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Sunday, 22 October 2017

An issue of quality

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The flight to quality has generally benefited the Triple A issuers. They have made significant progress with their 2008 financing programmes, without incurring the wrath of investors looking for weakness in their credit armour. Mike Winfield reports.

European agency issuers have arguably been the greatest Triple A beneficiaries of the flight to quality resulting from the global financial downturn. Their borrowing costs have contracted relative to Libor this year – at least at the shorter end of the credit spectrum.

Sovereigns are also benefiting in Libor terms, while seeing their spreads to Bunds widening to previously unthinkably inflated levels. Much of their new debt priced at significant concessions to their existing curves. The issuance volumes from sovereigns have remained high as investors have preferred the security they – like agency issuers – have offered investors. While the economic conditions in the Eurozone have not been conducive for the ECB to follow the Federal Reserve in lowering its 4% refinancing rate which hasn't changed since June 2007.

Since the late summer of last year the European economies have been characterised by soaring levels of inflation, as growth has started to falter. Overall, euro area consumer prices reached a new high rising by 3.6% in the year to April 2008. What seemed to be a temporary surge in prices – mainly due to the high price of oil – has now turned into what the ECB likes to call a 'protracted' period of inflation, driven not just by commodities but second round effects of generous wage negotiations – especially in Germany, Spain and Italy. Currently the ECB risks missing its own inflation target for the tenth year in a row, despite the credit crunch, and there are clear signs that economic growth is weakening in countries like Spain, Italy and Ireland.

Public finance data last year revealed a mixed picture for the European economies in their ability to deal with an economic slowdown that looks ever more likely. Spain shows more room for maneuver, having been favoured by buoyant revenues in the past three years. In Germany, sustained efforts to ensure fiscal responsibility have provided the best fiscal position since unification, according to the IMF. France and Italy, on the other hand, with already high levels of public spending and expected low revenues for 2008, have much to fear from the prospects of a slowdown across the euro area. Looking ahead, a marked slowdown in economic activity seems inevitable for most major European economies as the new European Commission Spring Forecast recently revealed. Growth in the euro area is expected to slow to 1.7% this year and 1.5% next year. Its inflation forecasts are not very promising either, averaging 3.2 % for 2008 before easing to 2.2% next year still not below the ECB's target.

Despite this background, at the end of the first quarter none of the major issuers could be regarded as being significantly behind target with their borrowing programmes, despite a reduction in the overall borrowing volume of the SSA borrowers compared to 2007. This apparent anomaly was largely due to the substantial frontloading seen in previous years – very little debt had to be raised in the final quarter of 2007. While the deteriorating credit environment was not without SSA casualties, they were significantly fewer in number than elsewhere in the capital markets, and mainly manifested themselves in difficult pricing, rather than killing deals altogether.

By the end of the first quarter SSA issuance by syndication in the main three currencies amounted to €75.1bn, of which 59% was euro-denominated bond issuance, 35% was in US dollars and 6% was in sterling (at then prevailing exchange rates). This compares with €96.5bn of issuance in 2007 with euros accounting for 66%, US dollars 27% and sterling 7%, based on exchange rates at the time. While nominal US dollar issuance grew to US$42bn, compared to US$35bn last year, euro-denominated volume fell by 28% to €44.7bn. Within this figure syndicated sovereign issuance grew by €6bn to €32bn, which was more than offset by a €25bn fall in agency financing to €12.7bn. This was due to a general preference for US dollar assets as the Federal Reserve aggressively cut interest rates to combat the negative consequences of the credit crunch.

Although the volume of syndicated sovereign supply rose during this period, given the relatively large size of the deals, the real significance has been the fall in agency supply in euros and the corresponding increase in US dollar denominated supply. Nevertheless, both the largest European agencies – KfW and EIB – and most of the smaller Scandinavian borrowers were over a third of the way through their funding programmes by the end of the first quarter, surpassing the half-way point by mid-April as conditions for new issues started to improved.

The EIB had raised over €26bn of its €52bn–€55bn funding requirement for 2008 by mid-April which was generated from four global trades and one Eurodollar deal. KfW, the second-largest European agency, had also completed over half of its 2008 €70bn requirement. Moreover, the EIB had achieved a tightening of its new issue terms relative to Libor as investors sought safe haven in its Triple A rated assets. In its first five-year global debt issuance of the year the EIB priced a US$3bn trade at mid-swaps less 20bp in late January, while less than two months later it priced a similar deal at minus 25bp.

In the sovereign space, the Hellenic Republic (rated A1/A/A) has been the most prolific syndicated issuer with three longer dated issues maturing in 2024, 2030 and 2040, as the sovereign continued its policy of front-loading its bond issuance for the year. All of these issues underperformed Bunds as peripheral market spreads widened relative to German debt. This underperformance has been most acute in the weaker sovereign credits, but extends to all of the European issuers.

At the beginning of the year Austria sold an upsized €4bn 4.35% March 2019 trade through BNP Paribas, Goldman Sachs, Lehman and Morgan Stanley at 10-year Bunds plus 21bp, or swaps less 23.5bp. The deal was "the only syndicated offering from Austria this year, as a result of a reduced financing requirement and therefore attracted a very high degree of support, resulting in an eventual book size in excess of €11.5bn," said Alexandra Basirov, head of SSA DCM at BNP Paribas at the time. Despite having the benefit of rarity value, the deal offered a concession to the outstanding curve. As a result it tightened by 3bp to Bunds in the week in which it was launched.

By mid-April though, the deal was trading around 30bp over Bunds, having traded as wide as plus 35bp in late March. This underperformance has been accentuated by the amount of sovereign supply at the longer end of the market at a time of sharp curve steepening. Conversely, it is because of the European sovereigns' preference to fund at the longer end that there has been an increase in the number of syndicated deals. Almost all of this year's activity has been in 10-year or longer-dated bonds, and all have subsequently underperformed Bunds as the flight to quality has favoured German assets. In fact only Belgium has issued at the shorter end of the curve through syndication, attracting an order book of around €12bn for its €5bn 4% April 2014 OLO54. The trade was priced at 32bp over the comparable Bund, or at swaps less 19bp. This compares to the OLO50 which was priced a year earlier at just 3bp over Bunds, or less 17.5bp on an asset swap basis.

"The credit market environment showed marked signs of improving immediately after Easter with Finland, which followed the Belgian transaction as well as one for Ireland, able to print an 11-year benchmark at no significant new issue discount to its outstanding curve," said Sean Taor, head of SSA syndicate at Barclays. The €4bn 4.375% July 2019 deal priced at 34bp over Bunds, or 21bp through swaps, through ABN AMRO, Barclays, Deutsche Bank, HSBC and Nordea, compared to an initial guidance of less 19.5bp–22.5bp, with no sensitivity reported to the eventual pricing level. This was in contrast to sovereign supply earlier in the year which had required concessions of as much as 4bp–5bp. In this respect, sovereign pricing can be regarded as having deteriorated since the onset of the credit crisis.

Despite this, all European sovereigns have been able to achieve financing, albeit not on such favourable terms as the agency issuers which have been able to benefit from the more attractive funding opportunities afforded by the US dollar market this year. The shift in the US dollar/euro basis swap market in April has added to the benefit of issuing dollar denominated liabilities and swapping the proceeds into euros.

Spanish guaranteed Instituto de Credito Oficial was able to borrow an upsized US$1.5bn, for example, at mid-swaps less 17bp (which equated to around Euribor less 23bp) in a well received deal that tightened by around 5bp in the immediate after market. By comparison five-year Spanish government bonds were trading at around 20bp over OBLs, or swaps less 25.5bp in late April. The notable weakening in the asset swap valuation of five-year Spanish government bonds – in conjunction with the positive effect of the basis swap – actually led to a situation in which ICO was trading at a tighter level than its guarantor.

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