Sovereign debt restructuring could punch holes in eurozone state budgets following the bail-out of Ireland last week, spreading contagion across Europe.
Eurozone governments are protecting their budgets by not directly lending new money to troubled countries, such as Ireland.
Instead, they are guaranteeing loans made to the European Financial Stability Fund (EFSF). The EFSF then lends the borrowed money to bailed out nations. (article continues below)
The German government has lent the EFSF its own debt management office to raise the money. The European Investment Bank is handling the back office administration.
However, if a bailed out government restructures its EFSF debt and only pays back its lenders at a discount, guarantees could force eurozone governments to make up the rest of the repayment.
Anglo Irish Bank, the nationalised Irish institution, has already agreed discounts of 80% with debtholders in swaps announced just before and after the bail-out.
Germany is liable for about 45% of all EFSF repayments. France and Italy, which have large budget deficits, are liable for 20% each.
If troubled states such as Greece, Portugal and Spain do not contribute their share, or 15% in total, the liabilities of other countries will rise.
In Britain, Phil Milburn, a bond fund manager at Aegon Asset Management, has criticised experts who are calling for holders of weaker European Union (EU) government bonds to accept losses to stabilise the nations.
“These professors say bondholders need to take a haircut. That is not how it works. There is a price to everything. The bondholders would just price it out,” he says.
He says the effect of a haircut on Ireland’s ability to maintain financial stability would be catastrophic.
“Punishing bondholders makes things worse, not better. Ireland still has to be able to access the market.”
Milburn adds that a haircut would aim to punish institutional bondholders. But he points out that institutions are running pension and savings money for investors, who would suffer the losses.
Milburn says he is avoiding peripheral EU nations completely in his £291m High Yield Bond fund and the £374m Strategic Bond Fund he co-manages with David Roberts.