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Talk of ‘bond haircut’ spooks investors, says Paul Brain


Paul Brain, manager of the Newton International Bond Fund, says the crisis in Ireland has come to a head in recent weeks after the German and French governments suggested that bond holders take some of the pain in future crises, a so-called “bond haircut”.

This spooked investors, given the real threat of sovereign defaults in some of the peripheral Eurozone states.

While they were swift to play down their comments, insisting they were talking about the future, the damage had been done, says Brain.

“The issue is that the European Financial Stability Fund– effectively a bail-out fund backed by the International Monetary Fund and European Union– will only last for three years,” he says. “As a result, those struggling economies will lose this support mechanism just as the ‘bond haircut’ proposition would come in. With the threat of sovereign defaults in the periphery of the Eurozone unlikely to have fully dissipated by then, borrowing costs of the peripherals are likely to remain high as uncertainty remains.”

The European Central Bank has been suggesting that Ireland uses the EFSF to support its ailing economy, but the Irish have refused so far, stating that they have sufficient funding through until the middle of next year.

Brain says: “However, the Irish banks are relying heavily on the short-term funding facility at the ECB, while the estimated cost of fixing its banking issues is thought to be in the region of 30 per cent of GDP. It is conceivable that the ECB will force the issue in order to recapitalise Ireland’s banks, and we believe this would be the right thing to do. However, this is likely to have a domino effect as Spain, Portugal and other peripheral Eurozone economies would be likely to follow suit in order to avoid being the next focus of concerned investors’ attentions.”

Brain says the EFSF is structurally flawed. It is funded by the IMF and EU. It is over-collateralised, so if the Irish were to borrow, for example, EUR50bn, the EGSF would have to issue bonds to cover that. However, if Spain and Portugal then did the same, they would be ceasing to contribute to the fund, the number of contributing countries would fall, and there would suddenly be a risk of the whole thing failing as a much greater financial burden falls on those not making use of the facility.

“Realistically, the Irish have no option but to accept the ECB’s proposals should abnormally high borrowing costs persist, as the short-term lending facility upon which Ireland is currently relying is expected to be wound down – a potential recipe for disaster in itself – and it would be left with no other options. Further quantitative easing and greater provision of liquidity seems like a safer bet,” he says.

“In terms of positioning, we have modest exposure to peripheral Europe, having reduced our Irish exposure in recent months. However, we continue to prefer Ireland over Spain and Portugal, owing to the scale of austerity measures already implemented by the Irish – with more expected in December’s budget. Meanwhile,” Brain concludes, “we maintain significant exposure to the core Eurozone states Germany, Finland and Holland, while we are underweight the euro.” 

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