Germany’s sovereign debt, traditionally the strongest in Europe, has been largely unscathed by the economic downturn, enabling it to retain its preferred status with investors. However, in some ways the strength and importance of Germany has had negative consequences, not just for Europe generally but even for German guaranteed agencies. Mike Winfield reports.
Like other industrialised economies, Germany faces a higher budget deficit in 2009 than it previously did. It finds itself with a financing requirement of €323bn, of which €60bn is intended specifically for stabilising financial markets. Germany continues to pursue its traditional format to financing, but the ability of the government guaranteed agencies to fund is being tested, just as there are calls for them to assume a more prominent economic role.
Similarly, the demand for German assets relative to that of some of the weaker European sovereigns has recently applied pressure to the peripheral market spreads. This has resulted in German finance minister Peer Steinbrueck conceding that support may ultimately have to be offered by the stronger states.
Germany needs to raise significantly more in 2009 than the €213bn required to finance the previous year’s budget. The Finanzagentur in its overview for this year, released last December, outlined the means by which this additional financing will be achieved.
At the short end of the maturity spectrum, discounted Treasury bills with a maximum 12 month maturity have been added to supplement the six-month bill programme. For the longer part of the curve, quarterly two-year Schatz of up to €15bn will be sold, as well as two new five-year BOBLs of up to €19bn each. Ten-year Bund issuance will be increased by three taps, rather than two, with the current 3.75% January 2019 issue expected to reach as much as €24bn eventually. The outstanding 30-year bond issued in 2008 is expected to reach €8bn in size after a €4bn tap scheduled for June.
In keeping with its previous practice, "the Federal Government intends to adhere to the announced issuance calendar to the fullest extent possible in order to provide market participants with a secure basis for their investment decisions," the Finanzagentur said. The other tools at the agency’s disposal – inflation-linked and foreign currency issuance – remain available, should market conditions be favourable.
For "its retail business, the Federal Government will sell Federal Treasury financing paper, Federal savings notes and German Government day-bonds as tap issues. The Federal Government reserves the right to extend the range of products for retail customers during 2009".
Like other sovereigns, therefore, Germany has increased its supply of conventional debt to offset falling tax revenues resulting from declining economic activity and rising unemployment. January and July are the largest months for coupon repayments and the heaviest months for issuance, often creating a curve steepening bias.
Outperformance or underperformance?
Germany has generally outperformed all other major Eurozone fixed income markets this year. It was the continuation of an old trend – one that was exacerbated by the deteriorating credit environment, following the failure of Lehman Brothers last year. The widening of spread differentials between some of the weaker members and core Europe, in particular, has been an ongoing theme.
Italy, Spain and Greece have all seen dramatic spread widening to Germany since the beginning of 2008, as their domestic economies have weakened. Greece has come under the most pressure, with its 10-year issue yielding as much as 300bp more than Bunds at one point in late February – or, to put it another way, twice as much as Bunds, which were approaching 3% yields at the time.
Greece has already issued new three, five and 10-year bonds and is beyond 50% of its €43.7bn funding requirement for the year. Spain has also seen spreads under pressure, with the 10-year Bono trading as much as 125bp over the comparable Bund, compared to just 18bp over at the beginning of June 2008. In January, Standard & Poor's downgraded Spain's Triple A long-term foreign and local currency sovereign credit rating on negative credit outlook to AA+. This was due to the "much weaker potential growth rate over the medium term than that experienced over the past decade. At the same time, we project a substantial worsening in the Kingdom's public finances," the agency said.
Clearly the spreads of these countries were underperforming Germany, but there was also widening in other parts of Europe. Austria, which had traded with a single digit margin, as measured by the 4.65% January 2018 issue compared to the 4% January 2018 Bund, saw the spread reach plus 123bp in February. Much of this can be attributed to the heavy exposure that the sovereign – and in particular its banking sector – has to Eastern Europe.
France, on the other hand, saw its 10-year spread peak at plus 59bp, compared to plus 13bp the year before. This could be regarded as Germany outperforming other core European sovereigns. There has also been clear outperformance by Germany relative to US Treasuries, with the spread contracting from minus 85bp in December to flat at one point in March. The principal reason for this was the prospect of lower interest rates in Europe.
By simple numerical comparison, Germany remains the strongest performing Eurozone sovereign, although, judging by the amount raised, this is not borne out by the reception its debt receives when sold via auction. Some of the 2009 auction results for 10-year issuance have been shy of full cover. February's €6bn Bund sale saw just €4.2bn allotted, and the rest retained by the Bundesbank. Even at the €7bn Schatz sale the previous month, only €5.6bn was sold to investors.
The apparent disconnect between the strength of Germany relative to others and its inability to fully allocate new supply may be attributable to the fact Germany has no formal Primary Dealer system. Instead it has a voluntary group of 31 different institutions. Calyon recently suggested that "the lack of a Primary Dealer system has contributed to a number of quite weak auctions since the beginning of the credit crisis".
Many believe the current spread levels will remain elevated, assuming there is no issuance by a single unified issuer. The prospect of a single borrowing entity is currently regarded as slim by most market participants. "This notion would be opposed by countries such as France and Germany and is, therefore, unlikely to happen for the foreseeable future," said Torsten Elling, syndicate official at Barclays. "In this scenario, Germany is likely to continue to outperform as the economy is stronger and the country has much smaller reliance on the property sector than other sovereigns, with the deliverability of Bunds into the futures contract also adding an additional value premium."
The impact on agencies
While the quality of direct government obligations remains unquestioned, the funding levels of KfW and Rentenbank, both of which have sovereign backing, have progressively widened relative to their guarantor. Following the creation of the new sovereign-guaranteed bank asset class late last year, these issuers, which have traditionally funded at sub-Libor margins, have been required to pay increasingly generous spreads over mid-swaps in order to achieve successful capital market funding.
KfW is one of the largest SSA issuers, along with the EIB, and is currently projecting a 2009 funding requirement of €75m which it will achieve through financing in euros, US dollars, sterling and other non-core currencies. "Apart from the creation of the new government-guaranteed bank debt asset class, the cost of borrowing has been under upward pressure through the additional competition for funds due to issuance at the Federal State level and by the banks guaranteed by the these 16 state entities," said Elling.
As a result, KfW saw a 50bp rise in its cost of funding when this year it raised €3bn at mid-swaps plus 37bp, the equivalent of nearly 96bp over 10-year Bunds. At the beginning of 2008 it issued a €5bn July 2018 bond at mid-swaps less 13bp.
Moreover, the steepening of international fixed income yield curves has severely curtailed the option to issue longer-dated debt, something that contributed to KfW’s inability to match the size of its 2008 transaction. This forced issuers to the shorter part of the yield curve and into even greater competition with bank supply, a trend that will likely be exacerbated if widely expected changes to the Financial Markets Stabilisation Law in Germany are implemented, enabling a maximum five-year maturity for such supply. This will continue to apply pressure to new issue spreads for borrowers such as KfW and Rentenbank for the foreseeable future, possibly forcing their funding levels higher still.