ECB QE tapering set to see sovereign’s funding costs rise despite its being the primus inter pares of peripheral eurozone countries.
The spread between 10-year Spanish sovereign bonds and German Bunds is likely to widen to 1.50% by the end of this year, as the European Central Bank is expected to scale back its quantitative easing programme.
Ten-year Spanish sovereign bonds were yielding 1.61% on May 25, while 10-year Bunds were at 0.38%. Analysts expect the yield on the Bunds to rise by 40bp by the end of the year, as the QE programme is wound up. But ECB bond purchases have been more important in keeping Spanish yields low compared to other sovereigns and the return on 10-year Spanish bonds is forecast to rise to up to 2.30% by the end of the year.
“Spanish bonds have a high-beta profile,” said Jaime Costero Denche, macro and sovereign bonds Europe analyst at BBVA. “If their reference bond, the German Bund, increases in yield, they will rise even more. Higher German yields will force some asset managers to rebalance their portfolios and their demand for Spanish bonds will probably drop, pushing up Spanish yields even more.”
Spanish sovereign total gross issuance totalled €120bn of medium to long-term debt last year (it also issued €101bn in Treasury bills). After redemptions of €85bn, net issuance amounted to €35bn. This year’s gross issuance of medium to long-term debt is expected to amount to €132.9bn, so, with redemptions at around €87.9bn, net issuance will be €45bn. Spain is also expected to issue €97bn in Treasury bills.
The Treasury increased this year’s issuance to cover the deficit in the Spanish social security system. During the last few years, the government has made cash withdrawals from the social security reserve fund to cover the deficit (€19.2bn was withdrawn in 2016) but is now being forced to increase its bond issuance as the fund becomes depleted.
Net issuance has come down markedly since 2012, when the country issued €96.6bn in new debt (at that time the country was still reeling from the impact of the international financial crisis). Bankers reported that some 47% of this year’s issuance had already been completed towards the end of May.
Spain’s 10-year bond yields have been highly volatile since the start of 2016. They were in a 1.40%-1.50% range until July of that year, at which time the yield dropped to around 1%-1.20%. QE contributed to this trend by raising the demand for Spanish debt.
However, in the second half of last year, yields started to pick up again and peaked at 1.90% in March 2017. A rise in crude oil prices boosted the inflation component of yields, while President Trump’s economic policies were also seen as more inflationary. The Spanish economy has also been reflating (economic growth was 3.2% last year) and this had fed through to higher yields.
Furthermore, at the start of this year, investors were afraid that Marine Le Pen could win the presidential election in France, leading to the possible break-up of the euro. Bunds attracted investors as they were seen as a safe haven and investors withdrew from Spanish bonds, pushing up yields.
Emmanuel Macron’s election in May had the opposite effect and encouraged investors to buy Bonos, prompting yields to drop to their current level.
Among eurozone countries, Spain is often compared with Italy, and on most measures the Spanish economy has been performing better than Italy’s. The International Monetary Fund forecasts that Spain will grow by 2.6% this year while Italy expands by only 0.8%. Fitch Ratings gives Spain a BBB+ rating with a stable outlook, but in April it downgraded Italy to BBB from BBB+.
“Spanish economic growth has surprised on the upside during the past three years,” said Michele Napolitano, head of Western European sovereigns at Fitch Ratings. “This is mostly due to the labour market reforms that the previous government undertook, which improved labour productivity.
“Unlike in Italy, the Spanish government also aggressively dealt with the country’s banking problems by creating a ‘bad bank’ to assume the loans of bailed-out banks. Furthermore, in Spain, public debt as a percentage of GDP is starting to drop very gradually; we are not seeing this in Italy.”
By the end of this year, Spain is expected to have a total government debt to GDP ratio of 99%, compared with 132% in Italy.
Antonio Villarroya, head of G10 macro and strategy research at Santander Global Corporate Banking, said: “Spain is now the fastest growing large economy in the eurozone. Spain has just recovered its mid-2008 real GDP level, but, on the contrary, Italy is not expected to reach that pre-crisis level for at least another five years.”
In February 2017, Spain issued its first 15-year benchmark bond in almost two years - raising €5bn - in an attempt to reinvigorate its yield curve.
The sovereign has an unusual approach to its debt issuance, which is proving successful. It uses a so-called “early bird special” method. Investors who commit early to the transaction get rewarded with better allocations but without any knowledge of the pricing level. In January, using this model, demand for the sovereign’s long 10-year syndication topped €24bn.
In May last year, Spain followed other European countries - including France and Belgium - in printing a 50-year bond. It raised €3bn, paying a coupon of 3.45%. It was three times subscribed.