Upward bias seen for Greek bond yields, trade choppy

Market participants see a growing probability that a Greek restructuring could happen this
year or next. Among numerous scenarios, investors may have to accept lower coupon payments, a maturity extension, haircuts, or a combination of the above.

Against that backdrop, euro zone benchmark German bond prices rose, with the Bund future jumping to its highest in more than six weeks, helped too by data showing the U.S. economy grew less than expected in the first quarter.

The uncertainty around a potential Greek debt restructuring is leading investors to prepare for what is probably the worst case scenario, painted by Standard & Poor's earlier this year -- a 50-70 percent haircut, traders said.

Greek two-year yields fluctuated between 24 and 27.1 percent, having risen 2 percentage points in the previous session to 26.9 percent.

A bid/ask spread of 571 basis points -- its highest since May 2010, when Greece was granted a bailout -- indicated volumes were extremely low, exacerbating moves, but traders said the bias was for yields to rise.

"We had a seller and a buyer this morning ... but I suspect it's somebody buying them against the CDS, there's no outright buyers at this stage because there're too many risks," one trader said. "If you believe there's a restructuring around the corner you wouldn't want to own these (bonds)."

Buying bonds against credit default swaps -- the negative basis trade -- poses risks as well.

Senior derivatives users said the intrinsic value of CDS could be severely hit if Greece restructured its debt without triggering a credit event, according to IFR, a Thomson Reuters news and market analysis service.

The two-year bond, the worst hit since Germany suggested Greece may have to restructure, trades at about 69 percent of its face value.

"A 50 percent haircut is now practically priced in for maturities of five years and longer," ING rates strategist Padhraic Garvey said.

"For two-year paper a yield of some 45 percent would be required before a 50 percent haircut was priced there, which makes the current valuation of 25 percent look relatively tame."

Too far, too fast

For a 60 percent haircut to be fully priced in, the two-year bond's face value would need to drop to 40 percent, but such a move was unlikely to be a first step, said Elisabeth Afseth, fixed income analyst at Evolution Securities.

"A change in maturity is more likely ... so I suspect there will be someone coming in who sees value in the two-year before it reaches anything like under 40 in the price. The 50 on longer maturities is an obvious psychological level for no other reason than it's a nice round number."

Societe Generale strategists said given the uncertainty over Greece, it remained attractive to underweight peripheral euro zone government bond yield spreads.

"Beware though a bounce in the near term. Spreads have widened out too much, too fast, in the case of Greece," strategist Chiaran O'Hagan said in a note.

Elsewhere, Italy sold 10.1 billion euros worth of three- and ten-year fixed rate bonds and 2018 Euribor-linked bonds earlier on Wednesday, in an auction which analysts said drew solid demand after a recent yield rise.

Spanish and Italian bonds gave back their March gains over the past two weeks, with investors eagle-eyed for any sign of contagion from the Greek crisis.

But investors still had confidence the two countries could avoid following the path of Greece, Ireland and Portugal and that was shown by liquidity levels, traders said.

The Spanish bid/ask spread on the 10-year bond was 33 basis points, compared with 380 bps for similar-dated Irish paper and 298 bps for the Portuguese equivalent -- its widest since December 2010.

Bund futures settled 68 ticks up on the day at 122.67, the highest since March 18, with traders saying stops triggered at 122.54 also helped the move higher. The contract broke through last week's high of 122.65, a level previously signalled as offering technical resistance.

REUTERS