Debt drama: Advisers forced to confront eurozone woes

For financial advisers and money managers, the latest twist in the eurozone's deepening debt drama — Ireland's $116 billion rescue package — is a stark reminder to remain nimble-footed with regard to exposure to foreign debt. “We're worried about Spain, and that's a good reason not to put a lot of money back into that part of Europe,” said Theodore Feight, president of Creative Financial Design, a financial planning firm. He sold off his exposure to eurozone exchange-traded funds in May. At the end of the year, when Mr. Feight re-balances his portfolios, he intends to maintain his position out of Europe. “We're not sure they're over the mess yet,” he said. “And our clients are still uneasy about it.” The latest eurozone turmoil serves as a reminder that fixed-income isn't risk-free and that “we live in a very connected global world,” said Lane Jones, chief investment officer at Evensky & Katz Wealth Management. “Sovereign-credit risk is one of a handful of major head winds facing the global economy right now,” he said. Mr. Jones said that he doesn't anticipate any immediate impact on client portfolios, as Evensky & Katz has been concentrating on high-quality and mostly domestic bonds. Still, the sovereign-debt crisis engulfing Europe, which became apparent in April with a similar bailout for Greece, is likely to get worse before it gets better. “With regard to concerns about Europe, we'll be passing through periods like this at least until we get some structural changes,” said Kristin Ceva, manager of the $680 million Payden Emerging Markets Bond Fund (PYEMX). She said that the latest bailout, which has sparked another “risk-on trade” among investors, eventually could lead to a European version of quantitative easing. “Certainly, there is a view that there needs to be something done in Europe to contain the contagion,” Ms. Ceva said. The immediate fallout from Ireland's rescue package, which initially rattled global financial markets, is a vote against these kinds of government bailouts, according to Chris Diaz, manager of the $525 million ING Global Bond Fund (INGBX). “The system is built on confidence, and when confidence goes away, you end up with contraction,” he said. The market views the bailouts as postponing the inevitable decision to work out the debt the old-fashioned way: raising taxes and cutting spending, Mr. Diaz said. “Ultimately, that might not be a good recipe for growth, but there might not be any other choice,” he said. What has investors so nervous is the notion that at this point, Ireland might be the proverbial canary in the coal mine, with countries such as Greece, Spain and Portugal seen as the next big default risks. “It is yet another illustration of Europe's failure to get ahead of the crisis in its periphery,” said Mohamed El-Erian, chief executive and co-chief investment officer of Pacific Investment Management Co. LLC, which manages $1 trillion. “While the package provides emergency loans to Ireland, it does not solve the country's problems, which center on the government having taken on way too much debt when it decided to bail out the banks and their creditors,” he said. “The decision by the [European Union] and the [International Monetary Fund] to kick the can down the road was driven primarily by concerns that other approaches would involve collateral damage and unintended consequences.” The general perception that Europe is avoiding the impending crises in Greece and Ireland is leading creditors to pre-emptively sell their holdings in peripheral econ-omies, Mr. El-Erian said. “The longer the uncertainty prevails regarding Europe's peripheral crises, the more likely that more creditors will exit,” he said. “This means that the risk spreads will remain very elevated, worsening the debt dynamics and discouraging new investment, growth and employment creation.” Mr. Diaz, who is responding to the European debt crisis with an allocation shift to high-quality emerging markets and a full range of corporate bonds, said that there are similarities to what is happening in Europe now and what happened in the United States beginning in 2008. “The issues are being forced by the market,” he said. Those market forces are most evident in the swelling yields on sovereign debt in some of the more fragile eurozone countries. In Ireland, for example, the yield on the 10-year government bond has been pushed up to 9%, creating a record spread between the 2.6% yield on comparable German bonds. In analyzing eurozone debt, Mr. Diaz uses Germany as the benchmark because it is the largest and most stable of the eurozone countries. Along with Ireland, Italy's debt is yielding 4.6%, Portugal's 6.7%, Spain's 5.5% and Greece's 11.5%, though the latter has already received a bailout package. The trend isn't good, according to Mr. Diaz, who fears that wider spreads illustrate more risk of default, which could lead to more bailouts. “All the spreads are getting wider and they're going in the wrong direction, and the spreads are at all-time highs,” he said. The initial flight to quality, which strengthened the dollar against the euro, was driven largely by a new sense of uncertainty, according to Brian Gendreau, market strategist at Financial Network Investment Corp. Inc., which has $36 billion under management. “There's a feeling that the last shoe has not dropped yet,” he said. Investors are so skittish at this point that “it doesn't take a perception of increased risk for the markets to fall; it only takes a bit of uncertainty for the markets to fall,” Mr. Gendreau said. Although the solvency issues that the Irish banks face have been mounting for months, the bailout package served to confirm suspicions of trouble, thus shaking the global markets. But what is still missing, according to Mr. Gendreau, is a sense of relief. “The bailout should have been settling for the markets,” he said. “But the market right now is always wondering if it's enough.” E-mail Jeff Benjamin at jbenjamin@investmentnews.com.