Sovereign Bonds Roundtable 2009: part III
IFR: How do you think we stand with regard to risk appetite?
Ezquerra: We were talking about how to measure liquidity. Now it is: how do you measure risk appetite? That is even more difficult!
There have been a number of surveys saying that risk appetite is back to top levels, but then you think: what is risk appetite? And it seems that risk appetite is buying Greece at 200bp over swaps or ourselves at 80bp over Bunds and then saying: I’ll take more of that. That is not real risk appetite, frankly. Nor is having the national champions of each country issue a Pfandbrief and saying it's wonderful because risk appetite has returned. Let's hope there's more to it than this because we still have a long way to go.
Shane: Risk is better measured by whether the high-yield markets get back on their feet.
Ezquerra: We really need them to get back on their feet, and not just have top credits being less differentiated. There is still a long way to go; non guaranteed issuance by middle-tier banks, for example.
But the signals are quite positive and, touch wood, we’re past the worst. The sovereign markets have shown that they can stand up and be counted and we hope that we won't have any big systemic problems, but the road ahead is still long.
Bignier: I think that risk appetite can only be measured amongst the European sovereigns to a certain extent. There is little risk there, even when a Triple A rating is not awarded.
I think risk appetite can be seen in the CEMEA country market, Poland being an example. There was a very difficult period last year when the CDS of CEMEA countries was very high, with Russia around 1,000bp and Romania 800bp, and we were wondering whether there was any interest at all.
But we reopened Poland this year and we managed to bring Slovakia and Slovenia. I know that they are in the eurozone now, but for Slovakia and Slovenia we had to battle a little bit with the market to be able to launch the transactions. Poland, on the other hand, was surprisingly easy.
So, the demand is there. Croatia came to the market a few weeks ago, Lithuania as well. It was slightly difficult but they managed to close the transactions, and there is other Eastern European country looking to come to the market.
In the dollar market we saw Qatar go pretty well, and CDS is generally continuing to narrow.
The current levels reflect that the appetite for the risk is back. Nevertheless, I think that we will stabilise around here. The general economic environment remains fragile, especially in Eastern Europe countries and Russia.
Proni: Our experience with countries such as Poland, Hungary, the Czech Republic and Lithuania tells us that they are not going anywhere. It is quite difficult for us to find banks which are willing to support liquidity in them.
So, if that is a measure of risk appetite, I would agree with Enrique that there's not much of that yet – especially in, let's call them semi emerging or semi core regions.
We are talking to a number of market-makers and there seems to be some interest coming back, but it's all fairly lukewarm at the moment.
I remember in late 2003, before the enlargement of the EU, all these countries were the perfect convergence play; they were going to join the euro within the next three years. It’s funny how memories can sometimes be quite short.
Bignier: In 2006, Hungary issued a 10-year at mid-swaps plus 18bp.
Proni: Exactly, there you go; and where is Hungary now?
Bignier: Hungary did manage to come back to the market and I think they will probably look at it again in 2010, but they issued in the 10-year in March 2006 at mid swap plus 18bp.
Proni: And three years down the line no one wants to touch it.
Bignier: No, there are still some fears surrounding Hungary and we will test the market in the next weeks with Romania.
Now there is the IMF package that gives the market some comfort, but even with the EC package to Eastern Europe countries, for Hungary it's still difficult for them to come to the market. But I think we can measure the risk appetite there because in 2008 we were not able to launch any transactions for them.
Shane: I would argue that risk appetite has returned in a generic way. I actually think Hungary could do a transaction, Romania could do a transaction; it's now just a question of spreads, which was not the case at some points in '08 or early this year.
We can argue that risk appetite has waned again when it is not a question of spread, when people start saying: "I don't want to buy this at any spread”.
Proni: Risk appetite has stayed the same; it is just the risks that you are facing are growing. So, it rather depends which way you look at it.
Shane: I certainly feel that at the moment most of these borrowers have more cost effective routes, whether it's the IMF or EC.
But it definitely feels that the tone has improved. Whether that stays with us or not is another question.
Whelan: I think we are all reacting to the fact that the tone has improved a lot and it is the momentum of the improvement that is noted rather than the absolute price risk having gone back to whatever it was. And, arguably, it shouldn't go back to whatever it was.
Grodzki: I don’t wish to raise any alarm but you all know the issues. We're running into a big mess here because even though it seems to be going very smoothly, it's in totally the wrong direction.
What is happening is that the [UK] government is leveraging up in an unprecedented way, which is unsustainable. We will see falls, we will see inflation. So buying government debt at the moment is, I think, a very risky proposition; certainly because of inflation risk but also because of default risk.
We could see the differentials between governments rising massively.
Whelan: As an investor, do you look at the kind of debt portfolio that sovereigns have; the proportion that is index linked, the proportion that is nominal?
Grodzki: If we look at Venezuela as an example, they turned their banks into captive buyers by forcing them to hold massive liquidity reserves, which just happened to be perfectly suited for government debt issuance.
So, there's a lot of potential for fiddling, and we are therefore vigilant to protect our clients' interests. This is ultimately their future pensions. Of course, index-linkers allow us some protection here, and we welcome that.
But there are other issues, and in general we still haven't arrived at a base scenario for economic growth for the next few years which would allow for a happy ending to the story that is unfolding at the moment.
There is this inherent conflict now emerging between an economic recovery which inevitably leads to a rise in yields. That in turn will make it tremendously more expensive for governments to uphold the current level of indebtedness let alone increase it, as is projected now. We are walking an extremely fine line here. It will take some very favourable conditions to get out of this dilemma.
Whelan: The thing that is quite striking in the UK's case is that the longer yields have not really changed that much.
Grodzki: That is partly because there is a lot of captive demand coming from pension funds looking for duration-matching liabilities. Therefore, the true story is somewhat masked by various technical circumstances.
I think the 10 year yield is probably a more realistic gauge of investor concerns. We are looking at 10 year yields more than the short end or the very long end of the curve to check on our concerns with respect to investor appetite possibly fading.
The long end of the market has been subject to a squeeze for quite some time and that somewhat explains the anomalies in the yield.
Bignier: So, are you saying that you think that interest rates will increase for government bond, at least in the 10 year part of the curve?
Grodzki: If they don't, it will be because we will have remained stuck in the current slow and negative environment for even longer.
It is a very close call on whether 2010 will bring the green shoots which some of us may already have detected. But if they really were to start growing then yields would have to rise; there’s no question.
And if that rising yield is suppressed by monetary policy measures then clearly we are just fooling ourselves: it just prolongs and delays the problem and plants the seed for a very big disaster. It would basically create the next bubble, which would be much worse than the one which we are in at the moment.
Bignier: So, are you in favour of buying inflation-linked bonds? It's certainly a trend we are seeing currently in the market amongst our investor base.
Grodzki: Yes; and we hope that government doesn’t change the rules; there is a basic question mark now over whether you can trust governments.
Investors have certainly seen governments retroactively changing the terms and contracts between private parties in some cases.
Whelan: Are you referring to hybrid capital?
Grodzki: Yes, I was referring to exactly that. And that was a move that was not actually necessary; there was no pressing need to do it. It was convenient, maybe, but not more than that.
So if that is possible in what I would call a relatively benign situation, I dread to think what governments would do if they were really up against the wall. We are therefore fearful of governments going the Latin American way in terms of conditions – above and beyond the originally agreed contractual terms.
IFR: We mentioned-inflation linked bonds and, given the use of QE at the moment, we are seeing further inflationary pressures. Are we going to see more demand for the structure and are borrowers willing to issue?
Shane: On the demand side I'd certainly echo the view that there is lot of interest from accounts about protecting against these very risks.
It is that classic moment where everyone is talking about it, but the fact that inflation could pick up at terrific levels is not yet priced fully into the break even markets.
It's starting to feed through but it's certainly not there in the price yet. That makes it potentially an interesting time for investors to look at that market.
My expectations would be to see an increase in supply of inflation linked securities, and obviously it is part of the DMO's plan to do syndications in linkers.
Cannata: In Italy it is something that we are monitoring carefully. The demand is there for us to be able to launch a new bond, especially in the long end.
We wanted to be comfortable with the fact that investors are convinced, because we have a 30 year bond in the market that is quite old now. When the market conditions are right, it is time to launch a new one.
But investors have been quite uncertain recently and the preference has been to remain prudent, generally to not go further out than 10 years.
Bignier: We are seeing a lot of demand in inflation. There are sellers in the two to seven year part of the curve, and demand from 12-years up to the long end.
In the short end, investors are selling, as they expect recession for the next two years. The World Bank forecast was negative even for 2010.
We have seen demand since January this year switching to the long part of the curve: 12-years and above. For the time being, the bulk of the demand is concentrated in the 12s to 20s, the reason being that there is no supply here for the time being and the curve is squeezed. At least that’s true on the euro side but not so much in the UK.
When talking to investors, they believe we are in for a bit of inflation. At Soc Gen, we don’t think it will reach 6%, it will probably peak in 2011/2012, around 4% to 5%.
The demand is there, but the secondary market is not the most liquid.
Cannata: Although the demand is there, the 30 year is still a concern. It’s there in 10s to 15s, but the 30s seem a little bit scary – or it was at least until a couple of ago. We are continuously monitoring this sector.
Shane: In the UK, obviously there is a very well-developed pension market on the long end of sterling. A lot of the institutions have used the derivatives market as a way to protect themselves against inflation risk, but it is now much more attractive for them to use the cash market to do that.
I think we will see that demand flow into Gilt linkers and the long end as well, particularly because of the way the market has developed over the last six months or so.
Whelan: The UK has obviously been an issuer of linkers for a long time, across the maturity spectrum. There are a number of reasons for that, and one of them is this point about the credibility of an anti inflation stance.
But there is no correlation with what proportion we are doing one year versus the next year. It just reflects our desire to have an element of the portfolio in that form.
In terms of actual issuance plans, we have said that we are going to carry on doing some by auction but that we are also going to supplement that with some syndications.
Ezquerra: We have not had the need or the room to issue inflation-linkers but things are obviously changing. It is something that we are considering for the medium term.
It is true that there are benefits on the side of diversification, but as an issuer you also needs some comfort. It does help to diversify your investors but it's not a swimming pool you want to dive into without testing the water.
Whelan: If one starts from a perspective of just thinking about issuing nominals then one doesn't take much account of the regret risk.
Ezquerra: Regret risk?
Whelan: What we call "regret risk" is where after you've issued your 30 year nominal you think: “I could have got a much better deal on that next year,” or something along those lines.
Ezquerra: I agree that you need to monitor things on a continuous basis.
Proni: Did the announcement of the Bank of England's introduction of QE have any influence or effect on issuance decisions?
Whelan: No. There was an exchange of letters between the Bank and the Treasury about that – which you can read on the website – which clarifies that the MPC makes its monetary policy decisions and the government makes its debt management decisions independently of one another.
So we are specifically not seeking to take advantage of the fact that, as is very observable, there is quite a premium associated with the bonds that happen to be bought by the Bank. We have said that we would be issuing as that was unfolding. I think you can see that we were not reacting to that.
IFR: There has been a sharp contraction in the spreads between different eurozone members since the beginning of the year. Does this suggest that fears of a euro breakdown were exaggerated?
Ezquerra: I would say that was a very good opportunity for investors.
Shane: Because of the panic and fear that took hold of the market, there were terrific opportunities to buy governments at relatively attractive yield levels, certainly on a spread basis.
IFR: But does the recent contraction suggest the fears were overdone in the first instance?
Shane: We have really shifted from a situation of systemic risk. At one point we were in complete meltdown mode and now we are switching to a concept of idiosyncrasy; each specific sovereign is evaluated in terms of the risk of potential ratings actions, fiscal deficit positions and things like that.
We will see volatility in spreads again and I don't think anyone believes that we are going to go back to complete convergence any time soon, especially with the rating agencies being a little bit unpredictable in how they look at various sovereigns.
While I think we are still going to see volatility, what convergence there has been demonstrates that we had gone too far and that the market had become unnecessarily concerned.
Ezquerra: Investors came back when things had widened too much. There is now a bit of hope that the worst has passed.
IFR: Given the uncertainties in the market, have we seen an increase in the front loading of issuance?
Bignier: When we look at the figures for sovereigns, I believe that, as of today, somewhere around 65% of the global funding needs have been fulfilled compared to 54% last year. Nevertheless, the figure we have historically seen in the euro market is 70% by the end of July, maybe 65%–70%. So we are close to this figure and there has not really been any big change.
Whelan: The UK has always been a bit of an outlier on that. We don't front-load, we tend to just spread our plans across the whole year fairly evenly, which is what we are doing this year too.
Bignier: Issuers usually prefer to do 65%–70% by the end of July. August is closed, December is closed, so they really only have two or three months left.
But this was the already the case before the crisis.
Cannata: Yes, it was always like that.
Bignier: Which is logical.
Cannata: It is logical because in European countries in general the majority of borrowing requirements is concentrated in the first half of the year.
Ezquerra: In our case, we are done with issuing new benchmarks in the long part of the curve, but it will be interesting to see what happens after summer if the tone continues to improve. Let's be clear, we don't have any plans for this. But whether there will be more issuance in one part of the curve or another as the market reopens will be quite interesting. Even if people are already done, if there is a chance they might take it.
Bignier: Something that has surprised me in the sovereign markets over the last 10 months has been the return of the retail investor.
The volume is not huge, but clearly the trend is there. In September we had to establish a dedicated desk for our retail network sales force just to answer to the demand.
In fact, following the difficulties in Asia, the Lehman bankruptcy and Bear Stearns, I think that element of fear in the market had retail investors selling funds to buy bonds directly.
We saw a lot of demand for a number of countries where they were playing the spread; it was quite funny to analyse. The demand remains relatively small compared with that from other investors, but it is certainly something we have noticed.
Sometimes the trader was saying: "Five bonds, five bonds, you are crazy! You are making me change my pricing for five bonds?" It was quite funny.
Shane: The numbers are small but they add up.
Bignier: Exactly, and this is something quite new that we have not seen since the euro was created.
Cannata: This was true in our case. In mid October we were obliged to significantly increase the amount of the Treasury bills, just before the cut off of the auction.
In Italy we are seeing quite strong participation from retail. It had reduced quite significantly, but after September/October we observed a revival in this activity, first of all concentrated in Treasury bills, as usual. Now that those yields are low, we have seen a movement towards a lengthening of investment horizons.
We are getting requests about two-year zero-coupon bonds, and we are hearing that they are looking favourably on BTPs up to the five-year maturity.
Bignier: In France, retail investors are not allowed to buy Treasury bills, there is a clause.
Ezquerra: In Spain, there was a lot of panic buying, but the purchases have gone back down.
Shane: For retail investors, capital preservation is the key. They have been burned in so many places, whether it was the equity market or slightly more exotic fixed-income markets, so I think we will certainly continue to see this interest from retail accounts.
There is also a lot of Swiss retail dollar money, so there could be a whole wave of issuance completely derived from that target-coupon investor base.
A lot of cash has been taken out the equity markets and I think it's with us for at least the next six months; so that is another useful and positive development.