covered bonds and EU sovereign debt

Happy New Year

I first started looking at Europe as an equity investor in 1986.  What struck me most forcefully was the Babel of languages, customs, laws and investing habits, all packed into tiny little countries with only a couple of stocks each that you might want to buy.  Translation:  a huge learning curve, with not much investment payoff at the end of the day.

I decided that instead of following the top-down, country-by-country investment process practiced by my London-based peers, I’d ignore the local politics, pretend that Europe was one big place and just pick stocks.  I was running a global portfolio for the first time.  I planned to make my money in US and Pacific stocks and hoped not to damage myself too badly in Europe.  As my funds under management got larger, I hired someone with a much better cultural and language background to concentrate on European stocks.

As it turned out, my performance in Europe was, more or less by accident, extremely strong.  And a sectoral approach, rather than the traditional macro-oriented country selection method, had become the conventional wisdom within a decade.

One negative consequence of what I did in the Eighties is that there are holes big enough to drive a truck through in my political-legal knowledge of European terrain.

One of them concerns covered bonds in the EU.

Covered bonds are collateralized, that is, specified assets are set aside to ensure that the borrower pays back interest and principal on the bond.  Collateral for covered bonds is specified by law is each country where they are issued, and usually consists of mortgages or mortgage-backed securities, or project loans to governments.

The idea of a collateralized bond is that in the case of default, the bondholders become owners of the set-aside assets.  What’s unusual about EU covered bonds is what happens in the case of the issuer’s bankruptcy.  Covered bonds are “ring fenced,” as Europeans like to say, meaning that the collateral belongs exclusively to the covered bondholders and no other claimants.

Under normal circumstances, this protection wouldn’t mean much.  But the EU is proposing that, starting in 2013, the union will no longer guarantee the safety of its members’ government bonds. If the issuing country is subsequently unable to pay its debts, a restructuring may follow.   As part of the process, post-2012 government bonds of that country may have their principal, maturity or coupon altered in a way that reduces the bond’s value.

It may well be that this proposal s not the final word on the matter and that existing government bonds of places like Greece will also be subject to a loss of value if/when a restructuring occurs.

The odd result of this situation is that bond investors should and do clearly prefer the covered bonds of European banks that are stuffed to the gills with sovereign debt of Greece, Portugal, Ireland et. al. plus an unknown quantity of dubious private debt, over the government obligations of member states.


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