European Bond Update

There are three main stories to be aware of in the European bond market today.

First, Fitch cut its Irish bond rating of AA+ to AA-, citing widening fiscal shortfall and the rising cost of the financial support programs. S&P and Moody's had reduced Ireland's sovereign rating earlier this year, but the Fitch move puts its rating one notch below S&P and 2 below Moodys. Our sovereign rating model had Ireland at the bottom of the developed country universe and although Fitch say the outlook is stable, our work warns that Ireland's macro situation could yet justify another downgrade. Irish bonds weakened on the news but net-net on the day the spread over bunds is 1 bp narrower. At the 2-year sector, the spread has widened a couple of basis points.

Second, Spain authorities released their latest Financial Stability Report and noted that the central bank is closely monitoring the 90 bln euro bad loan portfolio of Spanish banks (~2.4% of the bank's 3.75 bln euro assets) which have been officially acknowledged. The central bank indicated that it expects the government to establish a fund to finance the restructuring of the country's banking system in the coming months. Our sovereign rating model warns that the rating agencies may be too optimistic on Spain's rating. Our assessment our the macro situation puts Spain at AA rather than the AA+ by S&P, and triple A by Moody's and Fitch.

Third, Polish bonds are among the strongest in the region. However, the news stream is anything but supportive. News that the government is considering to mandate a cut in employee contributions to private pension funds (to 3% from 7.3%) and divert the rest to state-controlled funds, which ostensibly would buy government bonds. The Finance Minister is quoted on the news

wires projecting this would reduce the deficit by PLN13 bln and reduce the debt by 1%. It was emphasized that this is just a proposal at this point and not a draft law.

The EU projects that Poland's debt will exceed 55% of GDP next year and move above 60% in 2011. This may complicate the adoption of joining EMU.

If the scheme is adopted it would reduce the government bond sales which would be a positive, but investors would prefer a more substantive effort of fiscal reform, rather than what some would call creative accounting. There appear to be ramifications for Polish equities as well. Private pension funds reportedly have little less than a third of the AUM in equities. If less money is going into the private pension funds, then this reduces one source of demand for Polish equities.