Further downward pressure on Irish bond yields will be closely linked to improvement in sovereign debt sentiment

A PROFIT IS not always recognised in its own land. Last week’s revelation that a US west coast money manager had assembled a €5.5 billion holding in Irish government bonds caused a minor stir in Irish media circles. That this overseas fund manager chose to “exploit investment opportunities created by the volatility and panic during the second half of 2011” came as a surprise to those who would have long touted Ireland’s elevated bond yields as symptomatic of heightened default risk.

As an investment, this foray into Irish government bonds has paid handsome dividends. It has been reported that position-building started in late July of last year, at which time Irish bond yields were between 14 per cent and 24 per cent across the maturity spectrum. Today, Irish yields are straddling 4 per cent in two-year maturities, 5 per cent in five-years and are below 7 per cent in 10-year bonds.

The capital gains associated with such yield declines have delivered a total market return of 59.6 per cent from their mid-July lows, by some distance the best performance of any sovereign bond market globally over this period. The US fund manager in question is a self-confessed contrarian regarding his financial market pursuits. However, like all successful contrarians, there is clear “method in the madness” of his Irish gambit.

Ireland’s exaggerated yield levels of late July 2011 were a direct consequence of German finance minister Wolfgang Schäuble’s mid-April forewarnings of an imminent Greek debt restructuring, which caused “me too” panic in both the Irish and Portuguese bond markets. Such fears were accentuated by Moody’s junking of Ireland’s sovereign credit rating in early July, given the “increasing possibility that private sector creditor participation will be required as a precondition for additional [official] support”.

In the event, the Eurogroup summit of July 21st, while delivering on its private sector involvement threat to beleaguered Greek creditors, declared such actions to be an “exceptional and unique solution” to the intractable problem of Greek debt sustainability. For those prepared to accept the veracity of this official commitment, Irish bond yields (with their embedded restructuring risk premiums) represented a compelling investment opportunity.

Indeed, the Eurogroup summit supplied a further boost to Irish bond market sentiment, its agreement to lowering “bailout” interest costs and lengthening loan maturities providing a substantial fillip to Irish debt sustainability prospects.

The Irish bond market of late July 2011 was unloved and illiquid, and thus ripe for reversal. By late September, the yield spikes of April-July had been more than corrected and, following a consolidative period in October/November, further sharp declines in bond yields have been sustained to date.

Such reversal in fortune was doubtless catalysed by the west coast player, but the market’s sustained improvement has ushered in a broader church of investor interest, including hedge funds, banks, pension funds and insurance companies. Daily trading volumes have picked up commensurately, now averaging three to four times the debased levels of last summer.

Ireland’s fundamental backdrop has provided a solid underpinning for the improvement in bond market sentiment, with ongoing troika targets being met/exceeded on fiscal and banking sector stabilisation, and overall (GDP) growth performance by the Irish economy providing grounds for optimism that a corner is finally being turned, however slowly.

A heavy (€14 billion) redemption period for Irish government and government-guaranteed debt in the five months to mid-April next only serves to reinforce the market’s current supply/demand imbalance.

The bond market’s supply/demand technicals are even more robust, however. The Irish market is simply starved of paper, with no outright sovereign issuance since September 2010, and with that relatively limited €85 billion free-float of outstanding bonds (55 per cent of GDP) now additionally curtailed by accumulated ECB purchases (€15-€20 billion) and the “hold-to-maturity” carry-trades of Irish banks (€10 billion).

The investment appeal of Irish government debt has been reinforced by the credit rating actions of the past few weeks, during which both S&P and Fitch saw fit to reaffirm Ireland’s BBB+ investment grade status, while effecting a host of downgrades elsewhere.

Clearly, Ireland is reaping the benefits of having been an (enforced) early mover along the adjustment path towards economic and financial stability, with policy responses now lauded by S&P as having been “proactive and substantive”.

Indeed, last month’s peer-group actions raise a further question mark over Moody’s junked assessment of Ireland’s creditworthiness (BB+), not least given that the main consideration behind this substantially lower rating was last year’s perceived threat of a broader-based private sector involvement application for euro zone sovereigns, a threat no longer valid.

Also boosting the Irish bond market of late has been the NTMA’s surprise €3.5 billion exchange of existing 2014 debt for a freshly minted 2015 issue. This reduction in 2014 debt outstanding amounts to 30 per cent of the refinancing needs for that year and thus considerably enhances the Government’s cash management efforts.

Further, the new 2015 issue is now the obvious vehicle with which to pre-fund remaining 2014 obligations, either by way of additional bond switching activity or via tapping of the new bond as market conditions normalise during the course of this year.

Now that Irish bond yields have substantially normalised, further progress from here will be more closely linked to broader-based improvement in sovereign debt sentiment. Sentiment is a fickle friend, and that final all-clear on the euro zone debt crisis has yet to sound, not least with the second Greek bailout package (and attendant private sector involvement) still awaiting completion.

Nonetheless, all sides to the Greek debate appear finally to be converging on an orderly outcome. Meanwhile, the potency of the ECB’s latest crisis-resolution efforts (via unlimited three-year bank refinancing operations) is becoming increasingly apparent to both bond market participants and commentators alike.

The Irish authorities intend to take advantage of any debt “arrangement” that Greece secures with its troika creditors in seeking some restructuring of the €31 billion promissory note arrangements for the IBRC wind-down. The discussion on this issue has been somewhat confused, with undue focus on that red herring of high debt servicing costs (virtually all circulating among State-owned institutions).

More likely the focus will be on replacing the existing arrangement with an EFSF-funded alternative, not so as to reduce the debt-servicing burden per se, but rather to avoid the necessity of €21 billion in related bond market borrowings from 2014 onwards. Such a deal, if delivered, will provide a further boost to Irish bond market performance.

Donal O’Mahony is global strategist at Davy.