Sovereign Bond Markets Roundtable 2008: part two
IFR: What are your views on European sovereigns issuing in US dollar format? Both Spain and Italy have recently done this with deals that have clearly been driven by the movement of the basis swap. This was the motivation for Italy issuing in dollar format on this occasion, if not all occasions. One question particularly stands out: do you think the basis swap shift is a permanent or a temporary phenomenon, and why did it move in the first instance?
Ezquerra Martin: I have asked many different banks, because obviously it is not a market that we follow from the Treasury – we just look at the quotation and it is difficult for us to judge the underlying forces. But the most rational explanation I've heard so far is that European banks are having to fund assets denominated in US dollars, and cannot obtain funding in dollars. So they fund themselves in euros and reverse the position through the basis swap market by paying dollars. For European sovereigns who are accessing euros, on the other hand, we are interested in the opposite trade when we issue in US dollars.
So from this point of view, insofar as European banks have trouble funding themselves in dollars, they will maintain this trade and they should keep some pressure on the basis swap. That's the most rational explanation I've heard. I can't say I underwrite it fully, but what we did see was enormous volatility in basis swap spreads, because there's not the usual sort of arbitrage that takes place between asset swaps in the dollar market, the euro market and the basis swap.
IFR: Spain's five-year trade earlier this year was done at swaps less 28bp. I think there may have been an incremental 7bp or 8bp pick-up, or cost saving, because of the current level of the basis swap. Is that of interest to other European issuers?
Leclercq: If we look at the market, it seems to present a very good opportunity. We are looking at the market to really try to find out if we should follow this route: what we should do and what kind of pricing may be attainable, although this is only under consideration at the moment I hasten to add. If we did do a US dollar transaction, it would be an addendum to our normal issuance programme, so it would not change the normal predictable programme we follow. In addition to the normal euro-denominated bonds we issue, we view US dollar issuance as an opportunity, one that could help us achieve cost efficiency. If I look at what Spain was able to do, it does appear to be very attractive.
So we are really looking at that and hoping that we may be able to follow this example. There is, however, a whole documentation process to overcome first. So, at any such time a decision is made to issue in US dollar format, it will depend on if the market is still there and if the asset swaps level remains attractive. We would hope the basis swap element may still be there, although there are other elements which are important in the overall decision to proceed. I think that the basis swap shift may not be there to stay forever, but probably for some months more.
Hogan: In addition it is sensible to keep in touch with the dollar investor base from the point of view of sovereigns and supranational issuers. Earlier in the year investors were focusing on dollars because the Fed was on the move. The Fed was showing leadership at a time of uncertainty, and the US dollar yield curve was steepening dramatically, so there were opportunities. For example, when the Fed introduced their initial rescue packages, it was the dollar market that reacted quickest and the most violently and improved the most dramatically. So to have a facility in place to take advantage of that when the dollar market was picking up was very sensible. Now, as the Fed's behaviour has changed and the markets are settling down, the need to lower rates is much less pronounced. Whether issuers who may not typically invest in dollars will look at other currencies we will have to see, but I think in the first four months of this year there was a definite desire for low yield, highly rated dollar products, which may diminish over the course of the rest of the year. From a supranational or sovereign perspective, one of the things to be sensitive to is that the environment may change completely where there was a premium for low yield, high rated paper. As the markets equilibrate and desensitise to the concerns about credit, it's likely – certainly given historical spreads against corporates – that the demand is going to go completely to the other side, to the higher yield, more risky sector. This will create additional strains on the sovereign and supra-sovereign community to continue to issue at desirable spreads.
Nijsse: We have concentrated on shorter dated issuance of euro commercial paper where prices are set in either pounds sterling, US dollars or euros. We have benefited from issuing in US dollar format in this way. But longer issuance is, of course, a judgment of whether you think it fits in with your issuance programme and issuer profile, even if it turns out to be a short-term opportunity. So it is a sort of choice: do you want to make use of short-term opportunistic borrowing, or do you want to do a longer term programme? So far, we don't have immediate plans, but we always look at all opportunities and we don't explicitly exclude it.
Maisey: I think there are very attractive funding rates at the moment. In terms of whether some of those things will persist, I think some of the currency basis – and even the level of the three sixes basis – are supply and demand driven. Some of these things are things that people didn't focus on before, so there are a number of idiosyncratic risks that no-one was really paying much attention to previously. So how long that lasts is very hard to tell and I don't think there is a "back to normal", where we just go back to the position everyone was in a year ago. A lot of lessons have been learned, people won't just go, "great, we are back to how we were".
The other thing is there is a lot of demand for very high quality dollar paper. But a lot of these investors are buy and hold, which results in less secondary market trading because people have generally bought those issues in the primary market and just hold them to maturity.
IFR: With regard to covered bonds in particular, they were positioned as a rates proxy to investors and were traded on the electronic platforms which came to an abrupt halt at the end of last year. Can this liquidity be restored on the electronic platforms do you think, and in what way can that be achieved?
Proni: I think eventually it can. The real question is how and when. I do not believe that it be restored in a timeframe that we think is both realistic and acceptable and the main question, especially for MTS, is: can it be restored according to the old market-making model, or do we have to adapt to a new reality and find a new paradigm according to which we can actually achieve the kind of liquidity that we had achieved previously?
For the time being, given that covered bonds have been perceived by the investor base previously as proxies for government debt, the fact that they are no longer perceived as such has to account for the new reality. This is pretty much an immaterial point as the prices speak for themselves. The change in perception is going to take some time to revert – if, indeed, it ever does. MTS has been involved fairly closely with the covered bond industry and has attended a number of meetings with the individual banks, the individual issuers, as well as the ECBC. We are in the middle of seeing if we can devise, together with the market, a way to slowly re-establish that liquidity.
The first thing that MTS has done on its own is to get rid of the previously more rigid approach requiring banks to commit to providing liquidity in the market and giving them a bit more of a free reign. Namely, the requirement to post prices according to a maximum bid offer spread in minimum sizes, which as far as covered bonds were concerned, was actually restricted to certain securities that had a minimum amount outstanding and other sorts of objective criteria, has now changed. We are moving towards what some sovereign issuers have done in Europe with their own issuers to a certain degree, giving the banks a bit more freedom to make their own best efforts in order to try and re-establish some semblance of liquidity.
Lately, activity has started to come back into the electronic market place. Obviously we are still quite a long way off getting back to where the market was a year ago, where the product was perceived as a potential rates proxy. Of course, covered bonds are different to mortgage backed bonds, but the investor community at large is no longer perceiving it that way and I think it's going to take some time before this situation changes.
IFR: Is it the case that liquidity also fell dramatically in the agency market?
Proni: Yes, although not to the same extent. Agencies are somewhere in between, although it depends on what is meant by liquidity drying up: there is a question of degree here. Obviously sovereigns have still remained by far the most liquid instrument – much less compared to what they were before, but much more relative to the other asset classes than previously. So I think there is also a question, not only in principle, but of the degree with which you look at this and analyse the situation.
Wilders: I think it depends on the proxy that you use: if you take electronic trading in the inter-dealer market, which eventually increased, and the spreads that people pay is related to cost, what does that say about liquidity? Or you look at the overall volumes – and I think I can speak for all of us – in our market they were relatively high. If you look at the spreads versus corporates, et cetera, then it means that accounts must have been better buyers, so we must have had liquidity. So it is a question of how it is measured. All in all, I think the government bond markets functioned relatively well, albeit at levels that we have not been accustomed to previously.
Maisey: I think that there is more differentiation. Some types of bonds have totally disappeared, while volume in high quality government bonds hasn't really dropped, although some of it may have moved off the electronic trading platforms and on to a voice basis. I think those things will come back. I don't think that's something where you can just flick a switch and it goes back to where we were – it takes time, and people are nervous and they are going need a gradual re-introduction. Maybe now it is a good opportunity for new models to come out, new ways of trading things that answer particular needs.
Hogan: I think the covered bond and agency markets are suffering, if that's the right word, from similar concerns that affected the EGB market over the last 18 months and I think the solution will also be in the form of prices moving back onto the screens. To have the covered bond and agency markets trading over the phone will not be sufficient to restore investor confidence in the marketplace.
Proni: That is the difference between the sovereign and the covered bond market: the latter has almost disappeared, while the former has actually moved in terms of the location at which liquidity can be found.
Hogan: Because the sovereign universe consists of a smaller number of issuers, the situation is somewhat easier to resolve, whereas the covered bond market consists of a multiplicity of issuers from numerous different jurisdictions.
Wilders: I agree that the transparency is the most important thing. It is necessary to have a starting point, even though it may not be possible to trade from that starting point. We have asked our primary dealers to have an arbitrage free inter-dealer price out there, and obviously not everyone can trade on that price. But it is at least a starting point for a discussion which is difficult if the market has entirely disappeared.
Hogan: The central issue in the covered bond market has been the issuers. I think the leadership shown by the DTSA to assess the market at times of both normal conditions and at times of extraordinary conditions has been crucial. It makes sense to monitor dealers in both normal and fast conditions and then make comparisons against their peer group.
Wilders: It is also very important to have a price somewhere. It doesn't matter how wide spreads were to begin with, but it starts with some transparency and even though it can be painful to have to trade on a very wide spread, that's the chance you took when you bought the bond or went short of the bond. That's what it is all about: transparency. It is obviously more difficult in the covered bond market because of the number of issuers.
Rivoire: I think it is not only a question of transparency and liquidity. You've also got the question in terms of quality of the credit and in the last 12 months we have seen a re-pricing of all credits as well as a re-pricing of liquidity. Obviously the covered bond market has re-priced because the quality of the pools behind the covered bonds may be different. Because the regulations are different in various countries there may be different consequences too. For sovereigns, the market has just re-priced the liquidity and obviously there are a fewer credit differences, but it is more the liquidity that the market has re-priced rather than the quality of the credit, which is the situation with covered bonds. I think that is a major difference.
That was more the case in the last 12 months, even if the situation has improved in the last few weeks, we have not seen any significant buying interest from investors in covered bonds. When we talk about market-making and about the transparency and liquidity, it is difficult for a bank to regard it as an efficient market because in fact the market doesn't exist anymore. In terms of net flows, even if liquidity has been lower than before the last 12 months, in the end all of the sovereign issuers have been able to sell what they need to sell.
Wilders: Whether you want to buy, or you want to sell, despite having very wide spreads, at least this approach will provide you with some transparency.
Rivoire: But the fact is that, for the covered market, even very wide prices don't mean a lot, keeping in mind the lack of investor participation.
Wilders: Nevertheless if it can be established where there is selling interest and where there is buying interest, even though it might not be very a very tight market, at least it is a starting point.
Rivoire: I agree, but the banks, as we said at the beginning, are in the middle between the issuers and the investors and if the investors are not there, at least for a temporary period, it is difficult for the banks, especially due to the agreements and commitments they have made, to compensate for the fact that investors have disappeared. It is difficult for the banks to stick to the same market-making rules if you've got parts of the market which have disappeared. But now the situation has been improving, the issuers coming back and the ECBC is working with the different platforms to see what is viable and what is not. But we have to keep in mind that market-making is efficient only when the market is efficient and only if the market is working as it should.
Wilders: But this is exactly when you need market-making. If everything is going well, who needs market-making? So it starts with the situation where there is someone in the middle with information about where both buyers and sellers are located, and puts them on a screen somewhere to give some transparency. This is the basic premise of market making: knowing where the buyers and sellers are,
Rivoire: If I may, I think that when you say we need market-making when the market doesn't work, in one way I totally agree. But from another perspective, it is dangerous to force the banks to continue to quote when they don't want to trade. It is necessary to make a distinction between quoting prices and trading.
Hogan: There shouldn't be any difference between quoting and trading, because all your prices should be live continuously.
Rivoire: No, there is a major difference. If you quote and you want to trade, you are pleased to take and to keep the position. If you quote and you don't want to trade but were forced to, what are you going to do? In this scenario if you trade the probability is that the position will be sold back into the street, which will accelerate the magnitude of price movements in the process.
Wilders: Even I have an interest at zero bid- 200 offered, so at a certain spread there must be a willingness to trade.
Hogan: I assume you are describing the core issue of the existence of compulsory market-making in Europe, whether it is in governments or covered bonds or agencies. I think as a group communally we agree that that's not disappearing. So if that's your premise then you have to try to optimise the situation, given the risks and the undesirability of making markets. I think Belgium and Holland have shown leadership to the market by saying: "We recognise and understand that there are conditions where we will call them extraordinary, where you don't want to make markets, but some of your peers might wish to make markets and we will reward them for doing that.”
So what the platforms need to do – in conjunction with issuers, regardless of what category they are in – is be able to monitor and compile and report to those issuers the performance of the dealers. So you have the willingness of the issuers to be flexible as well as the commercial peer pressure within the dealer community, which has always existed and which always will exist. Add to this the desire of investors to see a price somewhere somehow; and the ability of the platforms to compile, tabulate and distribute this information, and then you have the beginnings of the solution.
Rivoire: I agree but the situation is different between the sovereign and the covered bond markets.
Hogan: It is just the difference in price, though.
Rivoire: No, no, no, that's wrong.
Ezquerra Martin: One is made up of sovereign and the other a multitude of many banks from various jurisdictions.
Proni: I would like to make the point that yes, we agree that it is the issuers who should take the lead, although it begs the question: should you really disregard the type of issuer? For example, is a covered bond issuer in a position to offer similar incentives to a sovereign issuer? Because if they were, then I would assume that the covered bond issuers could actually have implemented similar systems and restored liquidity in the same way that has happened for sovereigns. In which case, why didn't they? I'm not sure they can actually afford those incentives.
Wilders: At some point, it starts to become interesting as a market-maker. Going into an auction with an off-market price, if you get it you are happy and you never know if that's what everyone else is doing.
Proni: We agree that it is better to have some prices, as bad as they may be, than no prices.
Maisey: I think it is definitely better if there is always a price for something from a theoretical point of view. I think at the moment, though, the problem is that there has been a lot of pain and people have become very nervous. This has led to the view that, "irrespective of price I just don't want to hold that bond or get left with a certain position in something, because I can't cover it". I think this brings us back to the point on the differentiation between different credits and different markets. There are certain covered bonds where the market is going to return to normality more quickly than others, or where it has suffered less than others. There are others where potentially the market will never come back and then people conclude it proved it had to be a bad idea, and people didn't understand the risks or don't want to trade anymore.
Everyone understands electronic trading is an efficient way to clear risk, to find buyers and sellers, and the price transparency is a big benefit. I just think it will take some time for people to be confident enough with the potential downside of being a market-maker, sticking your head above the parapet and putting prices out there. At the moment it all looks like downside to do that, there isn't enough upside in doing that currently. Maybe it will come back very aggressively, but it is more likely to come back over time.
Rivoire: I think that it is not only the banks, but the issuers as well – in fact all market participants – that are working to try to find the best way to do it, taking into consideration the new market conditions, which obviously vary between the different asset classes. But all the banks are committed to try to provide the best market, the greatest transparency and the best market-making they can. But, once again, the banks need the market to return to a more stable footing to be able to do this in a very efficient way.
Click here for Part Three of the Roundtable.