Portugal bluffs a call

On February 11th, Portugal announced that it would buy back up to  9,4 bn of it’s own bonds in a reverse auction to be held this week. The idea is that the country calls bond holders to emit offers, has a look at the amounts offered at each price and sets a price that will secure him the desired amount.

Compare this to a bluff in poker, where Portugal would be a player who wants to show he’s so sure of his hand that, even though everyone at the table can see that his cash pile is alarmingly low, he is willing to risk more.

In fact, it is a comparatively low amount and, more importantly, its directed to April and June maturities. This diminishes in some degree the awe that the gesture is meant to produce, but still, brings again to the fore an interesting proposition worth exploring these days.

Can a country benefit from acquiring at a discount its own debt in the market? The argument in favor goes like this: the country pays only a percentage of face value but redeems it all. Hence, it obtains a condonation of its debt from the markets, without the stigma that a negotiated solution carries (being shut from new credit)

This is an argument so powerfully intuitive that it will always have strong supporters. In reality, however, the benefits of this operation tend to be elusive.

There are many good studies on this issue: this and this are two very accessible and authoritative ones. I will try to summarize the issues at stake here, though:

When investors lose faith in a country’s ability/willingness to serve their debt they become willing to sell it a a discount. The discount is the probability that the market thinks it has to recoup its investment.

Now, when the country decides to buy back its debt, it pushes demand and prices up. More fundamentally, investors, aware of the move, understand that the country will get rid of a significant amount of debt at a deep discount. This will leave a lower nominal debt to service. Since the country redeemed the debt at a discount, its paying capacity will have been reduced its reserves to a lesser extent than its (nominal) obligations. In other words, the financial situation of the country will have improved, which is not strange because this was the goal sought in the first place.

However, this improved financial situation coupled with the willingness it is showing to avoid default, will immediately be reflected in the price of its bonds. The remaining debt will see a lower discount and the country may very well end up with the same amount of debt in market value (even if the face value is lower) minus the reserves employed in the buyback. This unenviable situation is one that countries like Bolivia or Ecuador have found themselves at in the past.

There have also been a very few successful stories (I believe Brasil has been one of these but can’t be bothered to “research” it in twitter) What are the conditions for a country to benefit from a buyback, then? In the first place, the country must be legally able to do this operation. After all, a buyback can hurt the rights of minority bondholders or be discriminatory and hence some emissions forbid the debtor from buying back. Then, following factors play:

  1. Size of the acquisition: buying back the totality of the debt at a discount is the extreme. The country locks in its profits. If anyone can distinguish this one from a default, please send me private mail. Failing total redemption, the larger the amount bought back, the lower the impact of a rising price of not redeemed debt. A very small buyback, on the other hand, will have a very limited impact on the price of the remaining debt, but will also provide little benefit for the debtor.
  2. Size of the discount by the market: obviously, the higher the discount, the greater the gain for the debtor.
  3. Credible threat of collection by debtors: if the country can be forced to pay one way or the other, then buying back at a moment when debt trades at a discount could mean profiting from a window of opportunity. However if this is the case, the debt will typically be traded at small discounts
  4. Better perception by the country than by the markets of its financial situation. If the country knows its situation is substantially better than what the markets think, it may profit from this misperception without fear of the subsequent rise in unredeemed debt’s price, because it would have been unavoidable when the country kept paying back regularly. Normally this happens due to contagion from regional crisis as it has been the case in the few successful operations. Don’t try this at home… (an excess of optimism by the country will lead to hefty losses)

In the case of Portugal, 1 and 2 don’t seem to be met. 3 is probably checked and 4… I dunno, kind of scary, seeing the warning in bold letters. So probably Portugal’s motive here is less lucre than propaganda.

And indeed, if they can put a straight face and convince the market they are overflowing in liquidity, a crisis might be averted. At the amounts we talk about and with the ECB in the sidelines ready to back it up, it is likely that they complete the buyback without trouble and get no benefit of it (after all, who cares?)

However, if investors come “en masse” and they are flooded with paper at ridiculous prices, the success of this operation might well mean an endgame for Portugal’s debt. The markets would shut in panic that a default is underway and Portugal would go belly up.

What a strange game to play, where to win is to lose and to lose not to win… Sounds like a fado.


About Outis

Nobody is cooler than you
This entry was posted in Debt, Eurotrash, The tenpins, Trichet and tagged , , , , . Bookmark the permalink.

2 Responses to Portugal bluffs a call

  1. Outis says:

    The auction is over and it’s funny how reality always surprises us with unforeseen results. Instead of losing by winning or reaping an unproductive victory, Portugal seems to have successfully spined a rout as a victory.

    Theoretically, a good result for Portugal would have been a very large amount redeemed at a relatively high price (low yield) showing that investors are not willing to part with their bonds at a loss, since they have understood how wrong they were about the country’s ability to pay.

    Wednesday’s was a reverse auction, and the Portuguese treasury had to pick a price/volume point. Obviously, picking a low price was not an option, since it would have created a panic in the market (investors seen ditching Portugal’s bonds! – a little bit the kind of result that my drawing showed)

    So if investors were indeed ditching Portuguese bonds, what would the alternative be? Portugal would be forced to pick the cheapest tail of the bid’s distribution. Bids following a normal distribution, there will always be a small amount of bids for a high price (low yield) This would result in a small amount at a low price.

    What do the papers say about the auction? A small amount was bought back, at a very reasonable price…

    For some reason, this is generally being presented as a good result for Portugal, since it would show there is no hurry to dump its bonds. However, fact is 215 million were bought out of a 958 million bid, suggesting the average price offered was substantially higher to the one chosen.

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