EU Summit’s Failure May Consign Top-Rated Bonds to History
Europe’s failure to agree on a comprehensive solution to the sovereign debt crisis threatens to consign AAA rated bonds in the region to history.
Top-rated agencies in the 17-nation euro area have at least 847.5 billion euros ($1.1 trillion) of debt outstanding, according to data compiled by Bloomberg, and will be at risk should their sovereigns be downgraded. Moody’s Investors Service said today it will review the ratings of all European Union nations after last week’s summit failed to produce “decisive policy measures,” while Standard & Poor’s announced Dec. 5 it may cut 15 euro members, including AAA rated Germany and France.
“Double A is the new triple A,” said Raphael Gallardo, the head of economic research at Axa Investment Managers in Paris, which manages about $690 billion. “De facto, there are no more highly liquid, risk-free assets. It’s a dangerous problem because in a market crash, liquid AAA assets are the dam that contains the total exodus of liquidity.”
European leaders’ fifth attempt to draw a line under their debt woes ended in a fiscal accord that will bring tighter deficit rules, though with many details still to be ironed out and the U.K. vetoing an agreement among all 27 EU members. A lack of top-rated sovereigns would make it harder to gauge a risk-free benchmark for securities, reduce participation in euro-region debt markets and threaten ratings of agencies and supranationals such as the European Investment Bank and World Bank.
Markets signaled investors are disappointed with the outcome of the Brussels talks. Yields on 10-year bonds sold by Italy, which according to UBS AG data must repay about 53 billion euros in the first quarter of next year, climbed above 6.50 percent after falling on Dec. 9. France’s note yield was at 3.29 percent, from 3.13 percent a week ago.
The Markit iTraxx SovX Western Europe Index of credit- default swaps on 15 governments jumped 15 basis points to 378.5, approaching the record 385 set on Nov. 25. Swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements.
“The rating agencies are likely to be underwhelmed” by the summit, said Peter Tchir, the founder of TF Market Advisors in New York. “Countries will still be on watch and might still be downgraded.”
‘Soon as Possible’
S&P said it will publish a decision “as soon as possible” after the EU talks. Moody’s said there was the chance of “more severe scenarios,” including “multiple defaults” and “exits from the euro area.”
Banks use government bonds to make a return on their funds while they seek more profitable uses for them. The practice was encouraged by regulators, which agreed to view the securities as risk-free, and has now rebounded against the lenders. The European Banking Authority published last week the results of tests calculating the additional capital needs of banks that had to mark their sovereign bonds to market prices, finding a 114.7 billion-euro shortfall.
While a downgrade from AAA may make European assets less attractive to investors, the effects would be muted should ratings firms cut a wide group of sovereigns, according to David Watts, a strategist at CreditSights Inc. in London. When the U.S. lost its AAA status, its bonds rallied, he said.
“A government is the only supplier of risk-free assets for a particular currency because it can tax and, in the end, it can print money,” said Watts. “In Europe there are alternatives. If France gets downgraded, say, you can shift to Germany. But if Germany gets downgraded too, and their relative positions stay the same, then it shouldn’t make any difference.”
Supranationals, institutions backed by groups of countries and whose ratings depend on their backers’ creditworthiness, would also be under threat if sovereigns were downgraded, as would national state agencies.
German agencies including state-owned development and investment bank Kreditanstalt fuer Wiederaufbau, so-called bad bank FMS Wertmanagement AoR and agricultural financier Landwirtschaftliche Rentenbank have 563 billion euros of bonds outstanding, according to data compiled by Bloomberg. Similar agencies in France, the Netherlands and Austria have another 284.5 billion euros of bonds and bills.
Ratings of the European Financial Stability Facility, the region’s bailout fund, would be the same as the lowest grade of the current AAA backers, S&P said this month. The EIB, which is backed by the 27 members of the EU, is also under review for a possible downgrade.
“There is no direct relationship between our rating and our shareholders that is so strong it would automatically lead to a downgrade,” said Marius Cara, an investor relations executive at the EIB in Luxembourg. “Our capital isn’t structured on guarantees and our portfolio of assets doesn’t depend on the credit of the member states.”
Caisse d’Amortissement de la Dette Sociale, the French agency known as Cades that was set up in 1996 to refinance social security debt, also challenged the link between its top rating and that of its sovereign Dec. 7.
The yield premium investors demand to hold the EIB’s 5 billion euros of 3.5 percent bonds due 2016 instead of benchmark German debt is 166 basis points, up from 88 at the beginning of August, according to Bloomberg Bond Trader prices. The spread on the EFSF’s 3 billion euros of 2.75 percent notes maturing in 2016 was 156 basis points, up from 94 basis points Aug. 1.
“The fact that we’re talking about triple-A downgrades and the kind of volatility we’re seeing in spreads indicates that paradigms are changing,” said Ben Bennett, a strategist at Legal & General Investment Management in London, which oversees about $500 million. “We’re starting to get unhappy holders, people who thought they held one thing and then realized that wasn’t what they held after all.”