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ESM: Do a proper valuation before deciding

Michele Geraci * (Il Sole 24 Ore Radiocor Plus) – Milan, June 15 – After months of saga on the ESM, not all of Italian Government representatives and political parties who deal with the topic seem to understand well how bonds are valued. Sentences like “the ESM saves us money because the interest rate is lower than those of BTP (Long Term Italian Gov’t Bonds)” show poor financial education. Sentences such as “We, in Italy must draw loans from ESM without ifs and without buts” highlight a lack of interest in analysis and desire to understand.

As a professor of Fixed Income Market at New York University in Shanghai, I try to bring the debate on the right track.

When issuing a new type of bonds, in order to estimate the fair yield, we look for bonds with similar characteristics based on the principle of non-arbitrage: bonds with similar risk must have similar returns. There are many variables that influence risk, but the main ones are 1) The quality of issuer 2) the maturity 3) the seniority 4) the coupon. Let’s leave aside the coupon which, at this level of rates, has little influence, and therefore let’s focus on the remaining three. Those who say “the ESM saves us money because the interest rate is lower than those of BTP”, correctly compare two possible types of debt issued by the same entity (the Italian state) and the same maturity (implicitly, 10 years). But they are wrong, and by a large margin, when ignoring the third variable, seniority. It is normal that senior bonds should have lower yields.

Understanding risk is not easy and can be done from two points of view, from the point of view the issuer side or from the point of view of the creditor. From the point of view of the issuer, if we ask for a mortgage and our bank manager presented us two proposals, 5% without a collateral or 4% with a collateral, I don’t think we will immediately conclude that 4% is better without ifs and without buts. But our brain finds it a bit complicated to calculate well the value (for the bank) and the cost (for us) of this discount, we are unable to materialize this concept of risk because we lack the terms of comparison. More intuitive then is to use the creditor’s side. Let’s go back to ESM and ask ourselves: when the creditor lends us 36 billion, 10 years, privileged, what risk does it incur? What return do other bonds with similar maturity and similar default risk have? It seems obvious to me that the risk of default is almost nil because of the senior nature of the 36bn which jumps on the top of the 2,000 billion of outstanding Italian public debt which, instead, becomes subordinate. The first money the Italian state has to pay to creditors is the ESM, not the holders of the other 2,000bn. Virtually risk-free.

So, the fair price of an MES loan must be almost that of the German Bund, plus a little something. The Bund trades at -0.45%, we add + 20bps to keep the hawks happy, and we get to -0.25, which represents the right return for creditors (the ESM) and, on the contrary, the right cost for the issuer (Italy). Returning to arbitrage, those who still have doubts should ask: ‘is a Long MES / Short Bund trade attractive?’. Despite all this, ESM would like Italy to pay + 0.2% and with more conditions, light or not as they may be.

Who would still raises his hand to say again: ‘Yes to MES without ifs and without buts?’

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