European policy makers are setting up bond investors for a fall.
They're prodding them to buy the region's debt with unconventional monetary policies, but at the same time investors are losing almost any reliable way to hedge against potential losses.
Consider these recent examples:
1) Portugal's central bank imposed losses on some senior bondholders of troubled Novo Banco at the end of last year by transferring some of the debt to a newly created bad bank, which was being liquidated. That's bad.
What's worse is the move evidently didn't trigger credit-default swaps contracts, according to a recent ruling by an International Swaps & Derivatives Association committee, which was confirmed by a panel of lawyers. In other words, even if investors thought they were fully hedged against possible credit losses, they weren't.
This may be just one idiosyncratic case, but it's alarming because it sets a bad precedent at a time when the German Council has floated the idea of having a "sovereign insolvency mechanism." Under that proposal, the euro-zone bailout fund would postpone deploying any money in a future sovereign-debt crisis until bondholders had suffered losses, according to a Telegraph article.
2) It's incredibly difficult to sell negative-yielding bonds short, especially for international investors, in part because short sales of government bonds are closely regulated in Europe. Perhaps that's good in the short run because such sovereign debt will continue to rally in the face of unabated central bank and investor purchases.
But it's a big problem in the long term, especially as the total volume of such debt surges beyond $7 trillion globally, with a lot of that in Europe. These bonds may very well enter free fall at some point, should inflation pick up or central banks move away from their unconventional policies. Who will be there to take the other side of that selloff? Not short-sellers, who otherwise may be in a position to swoop in and buy to cover their shorts.
3) And then, there are the CoCos.
Investors bought about $100 billion of contingent convertible bonds from European banks in recent years. These securities, which were encouraged by regulators in the wake of the financial crisis, are kind of like stocks, kind of like bonds, and maybe more vulnerable than both to getting wiped out depending on a lot of fuzzy details. They're kind of untested.
Suddenly, holders of these bonds are becoming nervous for a variety of reasons. Their main way to hedge has been to try to sell -- which has caused sharp price moves in the debt of Deutsche Bank, Credit Suisse and HSBC -- or short-sell shares of the banks, which isn't perfectly correlated with credit risk.
They could buy credit-default swaps that protect against a deterioration in the bank's creditworthiness, but these also don't necessarily move in tandem with CoCos. That's because the contracts wouldn't be triggered if banks failed to make interest payments on this debt.
In short, as the total volume of European debt swells and yields plunge into uncharted territory, there are both gigantic risks and a shrinking number of ways to protect against them. This is problematic for investors with few other options, as well as the entirety of a market that's getting more vulnerable the lower yields go.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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