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Tuesday, 17 October 2017

Sovereign saviour

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The deployment of the European Financial Stability Facility and the European Union to assume the financing needs of Ireland hasadded a new dynamic to the sovereign landscape. But what impact have they had on the SSA market? Michael Winfield reports.

To view the digital version of this report, please click here.

Following the Irish bailout in late 2010 many market participants thought that the increasing presence of the European Union on behalf of the European Financial Stability Mechanism, and the EFSF in the market, could undermine the SSA sector. Many assumed the increased competition for funds would be a major headache for SSA issuers.

The first benchmark deal for the EU appeared in early January, with the EFSF not far behind. Contrary to some expectations both issues tightened significantly and, against this backdrop, can actually be viewed as having helped the market accommodate extra supply.

At the end of 2010 the uncertainty created by the situation in Ireland, and by extension the European peripheral markets in general, weighed heavily on the minds of bond issuers and their arrangers. At that time most of the frequent SSA issuers had largely completed their 2010 funding. The resolution of the Irish question had effectively seen attention turn away from how new issue markets would end 2010, to how they would open in the New Year.

The feeling was that any agreement reached between the EU, the ECB and the IMF, alongside calling on the EFSF, would increase funding costs for other issuers. For the EFSF – a new issuer in the SSA sector – the debate was really about its ability to independently raise funds in the market. The 120% over-collateralisation by the individual member states underpinned its Triple A credit rating.

By the beginning of December an expected €90bn bail-out of Ireland had become a reality. It had originally been thought that the European contribution would be divided into €50bn from the EFSF and €10bn provided by the EU, or the EFSM package. The EU had been a regular, if not frequent, issuer over the years, utilising its Balance of Payments Facility to assist Latvia, Hungary and Romania. The original division of responsibility would have limited the lending to be undertaken by the EU, which seemed somewhat counterintuitive as the EU had an existing yield curve.

The final terms of the Irish bail-out amounted to €85bn, with €17.5bn to be provided by the EFSF and the EFSM’s contribution standing at €22.5bn, to be raised by bond issues from the EU itself.

No room for failure

At the beginning of the New Year, the EU sold its first large benchmark deal and attracted a huge book in excess of €20bn for the €5bn December 2015 issue. At the end of the first week, after pricing at mid-swaps plus 12bp, the issue had tightened into sub-Libor territory. By early April it was quoted at mid-swaps less 7bp-9bp.

“Being the first issue of such size by the EU required a very small concession of 2bp to our existing debt,” said Herbert Barth, senior borrowing adviser at the EU, at the time.

On the other hand, referencing the EIB’s October 2015 issue, which was quoted around mid-swaps plus 3bp, could have implied that the pricing was 9bp back of the EIB, or that the EU was being overly generous.

“The important point was to demonstrate that the EU could ensure the support of over 300 accounts that took part, and the performance of the deal after pricing vindicated the pricing of the issue,” said Sean Taor, global head of public sector origination and syndicate at RBC CM. “It can also be seen as an endorsement of the efforts that had been made within Europe to present a rescue mechanism for those sovereigns in need of external assistance.”

Later in the month it was the turn the EFSF with a €5bn long five-year deal. It was vitally important the deal came off: failure, or even a lukewarm response, would have been a disaster. A book approaching €45bn sent a powerful message and helped to reaffirm faith in the eurozone’s ability to resolve its problems.

The EFSF’s inaugural July 2016 trade received massive support from across the investor spectrum – and went on to reward believers with a strong secondary outperformance. Vitally, the deal left the door open for other European issuers and showed that fears for the euro currency – and the European project – had sharply receded.

“We can see a change of perception following not only our inaugural trade, but also successful financing by the European Union and the EIB. Together, these transactions offer testimony to the changed perception that has occurred regarding the stability of the eurozone recently,” said Christophe Frankel, EFSF’s chief financial officer.

A whispered spread level of mid-swaps plus 8bp–10bp was communicated at the beginning of the week in which the deal was launched. This resulted in a shadow book of around €35bn by the end of the day.

The books were officially opened the next day with the guidance set at mid-swaps plus 6bp–8bp at 8am London time. Its final order book was amassed within 15 minutes, resulting in the deal being priced at the tighter end of guidance. In the end, more than 500 investors bought paper. “The issue was attractive to a vast array of accounts … as being an attractive way of buying into France and Germany, which make up the largest part of the EFSF structure,” said Emmanuel Smiecench, syndicate official at SG CIB.

Consequences

The tightening of both issues had a positive impact on the SSA sector. The deals have highlighted the positive value in the sector after the initial uncertainties were resolved, benefiting a number of issuers including KfW and the EIB.

“The impact of a new issuer – the EFSF – in conjunction with a larger role for the EU has seen some weaker sovereigns effectively replaced by Triple A issuance,” said Taor.“Another consequence of the changed pattern of European supply may be that syndicated sovereign issuers are ultimately replaced by what, going forward, may become the closest thing to being a proxy for what could be regarded as European bonds.”

The debate over the enlargement of the EFSF was boosted by the apparent agreement reached in March to enable the fund’s full €440bn capacity to be realised. That, along with €60bn from the EFSM and €250bn from the IMF, was expected to eradicate any remaining doubt about the effectiveness of the rescue mechanism.

Again, a political impasse created by elections in Finland caused the final approval to be delayed. At the same time the need for Portugal to request assistance was rising, with an estimated €80bn bailout under discussion – an amount that could be easily found from within the existing structure.

“The current expectation is that the division of funding for Portugal may be shared by the three entities (the IMF, the EFSM and the EFSF).  If the Portugal assistance programme mirrors the Irish financial support package, this would imply an annual funding need of circa €8bn-€10bn for EFSF and EFSM each over a three-year time frame.  From my perspective, as was the case with Ireland, this is unlikely to present any significant difficulty in funding for other SSA issuers, and may actually be beneficial to the overall dynamic of the market,” said Bill Northfield, head of SSA DCM at Deutsche Bank.

With the original shelf life of the EFSF due to expire in June 2013, the discussion has already moved on to what its successor, the European Stability Mechanism, will look like. The ESM, to be introduced in June 2013, will consist of €80bn of paid in capital, as well as €620bn of callable capital. The total subscribed capital of €700bn is clearly aimed at securing a Triple A rating.

The callable capital element, which is also an integral feature of many multilateral development banks, makes up a significant part of the ESM’s overall capital. It is proposed that 88.5% will be callable, compared with 95% for a borrower such as the EIB.

The cost of ESM loans, it has been suggested, will be set at 200bp over the funding cost for up to three years, with the margin rising by100bp for a period in excess of three years. There will be no service charge when ESM goes live in 2013. By comparison, the EFSF offers loans of up to three years at a spread of 300bp over its cost of funding, rising to plus 400bp for longer periods. Currently there is a service charge of 50bp.

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