Jumat, 23 Maret 2012

Spanish Bond Yields - Who's A "Natural" Buyer Of The 10 Year


From Peter Tchir of TF Market Advisors
Spanish Bond Yields - Who's A "Natural" Buyer Of The 10 Year
Spanish 10 year bonds are above 5.5% now.  They once again failed to hold early gains, and the losses seem to be accelerating. 
Once again, the back end of the curve is “flattening” with the 5 year 9 bps higher, while the 10 year is only 4 higher.
The 2 year has barely budged, which is largely because a lot of that paper is tucked away in non mark to market books of banks and doesn’t reflect any actual market price.  With so much manipulation of the market, you have to pay close attention to the signals that are least affected – like the 10 year bond, and even the 5s/10s spread even though the 5 year is far more anchored by artificially low 2 year yields.
It also seems that the number of runs that I’m seeing on Spanish bonds, and the big CDS indices has decreased a bit over the past couple of days – potentially a sign that dealers are caught on the wrong side of the market and the only flows they are seeing at these price levels, would take them even deeper into the hole.  That usually precedes a gap in spreads.  (or it could just be a bunch of traders taking long lunches on a Friday).
Who is the “natural” buyer of Spanish 10 year bonds?
Banks:  Banks always tended to buy 5 year and in.  10 year bond never fit banks as well as shorter dated bonds, so they were never the core buyer of this part of the curve.  This desire to be in shorter maturities has been accentuated by the LTRO.  LTRO encourages banks to buy 3 year and in paper for 2 reasons – i) no funding mismatch at maturity of LTRO, and ii) since LTRO is collateralized, far less risk of having to post variation margin on short duration bonds (at least until the whole curve inverts).  So banks across the board have many incentives to participate in the short end which was their natural tendency to begin with.  So banks as a whole do not like the long end, and foreign banks will dislike it even more.  It is very hard for a non-Spanish bank to justify long term positions in Spain.  There is $100 billion of debt in the Spanish system where banks issued bonds to themselves, got it guaranteed by Spain, and are using those bonds to get central bank money.  As a non-Spanish bank, you have to look at that cozy relationship and be nervous.  If, and when, the Spanish financials deteriorate, it is hard to expect fair treatment as a foreign bank when it is so clear that Spanish banks and the government have become very interconnected. 
So the reality is, the only banks that might buy long dated Spanish bonds are Spanish banks, and they are already pretty full of Spanish debt and even they much prefer to buy the short end.  In theory, that special little subset of Spanish banks, the Caja’s, might do as they are told, but since they are already on life support, that is hardly a deep pocket investor.
Insurance Companies:  Insurance companies have typically been the core buyers of longer dated sovereign debt.  It fits their asset/liability management programs well.  For Spanish longer dated bonds to find real support, they will need insurance companies to buy.  But will they?  First, the economic situation in Spain is bad.   The unemployment numbers are staggering, and the 50% youth unemployment rate is worse than in Greece.  The budget deficit is nowhere close to 3% and unlikely to get there in a declining European economy.  So the fundamentals don’t support investment, but that is only part of the problem.  Officials can talk about the low debt to GDP in Spain, but professional investors have to look at all the contingent and hidden debt.  Spain has implicitly and explicitly guaranteed the municipal debt.  The Spanish government is in up to its eyeballs in helping the Caja’s.  They have participated in the LTRO ponzi bond scheme even more than Italy has on a relative basis.  These contingent liabilities will make insurance companies more reluctant, but that would still be part of the “fundamental” analysis.
The intangibles are also lined up against investing in Spain here.  The insurance companies just had PSI shoved down their throats on Greece.  They were forced to participate.  They saw new laws enacted that were retroactive.  In a case where the fundamentals leave Spanish bonds as a dubious investment, the intangibles make it very scary.  Who wants to buy a bond today on the “hopes” that Spain won’t change laws, won’t demand debt forgiveness, won’t favor their own banks and insurance companies?  The reality is that only Spanish insurance companies are going to be keen to buy Spanish 10 year bonds since they are living in the fundamentals, and can’t really explain to their own politicians that they don’t want to invest, because they don’t trust the government.  They are already long these bonds, and it is unclear how much new money they are getting to allow them to invest more.
At some point insurance companies will buy longer dated Spanish bonds, but the fundamentals aren’t encouraging, and all the tricks and games and ploys that the Troika used to force losses on some Greek bondholders are too fresh in the minds of these investors to be buying hand over fist, at least not at these yields/prices.
Hedge Funds:  Hedge funds are part of the problem, not the solution.  Many funds are caught long this paper.  Unlike banks, who stuck to the short end during the rally, hedge funds piled into the 5 year and out part of the curve.  Some were covering shorts that were being driven in their mush on a daily basis.  Others only fully bought into the rally this year.  They finally decided that LTRO must be great, because it seemed like it was working.  They bought into the theory that Europe was somehow okay, and that even if things weren’t fixed, the next problem was far down the road.  I believe these late converts are the ones behind much of the recent selling.  They saw that yields had stopped moving tighter, saw day after day of small weakness, and then finally started seeing some real moves with some significant P&L impact.  Most will be getting out of their long positions here.  Any fund that bought Spanish 10 year bonds after January 12th is underwater now.  Depending on when you bought them in December you may now have losses too.  That is ignoring the fact that whatever P&L you showed on your February statement, is getting hit hard with the 10 year now down 4.5% since you closed the books.  I am not sure we have seen a renewed attempt to get short Spain by hedge funds.  I believe the bulk of the flows so far have been from hedge funds cutting Spanish risk, and not yet from those trying to get short, though that is some of the flows.
So hedge funds are likely still cutting longs, and will be growing shorts, not helping the move, but if they feel that the EU will step up and attempt to drive bonds higher, they will reverse direction. So for now, hedge funds aren’t the buyer, but they will be the easiest to convince to get “long for a trade” if not as a longer term investment.
Basis Trades:  Some people who are short Spain via CDS may buy Spanish bonds.  That is often a source of liquidity at times of stress.  I think it will have less of an impact than usual.  Spanish bonds still trade at high prices, even the 10 year, is above 102, so without the potential windfall profit from a “jump to default” scenario, they will be less likely to tie up capital on the basis (lower dollar price bonds give more positive convexity to the basis buyers).  There are also some concerns about how lucky the CDS settlement on Greece was.  The fact that the settlement for “old” CDS was on “new” bonds is scaring the more thoughtful basis traders.  The “new” bonds could have come at a much higher price, and with the settlement structure, could easily have caused large losses for the “basis” players in spite of getting the Credit Event.
The basis traders (and those funds already short via CDS) will be potential buyers of bonds, but they will tend to focus on new issues, and the basis trade isn’t particularly compelling in Spain – yet.   Though it is a lot more interesting than a couple of weeks ago when bonds were trading very well relative to the less manipulated CDS market.
ECB SMP:  Will the ECB step in with their secondary market programme?  This is the fear of the shorts.  The only “natural” buyer, if you can call a central bank a “natural” buyer, is the ECB.  The ECB cannot like this move and cannot be happy that talk is turning negative again (though they should never have been so giddy about the price move in the first place).  So the ECB must be considering stepping in and buying bonds.  There are some problems with that.  The SMP program is still near its limit.  Since the ECB didn’t participate in Greece’s restructuring, they still hold all those bonds on their books – except for the €4.5 billion they just received for their March 20th bonds.  So it is a bit unclear how much more they can or will add (why they didn’t reduce the positions during this rally is a mystery to me – since they could have freed up capacity and booked a profit).  Looking at the ECB’s Greek positions, it is clear that they too were more comfortable at the front end, and although they participated in longer bonds, they did put the bulk of their money to work at the short end of the curve.  They will get over it, but it does seem that supporting the 10 year is less of a comfortable position for them (maybe Ben calls them and play the Twist for them to encourage them). 
Finally, the countries that back the ECB and the countries being “supported” by the ECB may be less enthusiastic about intervention in the past.  The SMP is not merely a programme that buys bonds in the secondary market.  It buys bonds, and magically converts them to “money good” senior bonds for the ECB.  The fact that the ECB owned so many Greek bonds and without some legal chicanery would have had large losses, must scare the countries that back the ECB.  No one expected the ECB to own bonds that could lose money.  Will Germany and even France support taking more risk with the ECB balance sheet?  If the ECB does buy, will regular investors get comfortable, or will the shorts over time become more aggressive, knowing that every euro the ECB buys, means more subordination for the remaining bonds and a much lower recovery in the event of default?
I think the ECB will attempt to calm the markets, but the amount of money spent will be underwhelming at these levels, and the market reaction will be even more muted than prior ECB interventions.
There are relatively few natural buyers of Spanish long dated bonds here.  Fast money is likely caught long, and it will take a potentially reluctant ECB and some already overly exposed Spanish institutions to step up and stop the slide.  It may happen, but many of the policies that “bailed out” Greece created very bad precedents for bondholders, and some of those are coming home to roost, as is the understanding that LTRO ensures that banks can access liquidity, but does nothing to fix any problem at the sovereign level.

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