Second-guessing of likely German federal government swap use has become a near obsession for derivatives dealers, partly because the local debt management agency shrouds its intentions in secrecy. Increasingly sophisticated asset and liability management by insurance firms is also driving derivatives flow, while Landesbanks and mortgage hedgers remain active swap users. Mark Pelham reports.
The most talked about German user of the swap market is the federal government through Finanzagentur, its capital markets agency.
The agency announced in 2002 that it planned to use swaps to achieve significant annual savings on the country’s debt portfolio. In the first year, the Ministry of Finance granted the Finanzagentur a ceiling of €20bn of notional swap volume to cover its swap activities. That figure was increased to €40bn in 2003, doubled again in 2004 and has been maintained at the €80bn level for the 2005 financial year.
But beyond that headline number and a publicly stated target of cutting annual interest costs by €500m to €700m in the medium-term, the Finanzagentur’s actual market activity is surrounded in mystery.
The agency has a long-standing policy of declining to comment on its swap use and its effects, primarily in an effort to ensure the market does not trade against it. Many swap dealers are equally cagey about what the Finanzagentur has or has not done in the market – the risks of souring an existing or potential relationship are presumably too great.
There are, however, some clues as to the Finanzagentur’s strategy, not least from the agency’s own quarterly newsletter. The publication said that its savings target would be monitored by calculating the difference between the current portfolio, which would include all instruments, including issuance, stock-lending, repo and swaps, and the reference portfolio, constructed by simple extrapolation of the previous portfolio based on past issuance standards. It said that the largest cost savings would come from the “flattening of risk structures of the loan portfolio”. The newsletter also said that the Finanzagentur utilises both “tactical and structural swaps”.
The picture this paints is one of a two-pronged strategy. First would come trading activity taking advantage of market circumstances using EONIA or short-term swaps (which are understood to be to a maximum of three-year tenors) in combination with longer-term instruments, most likely paying the short end and receiving of 30-year swaps to reduce the duration of the portfolio.
“They have not specifically said they are targeting duration reduction, but if they want to save money and they want to use the swap market the only conclusion that you can come to is that they want to reduce duration. It means that there will be virtually no changes in maturity of their new debt because they will keep issuing the same bonds, but put a swap overlay on top of it to reduce the duration,” said one dealer.
Keeping to the conventional issuance programme is key, according to the dealer. “They do not want to upset potential investors by saying they are going to reduce issuance in certain maturities. Doing so in the 10-year, for instance, would upset Eurex massively because part of the success of Eurex relies on the fact that there is always going to be a supply of German 10-year bonds in big liquidity and coming out as regular as clockwork to fill the deliverable basket.”
The volume of the structural swaps that the Finanzagentur would have to execute would be relatively large if it is to keep to its issuance programme and reduce duration. In March 2004, a report in the German magazine Der Spiegel suggested that the Finanzagentur target was to reduce the average life of outstanding debt from 6.17 years to 5.22 years by 2007. At the time, dealers speculated that the figures released by the magazine would mean the agency would need to receive around €85bn in 10-year swaps, and €10bn in the 30-year sector.
Actual trading has been less substantial. While there have been reports of deals with average trade sizes over the past year or so of €250m–€400m, most traders are sceptical that the agency’s involvement is still anything more than peripheral in terms of flow.
Yet its substantial ceiling of potential trades ensures that dealers expect that the Finanzagentur will eventually become a major player in the market. When it does, the dealers most likely to benefit will be those that the Finanzagentur has already expressed a preference for – the leading houses of the bund issues auction group. The top five firms in that group, in order for this year are: Deutsche Bank, Goldman Sachs, ABN AMRO, Dresdner Bank and Morgan Stanley. All are credible swap houses, though plenty of other dealers would welcome the chance to bid for business.
It has been confirmed, with the finalisation of Germany’s 2005 Finance Act in February, that the Finanzagentur now has the capability to issue and hedge foreign currency bonds. Bankers suggested that the issuance of such an instrument was likely in the relatively near term, and that it and any subsequent similar deals would be immediately swapped into euros, with the swap and underwriting mandates again going to the leading bund bookrunners.
A bigger potential source of business for swap dealers will come from the increasing involvement in the market of German insurers. Traditional insurance company involvement with derivatives has been through the buying of bonds with embedded options, usually callable structures, in an effort to enhance returns and meet the guarantees they supply to investors.
This business received a healthy, if temporary, boost at the end of last year when the German government removed the tax-free status of life insurance investments held for a minimum of five years with effect from December 31. The decision attracted huge volume to these accounts, which had to be opened by the deadline and have money invested no later than March 31 2005. Consequently, German life insurers significantly upped their structured bond purchases throughout the last months of 2004 and the first quarter of 2005.
This created its own difficulties. “German insurers as an industry are effectively short volatility because they have given away these guarantees, which are effectively options, and at the same time they are trying to enhance yield by selling volatility through buying callables. So they are doubling up an already not very well hedged position,” said one trader.
Growing awareness of these un-hedged positions, combined with the greater and longer-term issues surrounding the massive pension deficits at German companies, is leading to more direct involvement in the derivatives markets.
Unlike firms in Denmark and the Netherlands, so far German insurers do not have the spur of regulatory involvement to encourage a focus on asset-liability management, but traders report an increased presence nonetheless.
“There is a trend, at least among the biggest insurers, to start looking at active management of their liabilities. This typically takes the form of products such as long-dated constant maturity swap floors to pay for guarantees and buying 10-year into 10-year receiver swaptions to meet longer-term pension commitments.
“In addition, we see a number of insurance company asset managers coming to market to change the pay-out of existing bond portfolios to macro hedge their liabilities and using whatever instrument is appropriate, such as caps and floors,” said one dealer.
There are also signs of increasing duration management activity through receiving the long-end of the swap curve. “All of our German insurer counterparties used to hedge their duration purely through bonds, which is cumbersome.
But now the most sophisticated companies are mainly using derivatives,” added the trader.
The use of more advanced asset-liability techniques looks likely to expand throughout the insurance sector, according to one marketer. “ALM is still the preserve of the big guys, but we expect to see a significant increase in the use of derivatives products across the insurance sector in this context over the long term,” he said.
In the short term, the most active group of German financial institutions in the swap market, except the major international derivatives dealers of German origin, will remain local banks. These firms maintain a regular active market presence to hedge their positions, with the Landesbanks and mortgage banks particularly active.
There has been concern that the removal of state guarantees and a consequent drop in credit ratings (see separate article) could damage Landesbank swap activity. However, dealers no longer see this as an issue.
“Even if Landesbank credit spreads blow out because they no longer have state support, I do not think it will alter their swap activities because their trades are collateralised for the most part,” said one trader.
There had also been concerns expressed over mortgage bank activity in view of the abolition of the specialist bank principle. Combined with a decline in the overall number of pfandbriefe issues in recent years this has brought about a reduction in the business they generate from swapping new issues against Euribor. But the mortgage banks remain a profound influence in the asset swap market, where they generate a healthy income stream from arbitrage opportunities when managing their asset pools.