During the second half of 2012 GGGBs had a vey nice rally, more than doubling in prices with the 10Y bond closing at 53.20 on Friday. The reasons had to do with the reduction of the Grexit risk,  commitment by official lenders on long-term financing (at very low rates) and a possible official haircut after the German elections. What I ‘d like to note is that, in my opinion, there isn’t much upside left on this trade unless there are serious rating upgrades of the Greek economy.

Looking at the ECB elidgible assets database, one can observe that the (ISIN:GR0128010676) 2023 bond carries a 57% valuation haircut.

ECB GGGB valuation haircut

That means that a bank can only finance 43% of a bond purchase through the ECB and will have to commit another 57% as capital or unsecured lending in order to settle the purchase, making it a very low leverage trade. Although the bond does pay higher coupons than current low-risk core bonds, the major source of income for a buyer is the capital gain from the difference between the current market value and the nominal amount payable at maturity which can be amortized during the remaining life of the instrument. As a result, one can make a very crude and simple calculation that investors will be willing to buy the bond as long as the future capital gain is more than the capital they ‘ll have to commit because of the high haircut (assuming that capital is expensive). In other words the higher price accepted would be:

PV(100) – market value = 57% * market value. If 100 is discounted with the current 10-year AAA yield of 2%, the actual PV is 82 and current market value 52.20.  Obviously, the above formula implies a 100% return on capital. Given the fact that the current 10Y bond YtM is 10.68%, this return is quite sensible. As a result, GGGBs are trading at a fair value for leveraged plays and do not provide an opportunity for further ‘easy profits’. Higher prices will be possible by the push-to-par effect for short maturities and future rating upgrades which will lower ECB haircuts.

Assuming a 2% annual return on capital (22% total), the highest price possible under current conditions would be close to 72.9.