EU Bonds: Portugal Proving the Point & How You Can Profit

First the bank bail-outs, then countries joined the queue. Talks of Greece defaulting, Irish riots and Spanish air-staff simultaneously taking a 'sick-day'. Just what is at the root of the EU's troubles? And how do last week's events with Portugal exemplify the problem?

A Flawed Strategy

Einstein summed up the challenge being faced within the EU succinctly when he proclaimed "you can't solve a problem with the same kind of thinking that created it." In Europe today, many countries are struggling under the burden of too much debt and the problem is being tackled with the issuance of yet more debt. Crucially, without growth, debt as a percentage of GDP will continue to worsen even before new debt is added to the equation. Investors are losing patience.

Portugal Proves the Point...

According to central bank forecasts, Portugal's economy will contract by 1.3% this year, pushing the country into its second recession in three years. In reaction to this poor growth outlook, Moody's downgraded its bond rating not one but two notches on Tuesday night. The very next day it sold €1bn in short-term government debt. Unsurprisingly, investors asked for a higher interest rate on their loan -- exacerbating Portugal's problem. As the finance minister conceded, servicing debt at current yields is "unsustainable over the long term".

...but Presents Opportunities

A downgrade in a country's government debt may trigger a wave of forced sellers. Pension funds, insurance companies and ETFs are focused on matching their liabilities to their assets. Therefore, they may be restricted in holding debt rated below a certain level. With Portugal's government debt downgrade (again let me emphasize by not just one but by two notches), these investors may have to sell certain Portuguese debt holdings. Any forced selling may be exploited with the purchasing power in your hands.

Misunderstood Markets

In addition, as Christine Lagarde, the French economy minister, admitted "Europe is difficult to understand for markets. They work in an irrational way sometimes," and it is possible to profit from this 'irrationality'. Companies located in an EU periphery country, with strong balance sheets and demand insulated from worries about their homeland (i.e. international exposure etc), may suffer from illogical moves in the markets that punish anything connected to the country regardless. This debt can be picked up 'cheaply'.

United They Stand; Divided They Fall

The problem with the "EU" banner is that it links together economies that are quite different from each other. Much press has been dedicated to the fate of the 'PIIGS' -- Portugal, Italy, Ireland, Greece and Spain but it is interesting to compare journalistic exposure with economic impact. Greece Ireland and Portugal account for less than 5% of EU GDP. It is wise to remember that often overreaction offers the most profitable investment opportunities.