Monday, January 17, 2011

EU Crisis Creates Arbitrage Opportunity

By Grant de Graf

Yield Spread: Portuguese 10-year vs. Bund 10-year

The Euro Zone is the unwilling master to a relatively new set of developments: a Greek tragedy, a howling Celtic tiger and a wind swept Algarve. But in the wake of the unfolding financial woes that are sweeping across Europe, one cannot ignore the opportunities that are flashing across screens, especially in the arena of bonds and the yields they are producing.

If the new bond issues by Portugal and Spain indeed carry with them the guarantee of the EU as is being proclaimed, it is difficult to understand why the German bund and the Portuguese bond for example, are trading at different yields. Although the 10-year spread between these bonds has narrowed after reaching a 429 point historic high, following the successful sale of Portugal's bonds last week, there still remains a significant gap. Seemingly, if both bonds assume the same risk, given the EU's guarantee for non-default or a bailout, the obvious trade would be to short the German bund and long the Portuguese bond, anticipating that the spread will narrow. There are however, a few things that could go wrong with this trade.

Firstly, the extent and terms of the guarantee by the EU against Portugal's default need to be established. The guarantee may not necessarily amount to a contractual obligation, but rather an indication of sentiment, which is not a premise that will persuade investors. Secondly, speculation about Portugal's financial demise could advance a sell-off of Portuguese bonds, even if the bonds are "guaranteed". No one wants to necessarily have to test the strength of a commitment.

Still, the fact that there exists a spread to such an extent between the yields is puzzling, if in fact the risk for the bonds is similar. This also suggests that investors have doubts about the extent of the EU's commitment to salvage Portugal, if the need should arise. Alternatively, the market suspects that the possibility of a Portuguese bailout could result in contagion to Spain, a country that in the words of economist Nouriel Roubini "Is too big too fail and too big to bail." Let's not even go there.