In a week in which euro zone debt fears returned in earnest for the first time in 2012, a positive investment tip about one of the three bailed out peripheral euro economies was eye-catching in its timing. RBS on Thursday issued a recommendation to its clients to buy the bonds of one of Ireland’s main commercial banks Bank of Ireland.
Now, financial markets have for some time priced Irish government debt more positively that either Greece or Portugal, in large part due to the country’s superior private sector growth prospects and the government’s seeming acceptance of and adherence to the austerity targets demanded in return for European bailout funds. That said, there is little end in sight to problem of banks bad debts and mounting mortgage arrears and few signs of recovery in a housing market where prices are down some 50 percent from pre-crisis peaks. Moreover, Ireland has scheduled a referendum on the new euro fiscal pact for May 31 and, if it’s rejected, the country could lose access to future euro emergency funds.
But, in a note entitled “The Celtic Tiger is coming back on track”, RBS credit strategists Alberto Gallo and Phoenix Kalen took a positive tilt on developments and recommended investors snap up the 8.45% yield available on the senior unsecured bonds of ailing, government-backed Bank of Ireland — the country’s “main viable bank”. The bonds mature in 2013 and had an original coupon of 4.625%.
The broad RBS argument is that Irish banks are tackling their problems, deleveraging more than banks elsewhere on the euro periphery, using less ECB liquidity and doing fewer sovereign carry trades. But the main reason for the trade is that they do not expect government support for the banks to be removed before the maturity of these bonds next year and therefore feel the 8.45% yield now available is a pretty good compensation for interim risks of deposit flight and those emanating from exposure to the still-dire local housing market. What’s more, this yield is a premium to the 10-year Irish government bond yield of some 6.9 percent even though the banks continue to be effectively gauranteed by the sovereign. The reason for the premium is the risk the government backs away from that pledge, something very much at the centre of the debate about rescheduling promissory note payments to the shell of failed real estate lending behemoth Anglo Irish Bank.
These risk premia reflect fears that the Irish government could reverse its support for bank debt, in our view. The IMF and EU are showing more flexibility for Ireland and have agreed last week to the exchange of the next promissory note payment for government debt. That said, we think concerns on senior bank debt haircuts are overdone, and particularly so for Bank of Ireland. First, haircuts are not necessary, as Ireland is currently on track with its fiscal targets. Second, a voluntary bank haircut would have negative systemic consequences for funding, potentially shutting both banks and the sovereign out of primary markets. Compared to the little amount of outstanding senior debt, this is unlikely to happen. Third, our economists expect the Irish referendum will centre on the fiscal compact, not on EMU membership.