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Profits Made In Greek Tragedy

Buying U. S. Treasury bonds, which pay on average 20 basis points more than Government of Canada bonds for mid and long terms, is looking more attractive in spite of the American economy’s well-known problems. As well, the U. S. dollar is gaining respect. The greenback has been soaring as global investors flee from the potential default of the sovereign debt of several European countries, boosting the American currency’s exchange value dramatically in spite of what will be record U. S. bond issuance this year to cover the country massive tax and trade deficits. Investors will have to digest US$2.43 trillion of treasuries, a feast of debt that will have to made tasty with discounted prices and higher yields.

U. S. treasury bonds have become the ultimate refuge in the event that defaults by other countries take place. For now, the U. S. bond market is widely seen as the place to be, though in the long run, the troubled U. S. dollar offers only poor refuge compared to the fiscally sound Canadian dollar.

At the heart of the problem is a potential default by Greece, which could become the Lehman Brothers of the global bond market. Greece needs to sell 53 billion euros — around C$76 billion — of bonds this year, the equivalent of about 20 per cent of its GDP.

The European Union may figure out a way to bail out Greece, but then there would be the rest of the so-called PIIGS — Portugal, Italy, Ireland, Greece and Spain. A default by Greece could generate a contagion effect with other bonds tumbling. Because the PIIGs all use the euro, the currency could be pushed down and force the European Central Bank to intervene, but only if it could get the support of other central banks.

EU’S FOLLY

What has been happening in Greece shows the weakness of the European Union’s financial system. The European Central Bank, the ECB, controls interest rates. But there is no central fiscal authority with the power to control taxation and spending. That’s a lopsided financial system and the problems in Greece are showing what can happen not just to Greece, but to the rest of the PIIGS.

When Greece joined the EU in 2001, its public debt was more than 100 per cent of its gross domestic product. Interest rates on its bonds were in the double digit range.

But going into the Eurozone, where rates were much lower, it was able to finance its public debt inexpensively and, it appears, deceptively via concealed foreign currency deals orchestrated by a major Wall Street investment bank. Cheaper credit was a green flag to the Greek government to spend with enthusiasm. When Greece went into a mild recession last year, the economy’s tax revenues declined. Credit rating agencies reduced the nation’s sovereign debt to the lowest of investment grades, B+, which is four notches below the AAA rating of the U. S., Canada, Germany, France and the U. K.

At time of writing, Germany says it may be ready to help out Greece. German Chancellor, Angela Merkel, wants to do the bailout, but her domestic opposition is threatening to topple her if she does. Germans have tightened their belts and reduced retirement benefits, while Greek workers have had their state retirement benefits enriched. It looks like a case of the poor — German workers — being asked to help out the rich — the Greek workers. Add in the official German unemployment rate of 8.1 per cent, and the bailout is clearly in trouble.

The EU’s economics commissioner, Joaquin Almunia, says that Greece will not default on its public debt and join the ranks of nations that can only raise capital at what amount to loan shark interest rates. Yet the global bond market has already priced default risk into Greek national bonds. They now pay nearly four per cent more than German state bonds, called bunds, but that’s no bargain if the bonds turn out to be no good.

If Greece does not get a bailout, then its borrowing costs — and the borrowing costs of other EU members, including the other PIIGS — will soar. If Germany does provide a bailout, there will be a cost and Greece or other European countries will have to shoulder it. This is not punitive. After all, when you borrow, you have to pay back the loan. And that is what the crisis is really about.

But if the other PIIGS also line up at the trough for handouts and get it, there will be a new rule in Europe that will reward profligate spending and put every member state’s credit rating at risk.

The issue comes down to whether Greece will get a bridge loan to help it pay. And that depends on the Greek government, which pays for pensions equal to 96 per cent of income when a person was employed.

MONEY FLOWS TO NORTH AMERICA

In this atmosphere of uncertainty, U. S. T-bonds and the U. S. dollar look good. So do Government of Canada bonds, but the Canadian bond market is small and lacks the depth to take in frightened money from the rest of the world. The action is therefore in the U. S. bond market and the currently hot U. S. dollar.

“We really do not know when the U. S. dollar will stop its rise,” says Patricia Croft, chief economist of RBC Global Asset Management in Toronto. But the problem includes contagion. If you extrapolate the present problems of the euro and the PIIGS, then you have to worry about the outlook for the future of the euro itself.”

Government of Canada bonds remain an island of tranquility, a fact reflected in lower perceived risks. Ten-year Canada bonds yield 3.39 per cent to maturity compared to 3.64 per cent for 10-year U. S.

treasuries. “Canada bonds appear a safer place to be,” says Christine Horoyski, senior vice president for fixed income at Aurion Capital Management Inc. in Toronto.

But that’s not the end of the story. “If the flight to quality continues, a trade into U. S. T-bills can still be profitable,” says Camilla Sutton, currency strategist at Scotia Capital in Toronto. She warns that on a yield basis, there is hardly any money to be made. But if an EU member state did default, U. S. treasury bills would be immensely profitable to holders.

Currency is the other subplot in this Greek tragedy. “In the near term, as the U. S. dollar strengthens, the Canadian dollar will not be able to rally,” Sutton says. “The U. S. dollar will outperform the euro, the Aussie dollar, the loonie, and Sterling,” she says. The rise of the U. S. dollar will stop only when sovereign default fears subside. Then the fiscally stronger position of the Government of Canada will push up prices of Government of Canada debt. “On a relative basis, the Canadian dollar remains strong — fiscally and in terms of economic growth and, for retail investors, that is where to stay,” she says.

“I continue to have a bias in favour of Canada,” Horoyski says. “If you worry about sovereign risk, you rush back to what you know. The International Monetary Fund and the EU will resolve the sovereign debt issues, but there is still political posturing and wrangling. U. S. bond yields are going to rise and there is not enough yield premium to justify incremental political risk.”

WHAT TO DO?

If you shun risk, stay with Canada bonds. If you have a taste for risk, buying U. S. T-bonds could be appealing. Buying Greek bonds, now selling for half their redemption value, amounts to a trip to the casino. It might work, but the bailout is not assured at time of writing and, in any event, the Greek bonds could be restructured to pay a lower interest rate and have their redemption date postponed by a decade or two.

Andrew Allentuck is author of Bonds for Canadians, published in 2006. His most recent book, When Can I Retire: Planning Your Financial Life After Work, was published last year.

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Andrew Allentuck’s book, “Cherished Fortune: Build Your Portfolio Like Your Own Business,” written with co-author Benoit Poliquin, was recently published by Dundurn Press.

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