Chapter 5. Possible Subordination Effects of Eurosystem Bond Purchases

Petya Koeva Brooks, and Mahmood Pradhan
Published Date:
October 2015
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Nico Valckx, Kenichi Ueda and Manmohan Singh 

The debt restructuring in Greece in February—March 2012 effectively extended senior creditor status to Eurosystem bond purchases. By mid-February 2012, the European Central Bank (ECB) and the national central banks of the euro area, collectively, the Eurosystem, swapped their Greek bonds acquired under the Securities Markets Program (SMP) for new bonds of identical structure and nominal value, with different serial numbers. This transaction provided the Eurosystem an exemption from the subsequent private sector debt swap under so-called private sector involvement (PSI), effected through retroactive collective action clauses.1 By swapping its debt purchases in advance of the PSI announcement, the Eurosystem effectively received preferential (senior) creditor status on its Greek bond holdings.2

According to the ECB, this exemption from PSI was “special” because Eurosystem bond market interventions were undertaken solely for monetary policy purposes. Treating Greece as a special case may indicate that the subordination of private debt holders will not be repeated in other contexts. At the same time, the ECB has cautioned against incurring losses on the SMP, which could—in an extreme case—require recapitalization of Eurosystem central banks and result in reduced financial independence.

In this context, a key question is whether the SMP has become less effective after the Greek PSI exemption—or had done so even earlier—because of subordination risk. This treatment of the Eurosystem may effectively have reshaped the seniority structure of all official holdings of sovereign bonds. From a market risk-return perspective, this treatment implied a possible mispricing of many euro area bond markets, leaving future SMP beneficiaries subject to rating downgrades because Eurosystem interventions reduce the private investor base and increase losses in the event of restructuring. Anecdotal market evidence confirms that the impact of SMP purchases has become controversial, although this controversy may already have been priced in before the Greek debt exchange in February 2012. Indeed, after the euro area summit of heads of state and government on July 21, 2011, when PSI for Greece was first announced, subordination effects were already under consideration.3

At the same time, although the SMP helped to reduce stress in government bond markets temporarily, because of the limited scale and time horizon of its effective use, it did not appear to be fully effective (Figure 5.1). Especially after its launch in May–June 2010 and after reactivation in August 2011, interventions were sizable and helped stem the rise in stressed country sovereign yields (Figure 5.1, panel 2) and the escalation of bond market volatility.4 Purchases amounted to €36 billion in the first month and €21 billion in the second month of the program but dropped to less than a few billion afterward. However, as purchases were scaled back, volatility and broad euro area financial market risks increased again, and SMP interventions were scaled up again in November and December 2010. Similarly, as sovereign market stresses increased again during the summer of 2011, the reactivation of the SMP in August and September 2011 with purchases of €51 billion and €37 billion led to a reduction in broad market stresses. However, as stress in some debt markets reemerged, SMP purchases increased again to €40 billion in November 2011 before the Eurosystem adopted other measures to help stressed economy banks in need of funding.

Figure 5.1Securities Markets Program (SMP) Interventions

Sources: Bloomberg, L.P.; and IMF staff calculations.

Note: GIIPS = Greece, Ireland, Italy, Portugal, and Spain. Bond yields refer to 10-year benchmark yields. Weighted series take government debt as weights. Bond volatility follows a GARCH(1,1). Scaled euro area risk is the principal component score of 13 euro area interbank market spreads, corporate credit default swap (CDS) spreads, euro area equity risk premium, SovX and EMBIG CDS, and euro exchange rate implied volatility.

This chapter examines various ways to quantify the extent of subordination arising from Eurosystem debt purchases. It first looks at illustrative empirical evidence, aimed at documenting developments in government bond prices and credit default swap (CDS) risk premiums during and after the Eurosystem debt swap. Next, it looks at theoretical models to quantify and illustrate the potential effect of subordination on bond prices and CDSs. Finally, it offers some tentative policy conclusions. The main finding is that the impact of Eurosystem seniority is primarily related to perceived probability of default and the proportion of outstanding debt already in the hands of the central bank. Moreover, credibility of SMP interventions matters.

Empirical Evidence on Eurosystem Subordination Risk

Insufficient data makes directly quantifying the subordination risk from Eurosystem debt purchases difficult. Eurosystem debt purchases under the SMP were largely put on hold after the PSI exemption. Only one SMP intervention took place afterward, in the week of March 5–9, 2012, for €27 million, the fifth-smallest intervention since the start of SMP purchases in May 2010, based on weekly Eurosystem financial statements. Hence, there is insufficient quantitative evidence to establish empirically the relationship between subordination risk from Eurosystem debt purchases and sovereign yields.

However, an event study analysis of news on its senior status can provide some gauge of subordination risk.5 Innovations in bond yields and CDS premiums in the days surrounding the July 22, 2011, statement by President Trichet and the Eurosystem debt swap on February 16, 2012, are examined. Following MacKinlay (1997), standardized cumulative abnormal yields and CDS spreads are estimated (in first differences). The underlying model is


in which Yi denotes the government bond yield in country i, CDS is the sovereign credit default swap spread, YLCH is the LCH Clearnet benchmark 10-year yield on AAA countries, and SovX is the SovX Western Europe CDS index. Standardization makes it easier to compare cumulative abnormal yields and spreads. The models are estimated using 70 daily observations with data up until one month ahead of the event, to avoid coefficient bias due to the events.

The results show little impact of the Eurosystem debt swap on stressed country yields, but the initial PSI announcement and the Eurosystem’s nonparticipation did have substantial short-term negative effects. The market effect of the Eurosystem, as a large creditor, shifting to preferred debtor status did not seem significant when evaluated around the time of the debt swap announcement (Figure 5.2). However, this lack of a significant impact appears to reflect that the market may have anticipated the event and already priced it in. Longer-dated stressed country bond yields and CDS default risk premiums seem to have risen unexpectedly following President Trichet’s public statement on July 22, 2011, that the Eurosystem would not be participating in the voluntary Greek PSI—one day after an important euro area summit had agreed on modalities of additional support for Greece (including PSI) and on greater flexibility of European Financial Stability Facility loans to the other program countries (Ireland, Portugal). In the days ahead of the summit, bond yields and CDS default risk premiums had fallen substantially, but these declines were reversed after the ECB President’s statement, although it cannot be excluded that markets may have been disappointed by some other summit-related news (for instance, the realization that the size of the European Financial Stability Facility had not been increased and large implementation risks).

Figure 5.2Event Study Analysis of European Central Bank Subordination on Bond Yields and Credit Default Swap Spreads

Sources: Bloomberg, L.P.; and IMF staff calculations.

Note: Figure shows the changes in selected euro area (Italy, Portugal, and Spain) bond yields and sovereign credit default swap (CDS) spreads. Scales are standard normal, that is, values exceeding +/- 1.96 are statistically significant at the 5 percent level.

Theoretical Approaches to Quantifying Subordination Risks

It is possible to incorporate the subordination effect in a closed-form bond price model or in a reduced-form CDS model. In both models, the subordination effect depends on three factors: probability of default, loss given default (one minus the recovery rate), and the share of Eurosystem bond holdings.

Sovereign Bonds, Closed-Form Model

Eurosystem seniority matters when the recovery rate is not close to zero or to 100 percent. For example, suppose a country’s debt trades at 60 percent of par before establishment of the Eurosystem’s senior creditor status (Figure 5.3). This rate could reflect market estimates of 40 percent default probability with 100 percent loss given default (zero recovery value) and 60 percent (nondefault) probability of full repayment. In this case (case I), seniority does not matter because upon default, no single bondholder is repaid. However, a preannouncement price of 60 cents on the euro is also consistent with another case: 80 percent default probability with 50 percent recovery (case II). In case II, seniority matters. For example, if the Eurosystem’s share is 50 percent of the country’s debt, the Eurosystem can recover all its claims at face value because the country will repay the first 50 percent of the total debt to senior creditors. For the Eurosystem, the after-the-fact (shadow) price of the bond becomes the full face value. After repaying the Eurosystem, the country that defaulted will have nothing left with which to repay private bondholders. The after-the-fact market price of the bond reflects this zero recovery and the bond will be traded at 20 percent of face value because there is still a 20 percent probability of nondefault with full repayment of 100. Annex 5.1 develops this model more formally.

Figure 5.3Illustration of Closed-Form Model under Differing Probabilities of Default and Recovery Rates

Source: IMF staff calculations.

Note: See text for explanation of case I and case II. “Ex ante” and “ex post” refer to before and after establishment of the Eurosystem’s senior creditor status. PD = probability of default; PRI = private bondholder; q = market price of debt before Eurosystem seniority; qECB = shadow price of debt for Eurosystem bondholder after establishment of Eurosystem debt seniority; qPRI = shadow price of debt for private bondholder after establishment of Eurosystem debt seniority; R = recovery rate upon default before establishment of Eurosystem seniority; RECB (RPRI) = recovery rate upon default for Eurosystem (private) bondholders after.

The net impact of subordination thus depends on three major factors:

  • Probability of default (PD)—The PD increases linearly with the subordination effect, that is, the difference between the original price and ex post price (after subordination). Figure 5.4 (panel 1) plots this effect for various default probabilities for a range of Eurosystem debt market shares. Evidently, the larger the Eurosystem market share, b, the lower the market price after subordination for any given PD.
  • Loss given default (LGD)—If the LGD is large, then having senior status does not translate into a large advantage. Also, for a small LGD, senior status is not valued much because even junior creditors could recover a large portion of the face value. The overall effect—the difference between the original price and ex post price—is thus not monotonic. Figure 5.4 (panel 2) illustrates this effect for an 80 percent default probability and various Eurosystem market shares for various LGD values.
  • The Eurosystem’s ownership share of sovereign bonds6—As long as the Eurosystem’s ownership of sovereign bonds, acquired through the SMP, is small relative to the original recovery rate, even with the Eurosystem expecting full repayment, the loss on private sector holdings will be limited. Therefore, the difference between the original price and the ex post price will be small.

Figure 5.4Bond Prices and Securities Markets Program Determinants

Source: IMF staff calculations.

Note: “Ex post” refers to after establishment of the ECB’s senior creditor status. b = ECB market share; ECB = European Central Bank; LGD = loss given default.

In contrast, when the Eurosystem holds a large share of sovereign bonds relative to the recovery rate, the Eurosystem’s senior status will lower the (ex post) recovery rate for the private sector dramatically. Figure 5.4 (panel 3) shows that this effect is monotonic but not linear. In particular, when the Eurosystem’s share is larger than the original recovery rate, there is a kink, above which private bondholders will not receive anything (ex post) in bad states of nature. Note that what is important in pricing the bonds is the expectation of the Eurosystem’s share including future acquisitions under the SMP. Increases in the expected Eurosystem share (or related uncertainty) can create further negative effects.

SMP purchases thus have two main effects on bond prices and yields:

  • Raising subordination risk—The rise in yields for distressed sovereigns at the time of announcement of a debt swap (in favor of the Eurosystem) reflects a net expected transfer of value from private bondholders to the Eurosystem. This subordination will also undermine the effects of any future SMP purchases because sovereigns will face higher issuance cost on any bonds not purchased by the Eurosystem.
  • Improving liquidity—To the extent that the SMP improves liquidity conditions, it would reduce the probability of default and thereby increase the value of residual bonds. This increase in value happens when the Eurosystem provides vital liquidity to the market, and ultimately to stressed country governments. Investors would be reassured that the Eurosystem is willing to smooth out temporary liquidity shocks. Also, a lower interest rate could decrease the default probability by improving debt sustainability. This beneficial effect would be enhanced by a credible and clearly communicated SMP intervention strategy.

Therefore, the net impact on bond prices of the subordination effect versus the liquidity support effect is ambiguous a priori.

CDS, Reduced-Form Model

Along the same lines, CDS pricing implicitly reflects liquidity and seniority effects. CDS and bonds should be perfectly cointegrated because they are assets with exactly the same cash flow and thus the same price.7 At the same time, the CDS model allows the role of SMP interventions to be illustrated somewhat differently and shows the role of credibility in SMP interventions (although the latter is also implicit in bond prices).

  • Liquidity effect: Starting from a standard CDS pricing formula, SMP interventions—by lowering sovereign yields, assuming the intervention is credible and sustained (see below)—reduce the cumulative probability of default (PD), which has a nonlinear (but less than proportional) impact on CDS spreads (CDS):
    in which n denotes the number of periods (years). The subsequent analysis abstracts from real-world versus risk-neutral PDs, which are analyzed, for example, in Bilal and Singh (2012).8
  • Subordination risk: Because of perceived senior creditor status, SMP purchases may increase private sector LGD and possibly offset the lower probability of default.

LGD for private bondholders increases with debt restructuring needs and the size of Eurosystem holdings. Intuitively, for a debt restructuring, the LGD will depend on the necessary reduction in the debt-to-GDP ratio (ΔD/GDP) and on the participation rate. Hence, official sector holdings have a nonlinear impact on expected private sector loss given default or haircut.9 If the Eurosystem is expected to be exempt from PSI, as in Greece, a higher Eurosystem share of debt holdings, b, will increase the private sector haircut or LGD.

Combining these elements gives equation (5.4):

Equation (5.4) makes it clear that the negative effect of SMP purchases rises progressively with an increase in debt because it entails larger haircuts (panel 1 of Figure 5.5).

Figure 5.5Role of Securities Markets Program Purchases in a Credit Default Swap Model

Source: IMF staff calculations.

Note: CDS = credit default swap; PD = probability of default; SMP = Securities Markets Program.

Substitution in equation (5.4) yields

Equation (5.5) shows that an increase in the share of SMP purchases, b, increases CDS spreads but more strongly so when CDS prices are already high (that is, when PD is more elevated) and to a limited extent when CDS premiums are low, that is, only when default or restructuring fears come into play (see panel 2 of Figure 5.5). When putting this in a dynamic context (although not explicitly done in this model), the beneficial effect of SMP interventions can be shown to hinge on the credibility of the Eurosystem’s SMP intervention strategy: subordination may lead to self-fulfilling default dynamics (upward shift of the PD line), if, similar to models of currency crises, the central bank’s purchases are not able to offset the increased private sector LGD owing to the Eurosystem subordination effect. This effect may prevail when the Eurosystem is not able to lower spreads (or yields), which would otherwise help improve debt sustainability and contribute to lowering the PD (or at least keep the PD unchanged).


This discussion illustrates that the SMP may have a subordination effect, but this effect will be important only at the margin, as was the case in Greece, and depends on the program’s credibility. The rise in yields for the most distressed sovereigns at the time of announcement of the Eurosystem’s exemption from the Greek PSI reflected a net expected transfer of value from private sovereign bondholders to the Eurosystem. This de facto subordination may undermine future SMP interventions because sovereigns may face higher issuance cost on any bonds not purchased by the Eurosystem. As shown theoretically, this subordination effect depends on three factors: probability of default, loss given default, and the share of Eurosystem bond holdings. At low PD levels, when LGD is relatively low and the sovereign debt ownership share of the Eurosystem is not too high, subordination risk plays a limited role. This conclusion is also borne out by the analysis in a CDS model, in which further SMP interventions have a negative effect only when adjustment needs are very high or CDS spreads are already extremely high. The latter analysis also helps illustrate the importance to the SMP of the Eurosystem’s credibility: if credibility is low, SMP interventions may be unable to stop self-fulfilling debt default dynamics. This effect may occur when the Eurosystem is not able to reduce sovereign spreads or yields, which would otherwise support debt sustainability and be conducive to lowering the PD.

Should anything be done to accommodate market fears about subordination inherent in SMP purchases? SMP subordination currently does not seem to play a large role in pricing and markets. However, in principle, it is possible to attenuate market fears about SMP subordination (beyond what is captured in these stylized models) by transferring some of the benefits accruing to the Eurosystem back to private sector bondholders.

Annex 5.1. Valuation of Sovereign Bonds with Eurosystem Senior Creditor Status

Eurosystem Ranked Equally with Private Bondholders

Suppose a country’s debt is trading at 60 cents on the euro (q0). This could, for instance, reflect market estimates of 80 percent probability of default (PD) with 50 percent loss given default (LGD); that is, upon default, the country can repay half of the total face value of bonds. The overall discount is 40 percent more than the risk-free discount, which is assumed to be zero. Therefore, if the total face value F is €100 million, the total market value V0 is €60 million. These relationships can be captured by the following simple valuation equation:

and the price the bond trades at is q0 = V0/F.

Assume that the Eurosystem’s share is b percent of the total outstanding. Then, b percent of the market value is held by the Eurosystem and the rest is held by the private sector. The values of the Eurosystem’s holding, VE0, and the private sector’s holding, VP0, are

For example, if the Eurosystem holds 20 percent, the value of the Eurosystem’s holding is just 20 percent of the original market valuation V0. The price (q0) is unchanged to any level of b.

Eurosystem as Senior Creditor

What if the Eurosystem becomes a senior creditor? As shown below, the effect on existing debt depends on the Eurosystem’s share (b). Note, however, that what is important is the expectation of b from the future SMP. And, uncertainty about b can create further distress.

When the Eurosystem was shielded from the Greek bond exchange, private sector claims suddenly became subordinated, which lowered the value of bonds left in the hands of the private sector. Amid expectations that senior status would be granted to the Eurosystem for other euro area government bonds, their prices should also fall (that is, yields should go up). The degree of price decline varies with three factors: the probability of default PD; the loss given default LGD; and the Eurosystem’s holding share, b, of the outstanding bonds.

The reason the Eurosystem’s claim depends on the share it holds is that its b percent holdings of bonds are now repaid before the private sector’s claim. The private sector’s claim is only the residual:

The Eurosystem’s claim would be fully guaranteed if its face value claim is less than what the country can repay; that is, its loss given default (LGDE1) would be zero. Otherwise, the Eurosystem would take all the repayments, although it only owns b percent of total outstanding.

The Eurosystem’s holding is theoretically valued at VE1 by using the LGD that the Eurosystem faces:

And the shadow price that the Eurosystem faces is

The price that the private sector pays is now changed to the ratio of its valuation to the face value of the bonds that it possesses,


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This chapter is based on Euro Area Policies: 2012 Article IV Consultation—Selected Issues, IMF Country Report 12/182, 2012.

Comments from Tommaso Mancini-Griffoli and Christian Mulder of the IMF Monetary and Capital Markets Department and ECB counterparts are gratefully acknowledged.


The PSI invited Greek debt holders to exchange their existing holdings for new debt at a face amount of 31.5 percent and cash-equivalent European Financial Stability Facility notes with a two-year maturity at 15 percent of the face amount. In contrast, the ECB received the full face (par) value of the Greek bonds that it had purchased in the markets at a discount on the face value (about €40 billion versus €55 billion face value) and would also benefit from future coupon payments on these new bonds.


In addition, Greek bonds purchased by Eurosystem central banks for investment purposes and European Investment Bank holdings were exempt from PSI.


ECB President Trichet stated in an interview in the Süddeutsche Zeitung on July 22, 2011, on PSI, “It goes without saying that the governments will have to redeem their bonds that are on the balance sheet of the Eurosystem without any change. Of course, being part of the official sector, we will not be participating in the voluntary private sector involvement mentioned on Thursday as regards Greece.”


Stressed countries refers to those which experienced sharp rises in sovereign bond yields during the period covered by this study.


In addition, one could analyze the spread between subordinated and senior bank debt CDS premiums, given the close comovement between bank CDSs and sovereign CDSs, as a proxy for sovereign subordination risk. Such an analysis would show that the introduction of PSI under the draft European Stability Mechanism Treaty in November 2010 and its effective use in Greece as agreed in July 2011 and reaffirmed in October 2011 raised subordination substantially, more so than the actual ECB debt swap in February 2012. However, this spread may be confounded by bank-specific conditions (for example, shares of subordinated debt) and country-specific legal considerations related to bail-in and resolution regimes, which will be overhauled following proposals by the European Commission (2011, 2012).


Note that this is not an independent third factor, but rather an attribute of LGD: the higher the Eurosystem’s holdership share, the lower the recovery rate (or higher LGD) for private bondholders.


Note, however, that the CDS-bond basis may widen as the result of credit tightness or relative margin requirements (see, for example, Garleanu and Pedersen 2011).


Note that the use of PDs abstracts from the debate on real-world versus risk-neutral probabilities. As shown in Bilal and Singh (2012), there may be substantial differences between the two.


This point is also made in Lin and Mutkin (2012).

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