Thinking about Haircuts

What a cruel month April has been to the peripheral debt markets. Greek 10-year yields have risen 349 bp, more than the cumulative increase over the previous 11 months. Portugal's 10-year yield has risen 180 bp this month and 190 bp over the previous 11 months. Of the three, Ireland has performed best with the 10-year yield rising 42 bp this month after rising 460 bp in the prior 11 months.

The surge in two year yields is even more pronounced. Greece's 2-year yield has risen almost 1000 bp this month, including the 140 bp today. Portugal's 2-year yield has risen 460 bp and Ireland's yield has risen 175 bp.

Surely a great deal of bad news has been discounted. However, back of the envelop calculation warns of the risk that additional and steep increase in rates in order to fully price in a restructuring.

For the sake of the argument, let's consider Greece. It is paying about 1250 bp more than Germany on 10-year money. We have argued that the premium over the risk-free asset can be thought of as having two components. The first is an assessment of the odds of a haircut and the second is the size of it.

At the first look, the neutral assumption that the two factors are the same size. We take a square root of the premium. This would show roughly a 35% of a 35% haircut can be accounted for by the current spread.

Given the debt levels and the Maastricht goals, perhaps a 50% haircut is more likely. The current spread implies only about a 25% of this. A 50% chance of a 50% haircut would suggest the spread can widen to 2500 bp or more than prevailing rates.

On the other hand, we have consistently argued that a Greek restructuring is simply a matter of time. To quantify that belief, lets say it means an 80% chance of a haircut. The current spread implies only about an 80% chance of a 16% haircut. A 80% chance of a 30% haircut implies a spread of about 2400 bp.

This thought experiment explains why there may still be downside risks to the peripheral bonds. There are, of course, other ways to try to back into what is priced in, like credit default swaps, that may generate different results. One can also look at different maturities. This is not meant to be the final word, but to highlight one measure that suggests still serious risks may lie ahead.