Greek Bond Exchange Has Surprise Upside

The Wall Street Journal

In the continuing drama over whether Greece will get the next slice of rescue funds from its official creditors, another critical financial test has been temporarily forgotten: the country's plan to exchange old government bonds for new. As Greece's disputes with its lenders have intensified, the bond exchange has looked a better and better deal for investors.

The exchange, the terms of which could be announced next month, was the price of securing German government support for the second bailout of Greece in July. Germany did not want its bailout loans to be recycled straight into the hands of investors as Greece repaid maturing bonds, so it demanded some "private-sector involvement" in the rescue. Bondholders would be seen making sacrifices as well as German taxpayers.

For some analysts, the bond exchange that emerged was the worst of both worlds. On the one hand, it compelled banks and other investors to recognize that the value of their Greek bond holdings was impaired, forcing them to take write-downs. On the other, it yielded precious little benefit to Greece.

The idea is to reduce the amount of Greek public debt maturing between now and 2020, pushing those maturities into the future. But it does nothing to bring down the government's mountainous debt, equivalent to 166% of gross domestic product this year, and rising. In fact, the opposite: "The deal literally increases Greece's debt burden, making an unsustainable debt even more unsustainable," says Adam Lerrick, a debt restructuring expert at the American Enterprise Institute.

Another criticism of the exchange was that it would be plagued by "free riders"—investors who wouldn't participate in the exchange because they'd be better off being paid in full on the original bonds. The deal is structured to be voluntary and many experts thought when it was announced in July that barely half of bondholders would accept it.

Now, things have changed: Participation, if the exchange goes ahead, is likely to be far higher, possibly more than the 90% minimum the Greek government is targeting. The main reason is that, as Greece has bickered with its official creditors, fears of a default have grown, bond prices have collapsed further and the exchange looks like a far better deal than it once did.

"When the deal was announced in July, the acceptance rate would have been 55% to 60%. Now, the probability of a near-term default has gone up dramatically and the price of the bonds has collapsed. … The acceptance rate will now be much higher, possibly even into the nineties," Mr. Lerrick says.

Greek government bonds maturing before 2021 are now trading at just under 40 cents on the euro. If investors exchange their bonds for par bonds, one of four available options, they receive top-rated collateral guaranteeing full repayment after 30 years. The value of that guarantee in today's money is just over 30 cents. That means the component that accounts for Greek risk—that would repay almost 70% of face value at maturity if it's repaid—can be purchased for eight cents on the euro.

One reason Greek risk is so cheap is that investors are worried that Greece won't secure the next €8 billion ($10.86 billion) of aid, the country will slide into a full-scale default and the exchange won't go ahead. (Another worry is that Finland's demands for collateral as price for its contribution to the second bailout could derail the exchange.) If the exchange does take place, however, prices of Greek bonds maturing before 2021 should rally.

There are other reasons why bondholders might be persuaded to exchange, some of which are contained in little-noticed details issued by the Greek government last month. One is that the deal is "all or nothing": Institutional investors were asked to inform regulators of their eligible Greek bond holdings. They can participate in the exchange with all their holdings—or not participate at all—but they can't cherry pick and exchange some of their bonds and not others.

True, many investors outside Europe, including hedge funds, won't feel bound to declare their full holdings and will hold on to "old" bonds. But the "old bonds" will probably be substantially less marketable than before. For example, though the Greek government has given no indication of its plans, it is likely to delist the old bonds from stock exchanges.

Another reason is that the exchange switches the governing law of the bonds from Greek to English law. Most international bonds are issued under English or New York law and the switch means that the new bonds won't be subject to actions by the Greek Parliament that could disadvantage holders of old bonds, in particular give them a worse deal in any future restructuring. "With the change in the governing law, Greece gives up some of the leverage that it has under the current bonds," says Steven Kargman, an international debt restructuring adviser.

However, a good deal for investors may end up being the opposite for Greece. Most analysts agree that even if this exchange "succeeds," it won't be the last. Most see a further major restructuring at some point that will significantly cut Greece's debt burden. If it happens, many of the techniques being used for this exchange, may well be used again. "Default is an obsolete technology," says one investor.

Write to Stephen Fidler at stephen.fidler@wsj.com