The mighty sovereign
Germany’s sovereign market is one of the strongest in Europe, and while spreads between it and other countries in Europe had been contracting, the onset of the credit crunch seems to have reasserted the preeminence of German debt. Michael Winfield reports.
The debt of the German federal government forms the backbone of the European government debt market and the reference point for the pricing and evaluation of all other sovereign debt. Although much bond pricing references swap market levels, the trading of this debt is also done by reference to German bonds – or futures based on them. The recent strong outperformance of securities issued by the Finazagentur seems to have been driven as much by the desire for the return of capital, rather than the return on capital.
The returns investors expect are often based on exactly this premise: in large parts of Europe, German bonds offer negative real rates of return with, by virtue of the common currency, no possibility of exchange-rate appreciation. The core rate of price inflation in Europe was running in excess of 3% in early spring, with market consensus still mixed on the prospects for resulting lower European interest rates. In this environment the demand for German assets is linked directly to overall levels of market turbulence, which remains a function of negative headlines emanating from the credit and equity markets.
The curve has therefore found itself in negative real yield territory, with only the longer-dated issues actually offering European investors a positive real rate of return – though there has been an expectation inflation will fall as the year progresses. If headline rates of inflation are taken of over 4%, only the nine issues maturing between 2024 and 2039 offered positive real rates of return. Yet the attractiveness of the asset class is unlikely to be impeded by this fact while financial headlines drive a flight to quality trend.
The Federal government plans to issue a total of €213bn to finance the budget in 2008, including re-financing redemptions and net borrowing requirements for this year. It is the same amount as it borrowed in 2007, affording Germany – along with a number of other sovereign borrowers – the accolade of predictability. "It can be argued that the market rewards issuers for this predictability, with those that take the market by surprise often being penalised in the long term," said Dan Shane, head of SSA syndicate at Morgan Stanley.
Since the disappearance of the Deutschemark the bulk of Germany’s programme has been denominated in euros. It issues debt across the full maturity spectrum, from six-month discount bills, two-year Schatz, five-year notes (BOBLs) and 10 and 30-year bonds (Bunds). The Finanzagentur has previously issued bonds linked to the European harmonised rate of consumer price inflation excluding tobacco (HICP ex-tobacco), or inflation-linked bonds, as well – occasionally, and when it is cost effective – bonds in US dollars.
In 2005 Germany issued a US$5bn five-year deal, the largest for a sovereign, as arbitrage conditions made it cheaper than issuance in the domestic market. "Realistically, the US dollar market is the only alternative source given the amount of funds required and rarely do the arbitrage conditions favour such issuance," explained Shane who co-led the deal along with Deutsche Bank and Goldman Sachs.
The bill issuance programme for this year is the same as in recent years: €6bn per month. Schatz are due to be auctioned quarterly in March, June, September and December, with each issue having a nominal value of €14bn–€15bn in total. New five-year debt is planned for April and October, initially of €7bn each, rising to €16bn–€17bn each after the issues are reopened twice. The current 10-year Bund was first issued in November 2007 and has already been increased by €13bn this year to bring the total to €20bn. In May a new July 2018 Bund will be issued with taps planned for July and August, taking the total outstanding to €21bn. The 30-year Bund, launched last year, will also be tapped twice this year, taking it to €18bn.
The Finanzagentur is open about its issuance plans, with only the timing of inflation-linked and foreign currency bonds determined by market conditions. In 2007 Germany added a new 2.25% April 2013 inflation-linked bond by auction to its existing 10-year issue, originally issued in March 2006. The original size of the inaugural linker was €5.5bn – with €3.5bn added later. Both were syndicated – unusual, in the case of the increase, as the debt office has historically utilised the traditional auction process, believing it to be the most cost-effective way to add to outstanding deals. On this occasion syndication was judged the best way to access the specific ALM investors comprising the bulk of the investor base.
Since summer 2007 German debt has assumed a safe haven status – along with US Treasuries – helping them outperform other sovereign issuers. Relative to Treasuries, however, Bunds have underperformed sharply, resulting from divergent economic outlooks in the US and Europe.
The Fed acted to aggressively reduce short term rates following the sub-prime lending crisis in the US. The European Central Bank, conversely, was constrained by the fear of rising inflation, and was yet to reduce the refi rate from 4% in early March. Despite the softening of the rhetoric in recent ECB meetings, the 1% differential between the target rates in the US and Europe saw Germany underperform across the curve.
The difference in 10-year yields has Germany, which yielded around 80bp less than US Treasuries at the beginning of 2007, trading as much as 50bp more by late January 2008. Despite being constrained by the prospects for monetary policy in Europe, Bunds have been the strongest performing sovereign in the Euro zone. The spread between Germany and other European sovereigns has been increasing, with peripheral markets also under pressure.
Germany's credentials reaffirmed
In late February and early March, the non-core European sovereign markets suffered a significant deterioration in spread levels relative to Germany. Although often accompanied by widening swap spreads, on this occasion peripheral spreads exceeded the movement of swaps with a seemingly one-way customer flow, leaving traders struggling to hedge exposure. It is thought bond positions were also being unwound on an asset swap basis creating better swap receiving interest.
The spread between Germany and other sovereigns had been gradually contracting. Italy, for example, traded in the plus 15bp–25bp range to Bunds for much of 2007, but in early March had gapped to its familiar range of around 69bp. Greece reached 72bp in the 10-year sector. This seems to undermine the theory behind the convergence trade, which suggests sovereigns other than Germany should only have to pay a relatively small premium to finance their own economies.
Gavekal, a hedge fund managing The European Divergent Fund, and Corriente Capital, anticipated this scenario, arguing the unwinding is the result of changed perceptions among asset swap sellers, namely Japanese financial institutions and Asian central banks. They had been seeking diversification away from US dollar-denominated assets, but as the euro appreciated they have been achieving this.
The creation of the sovereign wealth funds may also have contributed to the rethink of strategy. They need to diversify their bond portfolios and have built up strategic positions in a number of financial institutions in the US and Europe. Asian central banks are expected to increasingly allow currency appreciation, diminishing the attraction of the Yen carry trade, used to fund the asset swap positions.
The notion that Europe's budget deficits can continue to be increasingly financed from abroad appears to have been challenged. The French government debt to GDP ratio has moved from 35% when denominated in francs, to 70% over the last 15 years. The approach of the ECB – based on Germany's Bundesbank – is not to print money as the solution. This will only preserve – or even enhance – the appeal of Germany's debt.