Greece bailout: What ‘selective bond default’ means


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For Europe, the unthinkable now is reality: A euro zone country -- Greece -- is defaulting on its debt, as its bond investors are being asked to swap their securities for new ones with less appealing terms.

The idea is to reduce the country’s crushing debt burden and give it time to mend its wounded economy. Turn in your Greek bond that matures in two years, for example, and get one that won’t mature for 30 years.


Defaults are supposed to happen in Third World countries, not to a nation in the euro zone. It shows how the world has been turned upside down since the 2008 financial crash exposed the severe debt levels of many developed nations.

The credit rating firms haven’t yet ruled on the details of the European Union’s second bailout of Greece, announced Thursday. But it’s widely expected that, under the plan, Greece will be declared in “selective default” on its nearly $500 billion in debt, meaning that some investors will take losses while others may be paid in full.

As part of the EU’s program to lend another $157 billion to Greece to help it cover its debts, the Continent’s leaders want private bondholders to voluntarily share in the cost of rescuing the nation from fiscal ruin.

Reuters’ Felix Salmon nicely delineated the choices faced by Greek bondholders:

-- Do nothing, and hope that Greece pays you in full and on time. -- Turn in your bonds for a new 30-year bond and accept a modest annual interest return of 4.5%. Your principal would be guaranteed with an embedded zero-coupon bond (i.e., one that pays all of its interest at maturity) from a triple-A-rated EU institution, probably the European Financial Stability Facility rescue fund. -- Turn in your bonds for a new 30-year bond but take a 20% haircut on your principal. In return you’d be paid an annual interest return of 6.42%; again, the remaining principal would be guaranteed with zero-coupon collateral. -- Turn in your bonds for a new 15-year bond, take a 20% haircut on your principal, earn an annual interest return of 5.9%, and get only a partial principal guarantee through funds held in an escrow account.

It remains to be seen how investors will react, although some of Europe’s biggest banks and insurers, which own massive amounts of bonds of Greece and other euro-zone governments, signaled their support for the plan Thursday. Those institutions include German insurer Allianz, French bank Societe Generale and National Bank of Greece. . . .

More important will be what happens in the bond markets of Europe’s other financially challenged states -- Portugal, Ireland, Spain and Italy. In recent weeks, investors had been demanding ever-higher market yields on those countries’ bonds, meaning the securities’ values were tumbling as the Greek debt “contagion” spread. Those yields began to ease this week ahead of the EU summit Thursday on Greece. The yield on two-year Irish bonds (charted at left) fell to 19.1% on Thursday (before the Greek plan was announced) from 21.8% on Wednesday and 23.2% on Monday.

Italy’s two-year bond yield fell to 3.62% from 3.98% on Wednesday and 4.57% on Monday.

The EU plan for Greece also includes new financial aid for Ireland and Portugal and back-up credit lines for Spain and Italy. The EU’s intent is to show bond investors that the Continent is throwing its full financial support behind its troubled member states, hoping to allay fears about owning the countries’ debt. In theory, that should drive market interest rates down, lowering the risk of a wider crisis.

But as Reuters’ Salmon noted, there’s another way for investors to interpret the latest bailout:

Overall, this looks like a deal which can quite easily be scaled up and used as a framework for future default/restructurings. I don’t know if that’s the intent. But there’s nothing here to reassure holders of Portuguese and Irish bonds -- or even Spanish and Italian bonds, for that matter -- that they’re home safe. Greece will be the first EU country to default on its debt. But I doubt it’ll be the last.

-- Tom Petruno


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