Spain has moved to the center of the European crisis in recent months. After a recent trip to Spain, where we met with policymakers, private market participants and academics, I believe this is warranted due to its political challenges, fiscal issues and problems in its banking system. These risks are real; however, I still believe that owning Spanish sovereign debt is an attractive proposition.
The Risks – while real – don’t spell doom for Spain’s sovereign debt
Most recently, everyone seems worried that Spain itself will break up into separate countries. Catalonia, one of Spain’s largest and most economically important regions, held elections on November 25th which were widely interpreted as a prelude to a referendum on secession. But I believe secession is likely a low probability event at this stage. A majority of “pro-secession” parties wouldn’t necessarily translate into actual votes for independence in a referendum. Quebecois separationists in Canada ran the region for many years, but secession failed both times it was put to referendum. Then there’s the whole European Union question. A separate Catalonia would want to be in the EU, but membership for a newly separated country is not guaranteed. Polls in Catalonia don’t yet show sufficient support for independence without certain EU membership. Even if Spain didn’t veto, Catalonia may face opposition from the EU-governing body in Brussels, which likely doesn’t want to open a secession Pandora’s Box.
Spain’s major problems still revolve around its fiscal issues and banking sector problems. The nation’s effort to reduce its deficit has been unimpressive. In 2011, the deficit was reduced by a mere 0.5% from 2010. This year, the deficit target has already been increased from 4.5% to 6.3%.1 Regions in Spain control about one-third of the total expenditures and last year, they were responsible for a significant part of the divergence from the deficit target. I expect another miss in 2013.
On the banking side, recapitalization and reforms are on track but challenges remain. The new “bad” bank being set up, La Sociedad de Gestión de Activos Procedentes de la Reestructuración Bancaria (SAREB), aims to buy €90 billion of bad assets at deep discounts and then sell them over the next 15 years. This is one of the largest liquidation projects in history, happening while large parts of the advanced world are still going through a deleveraging process in the wake of the financial crisis.
But even there, Spain has options that can help it navigate these risks. Applying to the European Stability Mechanism (ESM) and the ECB’s Outright Monetary Transactions (OMT) program would buy it some time to get its fiscal house in order. Yes, Spanish Prime Minister Mariano Rajoy seems unwilling to sign a deal without assurance that it wouldn’t be too harsh for his nation. However, I still expect Rajoy to sign the deal after some market pressure in the new year. This will allow the ECB to buy Spanish bonds up to three years in maturity in potentially large sizes and would provide further action to support Spanish sovereign debt.
Investors are being well compensated for buying Spanish debt
In our view, 2013 could present challenges for Spain stemming from these political challenges, fiscal slippages and banking sector issues. Despite all this, we believe that the current yield levels in excess of 5.3% for 10-year maturity sovereign bonds, may compensate investors for this risk particularly as there is a backstop provided by the ECB already in place, and the potential for further ECB action.
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Fixed income investing entails credit risks and interest rate risks. When interest rates rise, bond prices generally fall, and a fund’s share prices can fall. Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes and political and economic uncertainties.