When investing in credit, you perform a cost benefit analysis by weighing the risks you are taking against the spread you receive over risk free securities. This excess yield spread is easily observable, and from it you can work out the implied probability of default. It is not the end of the story when a bond defaults though. The important factor that will determine the eventual loss that you may suffer will depend on how much you recover in bankruptcy, and when this recovery is realised. The difference between what you are legally entitled to receive (100 cents in the dollar) and what you actually get is termed a ‘haircut’. A bond that defaults where the bondholder receives a 100 percent timely recovery rate is not much of a problem, while severe haircuts dramatically reduce returns.
The corporate bond markets, particularly the dominant financial sector, will be facing a very interesting month ahead (financials form just over half of all investment grade corporate bonds in Europe, just under half in the UK). The Irish election is being played out on the back of a weak economy and fiscal rectitude.The previous administration attempted to guarantee all senior Irish bank debt, thus saving bond investors from a haircut, in order to maintain confidence and to reduce wider systematic risk. It was thought that the Irish crisis would be temporary. The crisis however is not temporary (see my previous comments here, and Anthony’s comment here). Ruling party Fianna Fáil, the architects of the policy error, is set to be replaced by Fine Gael on February 25th as the largest ruling party for the first time since 1927. The new arrivals are campaigning aggressively from a bondholders’ perspective, arguing that senior bonds in weak financial institutions should take a haircut.
When Irish senior bank debt was issued, investors received an extra premium for the risk but saw the probability of default as remote. The implied recovery rate was estimated to be high due to the systematic implications of bank defaults, as well as the fact that senior bondholders were perceived to rank legally alongside depositors. The problem with legal contracts is that they can be rewritten by governments, and depositors are heavily protected by the state operators as they vote for the government. Legal approaches to banks in difficulty have evolved, so now it is possible to split the claims of the depositor away from those of the bond holder, allowing the politically important voters to be protected while effectively subordinating senior bondholders. Sadly for these bond holders, the haircuts they’re likely to be forced to take need to be substantial in order to make a difference to the troubled issuers of the debt, and the haircuts need to be substantial for preferred creditors such as depositors to be paid out in full.
The Irish election and resolution of their banking crisis is a litmus test for how governments and other institutions will share the burden of losses. If losses are large for investors in Irish bank debt then it will not be a fantastic day for bank bondholders with or without Irish exposure.