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Analysis: Euro zone bond clause highlights rich nation default risk

By Marius Zaharia

LONDON (Reuters) - When 10 wealthy countries first demanded legal provisions making it easier to restructure government bonds in a crisis, they never thought this would apply to their own debt.

A decade ago the Group of 10 had places like Argentina or Mexico in mind, and yet from next week new euro zone government bonds will include these "collective action clauses" (CACs).

Applying such clauses - which can force investors to accept big losses on their bond holdings - acknowledges that a developed country can go bankrupt and debt default is no longer the preserve of emerging market governments.

From its own perspective, the euro zone has sound reasons for inserting the clauses. An absence of CACs on many Greek bonds allowed hedge funds to make big profits by dodging a write down of the country's privately-held debt earlier this year.

From January 1, 2013 all newly-issued euro zone government bonds will carry CACs, making it the first developed market to impose such clauses routinely.

They will allow a two-thirds majority of bondholders that agrees to a restructuring to force a dissenting minority to participate. In future, everyone will have to share the pain, should a government go the same way as Greece and need to cut its debt burden radically to avoid defaulting.

The aim is to make it easier and less costly for a government to restructure its debt. At the same time, the measure could, under certain conditions, create a two-tier market, with bonds not covered by the new regime worth more.

In 2003 the G10 made CACs the norm for most emerging market bonds issued under international law.

The group, which includes several euro zone countries, hoped to avoid a repetition of the U.S. bailout of Mexico during the "tequila crisis" of 1994-1995 or the large number of holdouts - investors who refuse to accept a debt writedown voluntarily - that complicated Argentina's restructuring in 2001.

LIFE NO LONGER SO SIMPLE

No G10 member included CACs in their domestic legislation, seeing a developed country bankruptcy as all but inconceivable. Three years of euro zone debt crisis has changed all that.

"(The G10) did not particularly perceive the CAC provision to be of relevance for themselves," said David Hiscock, senior director for market practice and regulation policy at the International Capital Market Association.

"It was more aimed at emerging countries issuing debt under international law, such as Mexico. Recent times have suggested maybe life is not as simple as that, certainly in the euro zone."

The scale of debt to be covered by CACs has ballooned since they were first debated. Anna Gelpern, a professor of law with the American University Washington College of Law, who has researched CACs for the past 15 years, said "the debate about including CACs was about a $300 billion market".

Now, with the euro zone adopting them, that sum could top $10 trillion in 10 years when the region will have rolled over most of its current bonds. "We're entering a new era when (developed market) money can be restructured," Gelpern said.

TWO-TIER MARKET

Over time this could lead to a two-tier market in euro zone bonds: those subject to CACs, which could impose losses on holders, and those without, whose holders - as happened in Greece - just might be repaid in full.

ING estimates show that all but about 15 percent of the current bonds without CACs will have expired in a decade, meaning most debt outstanding then will carry the clauses.

However, in any future crisis holders of CAC-free bonds could do what some hedge funds achieved when Greece swapped its bonds in March this year - escape having their debt restructured and seek instead to be repaid in full.

Athens imposed retroactive CACs on bonds issued under Greek law but some funds made huge profits by buying debt governed by international law, to which CACs could not be attached and which could not be targeted for restructuring.

Having traded at almost identical prices before the crisis, yields on the two types of Greek bonds varied by several percentage points as a restructuring loomed.

Analysts said this could point to how the two types of euro zone bonds could trade. However, debt of smaller, weaker "peripheral" euro zone governments would be affected more than that of "core" members such as Germany, and more so in times of crisis than in periods of calm.

"That price differential ... will be more perceptible in peripheral issuers rather than core issuers," said Padhraic Garvey, head of investment debt strategy at ING. "When you really see the CAC effect is when you move from a period when you have no stress to a period when you have stress."

ECB UNCERTAINTY

The difference in price could be felt as early as next year, some analysts say, depending on which bonds the European Central Bank decides to buy under its plan to purchase the debt of a euro zone country seeking a bailout.

The ECB is not allowed to finance governments directly and it remains unclear whether the central bank can legally allow bonds it holds to be restructured.

This raises uncertainty over whether the ECB will discriminate between bonds with CACs and those without when and if it resumes bond purchases. The central bank refused to take part in the Greek restructuring, setting a precedent.

The ECB's program is designed to unclog the transmission mechanism of its monetary policy by bringing down borrowing costs of stressed countries, so discriminating between bonds based on their legal terms may defeat that purpose.

"There is a lot of uncertainty around that," said David Schnautz, rate strategist at Commerzbank. "You would feel more comfortable knowing there is a big buyer of a certain instrument and non-CAC bonds may become favored by investors as well."

(Editing by Nigel Stephenson and David Stamp)

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