Sunday, 18 August 2019

Sovereign Bonds Roundtable 2009: part I

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IFR: How do you think the creation of the sovereign-backed bank asset class has affected borrowing in the capital markets since its inception late last year? What funding options are being considered by issuers in response to this – and higher sovereign funding needs?

Zeina Bignier (SG CIB): The creation of GGBs (government-guaranteed bonds) has not really hampered primary market activity. The increase in sovereign supply has largely been offset by the decrease of senior debt in the financial sector.

In 2008, the financial institution arena of course included covered bonds and, including these, it accounted for around €463bn that year. As of today, the financial institution sector, including the GGB market, is around €272bn.

Compare that to what the market was last year over the same period, which was €360bn; the €463bn was for the whole year.

The effect that GGBs have had on the market had more to do with the announcement of the schemes which affected spreads in the market. They paid a much higher spread than sovereigns or agencies (certainly, the old agencies, like EIB and KFW).

I would say that the competitive supply has triggered a widening in agency levels, and to a certain extent sovereigns. But in terms of capacity, I think that the market has absorbed this new asset class pretty well.

Daniel Shane (Morgan Stanley): Initially there was concern in the market, but not so much about the supply as such. The point you make is an absolutely accurate one in that people saw this replacing a lot of covered bond issuance. So, I don't think it was so much of cannibalising of demand but more an impression of the contingent liabilities that it was potentially creating for sovereigns. That was one concern that people had.

But I think that, very quickly, the market understood this was a very different asset class from sovereign bonds. Sovereign bonds offer liquidity; sovereign government-guaranteed bonds comprise a much more fragmented market. We've seen government-guaranteed issuance in the market already from numerous different agencies that carry specific guarantees, and they've always traded at a premium and with different degrees of liquidity than sovereigns.

It was really a different asset class and it did not create additional supply in the market. It was offset by the drop off we saw in senior bonds and covered bonds.

Georg Grodzki (LGIM): I would agree with the notion that the asset class has not necessarily grown at the expense of others, but we have certainly seen rivalries between government bonds and government-guaranteed bonds and between covered bonds and government-guaranteed bonds. So the relative value propositions in the market have shifted dramatically.

We see it as a transitory asset class and would not feel comfortable with sustained high issuance volume of government-guaranteed bank debt.

Banks should be able to fund themselves without an explicit guarantee. We are fully aware of the implicit support and we have the research resources in place to unmask any residual risk. So for us it's a symptom of the aberration in the marketplace, which, hopefully, will end soon. We therefore assume that it will not have a lasting effect.

IFR: The first guaranteed trade came at 25bp over swaps; did that strike you as the correct level?

Shane: There was also the US dollar equivalent, when we saw Goldman Sachs with the first dollar transaction around the plus 80bp level over swaps. I think there was a sudden shock surprise in the market that this was going to have a repricing effect for a whole range of different asset classes. You can't say sovereign issuance is completely exempt from that, but I think the majority of the impact was very clearly on the supranational and agency sector. My perception is that there is a strong differentiation between this asset class and sovereign – pure sovereign – bond issuance.

The likes of EIB and KFW obviously did see their spreads gap out substantially at the time, and this was very much in response to these issues coming to market.

Clearly, if there was explicitly government-guaranteed product being offered at 25bp over swaps in euros and 80bp over dollars, something had to give.

What happened to sovereign spreads in general was much more a comment on systemic risk in general and fiscal deficit positions. People were very concerned about the huge contingent liabilities, and if banks started defaulting just how much the sovereigns were guaranteeing.

It wasn't really a direct impact of the 25bp spread on Barclays.

Bignier: Last year, and at the very beginning of this year, the sovereign and agencies markets suffered as a result of the announcement of the government guarantee schemes. I agree that GGBs affected the agency market, the old agencies market, but on the other hand it is not the GGBs that have affected the sovereign market; that is more down to the huge deficits they have had to announce and the higher borrowing needs.

It all hit the market at the same time, and this caused a repricing of everything. SSAs was the last asset class to be repriced, and the effect of the announcements touched both agencies and sovereigns for different reasons.

IFR: So did it equate with a focus on the fundamentals of the sovereigns?

Bignier: At the very beginning, yes, but then I think the markets started to realise that this supply was not additional to GGBs; that ultimately the sovereign would be the one supporting the private sector in its own country. I think that within the investor community there is a clear difference between how they view sovereign risk and the sovereign GGBs or agencies, and there is definitely a clear appetite for sovereigns. We have seen it in all the transactions we have launched since January. I remember talking to a sovereign at the end of last year, telling them that we should be careful in 2009, that the threshold for a syndicated transaction would be around €3bn.

The first transaction was the Spain 10-year, where we reached a book of €16bn for a €7bn transaction. So, our research was completely wrong, even though we were still in a difficult market in January '09. So, I think investors are making a clear distinction between the sovereign sector and agencies and GGBs.

Enrique Ezquerra (Spanish Treasury): Our life would possibly be easier without the GGBs, but there has not been any problem with size. Touch wood, we have been perfectly able to raise considerably larger amounts of cash than we did in previous years.

But there has been an effect on price. It is very difficult to differentiate what part of any tightening or widening loss is due to GGBs or whether it is simply due to the deterioration in public finances, et cetera.

Shane: If you look at example of Greece, where there has not really been Greek government-backed bank issuance, sovereign spreads have still gapped out. What is driving this is much more specific; if there are deficit discussions, supply discussions, it's a factor.

Ezquerra: In Spain, we have really only had three-year issuance. If you look at the difference in behaviour between the three and five years it is practically none existent, although it is true that they have been moving all over the place, from plus or minus 80bp to plus 50bp and back to minus 10bp. So, the volatility is perhaps due to the uncertainties of how to relatively price all these new risks. At the end of the day the worry hasn't been competition from GGBs; there are a lot of other things to consider.

IFR: So, what funding options are being considered by issuers in response to both the potential competition and higher sovereign funding needs?

Jo Whelan (UK Debt Management Office): As a sovereign with higher funding needs than usual I think I can comment! From our point of view it is very much about the higher funding needs – it is not really a response to the government-guaranteed sector at all. But the challenge that we have had, which other sovereign debt issuers will recognise, has been quite considerable.

We have moved from needing to raise approximately £50bn–£60bn a year in the five years up to the last couple of years, to needing to raise well over £200bn; that is quite dramatic.

One has to take stock of that and think about stresses and strains on the distribution process and the methods that we and other sovereigns had typically been using for a while, which was very much based around an auction programme.

We in the UK actually consulted on this last autumn, exploring some ideas about supplementary issuance methods that we could use. We have implemented a number of those now in our programme for this year. The headline one that people will be aware of recently is our use of syndication, which was not something that the UK typically used before. So far so good, but it's only in one operation so far.

We are also doing a little bit around the edges in terms of slightly greater flexibility about what we issue using a process called a mini-tender.

These aren't fundamentally changing the basic approach, but they are, if you like, oiling the wheels, adding slightly more flexible processes all round the edges of the programme just to support the whole thing.

Maria Cannata (Italian Treasury): From October 2008 we started to be quite concerned regarding the potential competition, especially in the three to five-year segment of the market that has traditionally been quite strong for our funding activity. But now we can say that there was no real competition because investors understand very well the differences between a sovereign and bank guaranteed bonds. They distinguish quite well between the two. But at the starting point of this process we just didn't know!

So the problem was how to combine the need for more flexibility with our regular activity. In this sense, the change of auction method that we adopted has been very useful; before we had a fixed announced amount but now we announce a range and we cut the price at market level. This new method is very efficient. It reassures the market that the bond is priced at fair value because of the market price (although sometimes with a small correction). And for this reason we have seen investors putting orders in auctions, big orders, which is quite a new trend.

On the other side, it is also easier for banks to buy bonds and keep a position because they are aware that it's easy to re-sell to investors, and in this way the auctions are going very, very well.

At the beginning of the year we were also open to increasing our use of syndication and not always using auctions. But we realised that the auctions system was working very well and therefore we maintained our traditional stance.

We will use syndication only in the case of bonds with a maturity longer than 10-years, maybe 15 to 20-years in the nominal segment, and use it for new inflation linkers as usual.

We prepared several tools to face the situation and only some have been used.

Bignier: I think we have seen both trends used as an answer to this difficult market. First of all, there is much more syndication, which I believe has increased by 40% in the sovereign sector. Greece, for example, decided to go only for syndicated transactions this year. Ireland is another case in point, and Belgium has significantly increased its syndicated transactions: they have already done three this year, usually they do two.

Even France launched a 30-year. I don’t think France has any problems associated with risk assessment but they wanted to reach a large number of investors and have a deeper penetration into the market.

We have also seen more auctions, and sovereigns have adjusted their programmes to become more flexible in several respects: the size of the auctions, the number of lines they put up, and the fact that they could tap bonds off the run, Eurobonds. This has been extremely helpful for both sides: (guaranteed) banks and sovereigns.

For sovereigns, it has improved the cost of funding, because when you tap a squeezed line it is at a better level. For the banks, it has relieved their balance sheets as well.

From my point of view, the sovereigns adapted themselves to the market conditions extremely quickly, whereas the agencies took some time as they were much more sensitive to the pricing aspects.

Shane: Going back to the topic of higher funding needs, it was interesting – and you need to go back to January – that there was a real feeling of concern about whether sovereigns would actually physically be able to raise some of their prospective funding needs for 2009/2010. And the one thing that has given tremendous confidence from the beginning of this year is how the market has clearly shown its ability to absorb the amount of paper being issued.

We talk about €15bn books; it has almost become the norm for many of these syndicated sovereign deals. There is certainly liquidity out there now.

We can talk about tweaks and refinement and how you achieve the best pricing, and all the different aspects of syndication versus auction, and different tools as to how you change the auction process, and we could even debate foreign currency issuance, which is another route sovereigns have looked at. But it is now much more a question about how to achieve the best spread or funding costs or outright yields than how you actually get the money in the door. That concern has completely gone away.

IFR: When you are getting these big books, are they genuine? You talk about €15bn or €16bn of demand, but is it solid?

Shane: Of course there are some accounts that will inflate their orders in anticipation of cut backs. But at the time we close those €15bn books there are still usually accounts looking at the transactions. So I would say they are real in the sense that if someone wanted to raise €15bn euros at one time, that would be achievable.

Ezquerra: What we in Spain have attempted to do is take advantage of a couple of lead orders. Investors come to us and say: “We have an interest in a new 10-year, going to issue one,” or something. And, frankly, we have a debate whether it is worth simply auctioning the bond or taking advantage of this lead demand to try to build a good order book. Investors realise that there is value in the trade when you have strong, thriving demand.

If you manage to get a book which grows decently at first, which really grabs investors' attention, I believe it is very good demand. On occasion we have even had to close the books early and accelerate the process and not allow non European accounts to come in.

So, yes, it is always a moot point as to whether you could have auctioned a smaller size at perhaps slightly better pricing. But we also have our share of the problem of inflated funding needs! Size does matter at the end of the day.

Whelan: You are comparing it to the norm, which is auctions, and these are normally more than covered. You could ask the same question: is there real demand behind that?

Bignier: Syndicated transactions could allow a large part of the investor base that usually participates in the auctions to be present, in particular non euro investors. Since the beginning of the year, a lot of these investors have been coming into sovereign books.

With an auction, even though it is pre marketed, they generally prefer to come in later. The marketing process of the syndication is also extremely helpful when you want to diversify, and it can bring in very large orders.

Cannata: This is generally investors’ normal behaviour. But what is peculiar to this period is that we have seen larger orders, even in auctions, and obviously communicated by our primary dealers, but also from non euro investors.

We in Italy have not actually seen a particular change in the share taken up by domestic and foreign investors. We attract close to 60% – 56% or 60% – of foreign investors, and the rest is placed in Italy – which has been quite stable. Maybe there has been a moderate increase, but it is generally stable.

At the present moment, it is closely related to how effective the auction system is.

Certainly, there are times when there's a need for dialogue on a specific deal, especially with syndication. But, in general, the auction system works well and at present it is very efficient.

Unfortunately, we have seen some inefficiency in the secondary market and even now we sometimes have too a large bid/ask spread. The situation has improved, but not enough, in my opinion.

IFR: To what extent has market liquidity been restored in the sovereign bond markets and what does this imply for the future of an electronic trading?

Angelo Proni (EuroMTS): We need to start by defining liquidity. It is a term that is often used without any precise definition of what it actually means. A lot of people look at volumes and on the basis of that say it is a liquid market. At MTS, we tend to look at the tightness of the bid/offer spread: the bigger the sizes on each side of that spread, then the better liquidity.

It has improved over the past four to eight weeks, but it is still nowhere near where it was pre July 2007, which is when the secondary market started being affected – at least in our experience as a platform that collects executable prices on behalf of the dealers and in a mainly wholesale inter dealer market.

Spreads are still wider than what we have been accustomed to and volumes on MTS and the inter-dealer cash markets are still relatively low. Therefore, when it comes to the question of whether liquidity has been restored in the sovereign bond market on the electronic trading platforms, the answer is flatly "no". I still think that a reasonable amount of time will have to pass before we see the kind of bid/offer spreads that have been seen previously.

Clearly, business is good for the voice brokers right now. That's just a natural consequence of wider bid/offer spreads. What is encouraging from our point of view is that the dealers on our platform still quote consistently – obviously a bit wider, although there is a price discovery process. That certainly brings some value to the markets and a degree of transparency that is still helpful to many investors when they place orders with their dealers.

In terms of the future of electronic platform trading, I think it is not in question in itself, but we may be opening the door to slightly different models. I suspect the classic model of either pure inter dealer quote driven trading like MTS – or indeed the request for quote kind of trading that you see on platforms such as Tradeweb or BondVision – will be increasingly complemented by more hybrid techniques. If the dealers are willing to, their trades would be executed via voice brokers who can see the order book that market participants can't, working genuine interest to buy and sell, rather than just going through the motions of quoting. Maybe that will see turnover increase.

So it's very difficult to say how it's going to look like in, let's say, three years' time. I think that the present situation will carry on for some time to come. Market liquidity still has some way to go before we see the kind of depth and tight bid/offer spreads we were used to up until about 24 months ago.

Cannata: It's true that the volumes are limited, but it's also true that market participants now recognise the value of the transparency of this kind of a platform. That could represent a starting reference point for the rest of the market.

When prices disappeared from almost everywhere in December, not just from MTS, and you had a very large bid/ask spread, it was perceived as a dramatic problem by all.

Proni: I think what is helpful has been the fact that a number of DMOs – and I think the first one to actually do so was Italy – are moving away from the concept of actual quoting obligations. Italy did it a long time ago, but at the time no one really understood how elegant a solution it actually was. Not until we hit July 2007.

I remember conference calls with the other DMOs, and everyone was banging their heads against the wall as to what the correct level of required bid/offer spread was and what the size was going to be in that kind of volatile environment.

Following the traumatic process that took place, an increasing number of DMOs started doing essentially what the Italian Treasury had been doing, evaluating the primary dealers in the secondary market on a purely relative basis. That means that essentially any market-maker is compelled to do as best they can. It is a sort of self regulating environment that has actually demonstrated its worth: if we compare the bid/offer spreads that we see on the platform for those countries where a relative value approach is taken, those countries actually do perform better. That is quite objective and very measurable.

Shane: I think it is interesting to have this discussion about liquidity on the B2B or inter dealer side. It is almost a of tale of two markets in the sense that the experience that customers are getting right now is actually very different.

Liquidity for customers is now better for many sovereign bond markets than it was pre limits. The Bund market, for example. Given all the questions about balance sheets, that does seem remarkable.

Certainly speaking for Morgan Stanley, but I'm sure it's the same amongst our peers as well, the balance sheet dedicated to the sovereign business has actually gone up. It is now higher than it was a year or two ago.

Looking at risk for the various asset classes, we now have different risk limits for different products, but we are actually dedicating more balance sheet to the sovereign business.

So clients are actually seeing better liquidity. We still have a problem in being willing to offer liquidity to our counterparts; and this is what you see on the inter dealer systems at the moment.

I still feel that electronic trading platforms where there are inter dealers, whether it's with customers or not, definitely have a future. There is no question about this business; there is a huge amount of trade which is relatively commoditised and price based, and therefore electronic is a solution. You will still get customers calling up when they want to do large block trades, strategic trades, and are looking for better execution. But there is clearly a place for electronic trading platforms in the long term.

I think what we are seeing on the customer side will feed through to the inter dealer side, so I think it's just a question of a lag. Everything will settle down and we will see bid/offers improve.


Click here for Part two of the Roundtable.

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