A 'haircut' on Greek bonds? A buzz cut would look smarter

With Italy's debt problems quickly becoming the financial markets' latest full-time preoccupation, it's some solace that at least the crisis in Greece has cooled. The Greek government's decision to back away from a proposed risky referendum on the euro zone's rescue plan has removed the threat of an imminent meltdown, and paved the way for the plan to significantly ease pressure on the country's crippled bond market.

But critics warn that while Greece may have moved to the back burner, the rescue plan isn't enough to turn off the heat. Greece's problems could well come to a boil again.

Still a heavy burden

The plan's key feature is the "haircut" that major holders of Greek bonds (mainly banks) are taking – it will slash the value of those holdings by 50 per cent. While that's obviously a deep cut and will instantly erase a huge portion of Greece's debt, it's not enough, argued National Bank Financial economists Krishen Rangasamy and Matthieu Arseneau in a recent report.

"Under this plan, Greek debt burden will remain high compared to what we observed for defaulted countries," they wrote.

They said the debt haircut is expected to reduce Greece's debt to about 120 per cent of its annual gross domestic product by 2020, from about 165 per cent today. Assuming an average interest rate on the debt of 5 per cent ("a conservative assumption," they said), it translates to annual debt-servicing charges of 6 per cent of GDP.

That would leave Greece with some of the highest post-default-event debt servicing costs we've seen over the past two decades, the economists said.

A little more off the sides …

"A more realistic target for Greece would be for a debt service of 4 per cent of GDP or less, which translates to an 80-per-cent debt-to-GDP ratio," they said. "To achieve that target in 2016, a haircut of around 65-70 per cent would be needed."

Sound crazy steep? Not really. This level of haircut would leave Greece's bondholders recovering 30 to 35 per cent of the face value of the bonds. The economists showed that historically debt that's rated as high-risk as Greece's by major debt-rating agencies can expect recovery rates averaging less than 25 per cent.