Investors tired of earning next to nothing on their safest securities but eager to boost their fixed-income holdings are flocking to bonds issued by the deficit-ridden PIGS of the euro zone. The migration reflects the attraction of higher returns and declining fears that the troubled countries - Portugal, Ireland, Greece and Spain - will default on their debts any time soon.
Meeting strong demand for a new 10-year issue, Portugal yesterday auctioned €990-million ($1.39-billion) of 3.85-per-cent bonds due in 2021, exceeding its target of €750-million.
This follows an even more robust response to fresh Greek debt last week, when institutional investors snapped up €5-billion worth of bonds carrying 6.37-per-cent interest, more than double the return on equivalent German paper, regarded as the safest of euro bonds.
"I'm not surprised that Portugal did rather well," said Robert Smith, a managing director of Boston-based Turan Corp., which specializes in distressed sovereign credits. "There is general agreement that Portugal will either pay or be rescued."
The bonds hit the market just as Fitch Ratings warned that Portuguese debt faces a downgrade from its respectable double-A ranking over doubts about its fiscal reform plans. Portuguese bonds in the marketplace already trade at about the triple-B-minus level occupied by such weaker emerging countries as Peru.
"There is an underlying belief that they are money-good, that they will not fail," David Ader, head of government bond strategy with CRT Capital Group in Stamford, Conn., said of the euro zone bond issues.
Whether or not they develop a rescue plan, European policy makers recognize they can't let one of the euro members fail, and they are making the bonds more attractive by ensuring that European banks take a chunk of each issue, thus guaranteeing the liquidity of their purchases, which can be more important to buyers than the value. "Even if they were to default in two, three, four, five years, you're going to be earning quite a bit of money in between," Mr. Ader said.
Still, the risks are large. If any of the peripheral European governments default, the euro would be hammered, seriously denting the value of all bonds denominated in the currency.
And there are other dangers as well. "When you have zero interest rates [in the short term] there is tremendous demand for yield, and there is mispricing of risk," said Saleh Daher, another managing director with Turan. "When interest rates go up, then these risky credits are going to get murdered."
Yet demand for higher-yielding fixed-income instruments has soared, as institutional investors willingly embrace more risk in their portfolios but continue to cut back on their costly hedge fund exposures and other money-losing efforts at diversification.
Mutual fund flows into fixed-income products have been rising rapidly in recent months.
In the first few days of this month, global bond funds scored their largest weekly inflow in more than a decade, reported EPFR Global, which tracks worldwide mutual fund flows.
Even a small fraction earmarked for higher-yielding assets, less than 1 per cent in many cases, can mean a hugely successful bond offering.
But it's not "an all-or-nothing bet," said Arthur Heinmaa, managing partner with Toron Capital Markets in Toronto. "It's the culmination of a lot of small bets. They're all saying, 'I'm not buying a Portuguese bond for 10 years, but I may buy it for one month or 90 days and turn around and sell it.' "
The problem is that this requires willing buyers when the holder wants to sell. And if these potential buyers have run for the hills, the extra yield may not be worth that much.
"The calculation here [by bond investors]is that at the end of the day, euro land is going to hold together. And that is not necessarily a slam dunk," Mr. Daher said.
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Risk assessment
The spread on the five-year credit default swap over the standard contract essentially shows how the market rates the quality of the credit.
PIGS ...in basis points
Portugal / 117.71
Ireland / 119.19
Greece / 288.51
Spain / 98.50
Argentina / 1,039.22
Venezuela / 958.25
THE GLOBE AND MAIL / SOURCE: BLOOMBERG