Greece: investors can be fooled, but mathematics cannot
Greece did it on April 9 and Portugal two weeks later (having done it previously in January). Both countries, among those hardest hit by the euro crisis and the austerity straitjackets imposed on them, came back to the markets to issue government bonds.
Greece sold EUR 3bn of a five-year bond with a coupon of 4.75% at a price of 99.13% (effective yield: 4.96%), and Portugal auctioned EUR 750m of a 10-year bond at 3.58%. The media hailed the events as "the euro crisis finally fading away" and a form of "normalization" for both countries. Their embattled populations might argue otherwise, with unemployment rates nearing 30% in Greece and 20% in Portugal. But then again, why shouldn't we enjoy the moment after four years of crisis? A lot of investors, seeking yield and not dwelling on the risks, were enthusiastic about the issues, and oversubscribed them. And isn't the market always right?
In our view, prudence should still prevail. Let's look at Greece. It ended 2013 with a public debt-to-GDP ratio of around 177%, higher than it was in March 2012 (170%) before it applied a 50%-plus haircut to the privately owned part of its government debt.
How might this ratio evolve? It depends on whether the debt grows faster or slower than the economy, which further rests on two factors. One is the government’s primary surplus or deficit, i.e. its revenues minus its outlays save the debt servicing. Although disputed, Greece did indeed achieve a primary government surplus in 2013. It amounted to EUR 1.5bn, or 0.8% of GDP.
The second factor is the average interest rate the government has to pay on its outstanding debt. At the end of 2013, thanks to the 2012 restructuring, Greece’s net average interest rate cost was 2.3%. As a comparison those numbers were 2.6% for Germany and 3.9% for Italy. While quite low, the rate is poised to rise in the coming years.
But let's boldly hypothesize that Greece will manage a primary surplus of 1%, and that its net average interest cost will stay where it is for the next several years. Then Greece would need only 1.8% nominal GDP growth (real growth plus inflation) to stabilize its government debt-to-GDP ratio where it is today. Unfortunately, Greece now has a deflation rate of -1.5%, meaning that it would need a real growth rate of over 3% if deflation remains where it is.
Worse still, a stabilized government debt-to-GDP ratio is not what Greece agreed to with the Troika (EU, European Central Bank and IMF) in 2012. It promised to reduce its ratio to 120% by 2020. Even under our hopeful assumptions, Greece would need to post an average nominal growth rate of 7.5% for the next seven years to achieve that, which seems quite implausible.
Thomas Wacker, UBS CIO Head of Credit and Fixed Income, offers another argument against investing in Greece’s debt. Noticing that the country’s net interest expenses relative to government revenues are at 10%, he tries to determine how much debt Greece can afford: "Starting from current annual government revenues of EUR 80bn, a 10% net interest-to-revenues ratio means that EUR 8bn are available for interest payments. At 4% average interest cost [this remains a very low assumption, given that the interest Greece currently has to pay on new issues is higher], the maximum affordable debt burden is therefore EUR 200bn (109% in debt-to-GDP terms), compared to an actual debt burden of EUR 330bn, implying that a 40% debt reduction is required."
While the debt perspectives for Portugal are less bleak, it too should be viewed with caution, especially since all the debt projections assume that the ongoing global recovery will last for the next five to 10 years, which is seldom the case.
All in all, government bonds from the European periphery are not our choice in the bond market. We prefer alternatives in European investment grade and high yield corporate bonds that offer better risk/reward characteristics.