Posted by hkarner - 25. Februar 2017
Source: The Wall Street Journal By JAMES MACKINTOSH
Subject: Can You Make Money in a Euro Collapse?
In a euro breakup scenario, there are a few ways bond investors can protect against a redenomination into a devalued currency
As Europe is roiled by fears of a breakup of its currency, investors and lawyers have begun digging through bond documentation in the hope of finding ways to protect themselves against the possible return of the franc, lire and deutsche mark.
The plethora of bonds available offer many ways to bet on the possibility of the end of the euro. One opportunity comes from ancient bonds dating from before the single currency was created, another from bonds sold under English rather than French or Italian law. But so far, investors seem to be making significant bets on only the simplest option—that of switching to the bonds of safe countries such as Germany, even though the safety that its bonds appear to offer could prove illusory in a worst-case European breakup.
There is no sure-fire way to protect an investment against what would be the biggest default in history—the redenomination of French or Italian bonds from euros into new francs and lire. Even though the bonds would be paid in full in francs or lire, investors paid in the devalued currencies would still class it as a default.
There’s no blueprint for splitting up a currency, so any form of protection is inherently speculative. Even if investors protect against one form of breakup, they would remain exposed if the currency union fell apart in a different way.
The aim is to protect against the devaluation of new currencies that might be introduced for economically weaker countries such as France, Italy, Spain and Portugal. Any new currency in Germany and other strong countries, such as the Netherlands and Austria, would be expected to rise in value.
One intriguing option involves two-decades-old corporate bonds that were originally sold in francs, lire, deutsche marks, Austrian schillings or Dutch guilders. Dozens of these survive, and their legal position is far clearer than for euro-denominated bonds. Typically, they promise to pay in the legal tender of a country: if Germany switches to the deutsche mark, old Deutsche mark bonds will repay in deutsche marks.
A pair of almost identical zero-coupon bonds issued by Deutsche Bank in 1996 show both the possibilities and the drawbacks. They promise to repay in 2026, one of them in the “legal tender of the Republic of Italy,” and one in Germany’s currency. Investors who expect a breakup can buy the deutsche mark bond in the hope of being paid back in a far more valuable currency. Those confident that the euro will stay together can pick up 0.2 percentage points a year of extra yield by buying the lire bond, and be paid at the end in euros. Compare this with 2012, when the Greek crisis made a euro breakup seem to many to be imminent, and the lire bonds yielded a full percentage point more.
If 0.2 points seems like a paltry premium for Italian currency risk, it is. Italian 10-year government bonds offer a premium over German bunds of almost two percentage points, and while that includes default risk as well as currency redenomination risk, the spread between the two is much easier to trade. The lack of trading in obscure corporate bonds gives them a wide bid-offer spread, and most of the bonds would be impossible to buy in significant size.
Worse, in a euro breakup scenario, banks would suffer horribly as their cross-border exposures fell out of balance. Almost all the outstanding pre-euro bonds are from banks.
Euro-denominated bonds that are governed by international law offer a different form of protection: the English courts. Michal Jezek, a credit strategist at Deutsche Bank, estimates that a bit less than half of Italian corporate bonds and a third of French corporate bonds are under English law.
Even these are rife with legal uncertainty, because of the question of what would follow a French or Italian exit from the euro. If the euro disappeared altogether, the legal principle of Lex monetae, or “the law of the currency,” would lead to each bond being redenominated into its national currency—although complexities would abound for a euro bond issued by the Dutch subsidiary of a French company, for example.
If the euro continued to exist in some form, the international courts would have to decide whether the euros the bond promised to pay were French euros, which would turn into francs, or European euros, which don’t.
“You have to ask whether the word ‘euro’ [in a bond contract] is a reference to the lawful currency for the time being of France or Germany or whether it meant ‘the single currency’,” says Tolek Petch, a solicitor at U.K.-based law firm Slaughter & May and author of a book on the law of euro breakup. If the former, English law would convert the bond into francs or deutsche marks, just as local law would; if the latter, the bond would stay in the rump euro.
The decision might come down to how the bond was sold, Mr. Petch suggests, with a wide syndication by international banks in London probably staying as euros, while a Paris issue to French investors would be more likely to be treated as francs, even if sold under English law.
For the moment, investors are sidestepping these issues and trading the French election as a bet on French government bonds versus Germany’s. On Wednesday, the withdrawal of centrist candidate François Bayrou was seen as a blow to the chances of far-right candidate Marine Le Pen, and French bonds narrowed the yield gap over German bonds.
Even this trade has some legal uncertainty, as Germany could slash its government debt after a breakup and rise in the deutsche mark by repaying in a now-cheaper euro-equivalent basket of currencies.
Ms. Le Pen’s chances of winning the French presidency, pushing a referendum bill through a hostile parliament and then persuading the French people to vote to ditch the euro are slim, to put it mildly. Italy’s Five Star movement may be a more potent threat to the euro’s future, although Italian elections haven’t yet been scheduled. If “Frexit” or “Italexit” start to look like a serious prospect, bondholders will rapidly rediscover the importance of governing law and legal definitions of currencies—and the deep uncertainty they bring with them.