Evaluation: Cash for nothing – Portugal, Spain borrow extra, pay much less

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© Reuters. 20 Euro banknotes are displayed is this picture illustration

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By Yoruk Bahceli

AMSTERDAM (Reuters) – Spain and Portugal are on track to collectively shave at least 17 billion euros ($20 billion) off their debt service costs by end-2022, their crisis-borrowing spree essentially underwritten by the European Central Bank.

S&P Global (NYSE:) Ratings analysis shows the two countries are set to make the saving as their 10-year bond yields teeter on the cusp of 0%, thanks to the ECB’s aggressive pandemic stimulus, particularly its bond purchases.

In both countries the yields have fallen 40 basis points apiece this year, a far cry from the 2010-2012 debt crisis when soaring borrowing costs — in Portugal’s case to 17% — forced the duo to accept multi-billion euro bailouts.

For a graphic on Yields towards zero:

https://fingfx.thomsonreuters.com/gfx/mkt/nmovadgaepa/Pasted%20image%201606914280398.png

Analysis by Germany’s DZ Bank shows the ECB is expected to buy all the new debt Spain’s treasury has said it will issue this year, and over 80% of Portugal’s.

And if their bond yields fall below zero, effectively charging investors for the privilege of lending them 10-year cash, debt service calculations could be revised down even further.

Frank Gill, senior director in the sovereigns team at S&P Global, calculates that every 100 basis-point drop in the cost of debt at issuance cuts Spanish and Portuguese interest expenditure relative to gross domestic product (GDP) by roughly 0.1% the first year, and by 0.25% the following year.

He estimates Spain’s interest expenditure will fall around five billion euros this year — or 0.4% of GDP.

And by end-2022, it is expected to accrue savings of over 16 billion euros versus S&P calculations prior to the pandemic.

Portugal’s interest savings amount to 0.2% of GDP or around 380 million euros this year, Gill says and savings by end-2022 should total around 840 million euros.

Hence bond investors are sanguine about steadily mounting debt/GDP ratios which will end the year at record highs above 120%.

For a graphic on Interest expenditure set to decline across euro zone:

https://fingfx.thomsonreuters.com/gfx/mkt/bdwvklwmypm/Wk1zC-interest-expenditure-set-to-decline-across-euro-zone.png

“De facto, (the ECB) is monetizing this. The debt is not going into the commercial markets,” Gill said.

And once you factor in dividends national central banks pay to their governments on their holdings of the bonds, “then the actual cost of the debt is de facto zero. By that metric, it costs nothing to issue this debt.”

For a graphic on Euro zone debt ratios to remain elevated after pandemic:

https://fingfx.thomsonreuters.com/gfx/mkt/rlgvdayyxpo/PIMTr-euro-zone-debt-ratios-to-remain-elevated-after-pandemic.png

FURTHER FALLS

The moves may dismay those who saw Spanish and Portuguese debt as a higher-yield alternative to Germany and France.

But investors such as Arnaud-Guilhem Lamy, a BNP Paribas (OTC:) Asset Management portfolio manager, say 0% yields merely have a “psychological” impact when the ECB’s deposit rate is -0.50%.

Both countries also still pay “positive” real yields — returns after adjusting for inflation — rare among developed economies.

For a graphic on Spain and Portugal’s inflation-adjusted yields:

https://fingfx.thomsonreuters.com/gfx/mkt/xklpyblgkvg/spain%20port%20real%20yield%20nov%2024.png

Lamy therefore sees room for Spanish and Portuguese bonds to rally further, until they are around 25 bps above French 10-year yields, which currently offer around -0.3%..

Prospects of another 10 bps or so rally plus the ECB backstop should keep attracting buyers.

“It’s very difficult to have a longer term view on something that’s just got a big, almost price insensitive buyer in the background,” Simon Bell, a fund manager at Legal & General Investment Management, said.

“Even if you thought that over the longer-term, the debt was too high, it’s really not the time to take that on the longer-term view.”

One alternative is switching to Italy where one can earn 0.6% on 10-year bonds. The other option is to just buy longer-dated Spanish and Portuguese debt, Lamy said.

Portuguese 10-year bonds offer around 60 bps pick-up over Germany while holders of 30-year debt earn 90 bps.. The dynamic is similar in Spain.

As investors flock to longer maturities, yields will fall faster than at the short end, Saxo Bank strategist Althea Spinozzi predicted in a note.

Meanwhile, premia paid by Spanish and Portuguese 10-year bonds over German yields are near the lowest in over a decade.

That might be a reminder of the run-up to the 2010-2012 crisis when investors were happy to accept the tiniest of spreads.

But Yvan Mamalet, senior euro economist at Societe Generale (OTC:), says the debt will become problematic only if growth rebounds but governments continue to “run high deficits that will increase their debt ratio without any need to support the economy”.

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