,” said Ramon Nieto at Geroa EPSV Fondos in San Sebastian, which manages 1.1 billion euros, including bonds from regions such as Basque Country and Navarra. “Non-bailed out regions debt pay a premium versus Spain even as some of them such as Basque Country have higher credit ratings than the country’s treasury.”

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