Wednesday, 23 January 2019

Waiting for the storm to pass

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The European sovereign debt market emerged from a chastening second half of 2011 to start the year brightly, at least for healthy issuers. But the plight of Spain in mid-April served as a reminder that sentiment is still very fragile, and the market is unlikely to ever look as it did before the crisis.

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It had been a frenetic start to the year, with sentiment in the European government bond market surprisingly strong, especially considering the horrors of late 2011. Then came the Easter break, with Spanish yields jumping to 6%, reviving memories of former market chaos. Suddenly investors were again asking if European governments’ plans to cut deficits while implementing savage austerity plans were viable. 

As IFR went to press it was still uncertain how lasting the market turbulence of the Easter weekend will prove to be. The focus on Spain, which announced budget cuts to trigger the dramatic market falls, came at a time of especially thin liquidity in the market, exacerbating the impact of the sell-off.

Easter this year fell at the end of a very strong quarter for much of the world, with investors keen to lock in their significant gains, and at Japanese year-end, with investors there also largely absent from the market. The first day back after the Easter break saw the biggest market falls, with stability of sorts seemingly returning by Wednesday April 11. 

It remains to be seen whether the market will reverse course, with the optimism that characterised the first-quarter returning, or whether the Easter panic will be harder to shake.

Bankers, however, were upbeat, insisting nothing has fundamentally changed either side of the quarterly demarcation line. It is still some comfort to the market to have witnessed an orderly resolution to the Greek default, suggesting forthcoming obstacles will also prove surmountable.

Although a Spanish default would be a problem of a different magnitude, the market would at least have had several years to prepare for what, when the prospect of a Greek default was first raised, had been inconceivable. 

No more hay making

Even before Easter, investors and issuers had been well aware of the speed with which conditions could change. That was why issuers had been busy front-loading their activities, making hay while the sun shone. This was always setting the second half of the year up for a lull, with issuers fulfilling their funding requirements early. 

That is not to say things have returned to how they were. Confidence had returned to the markets generally, but that had not hidden the problems exposed in certain specific countries, where bailouts have been required or there is an expectation they might be.

“The bailout countries can forget it for the time being, investors aren’t ready to re-engage yet,” said PJ Bye, global head of public sector syndicate at HSBC.

The mood of caution extends from the PIG countries and the much beleaguered Spain and Italy, even affecting the likes of France and Austria, he said. Spread volatility was high on such paper in 2011, but such issuers will have access to the market sometime in 2012, he said. 

“Investors are now looking at the important things, like what a country’s policies are with respect to growth and unemployment, and whether these policies are being applied consistently,” said Ulrik Ross, global head of public sector DCM at HSBC. “If the outlook for a market is dire, if there are question marks around how it will implement its stated plans or if it is just unclear how a country is going to achieve growth, then investors will be cautious.”

Some might call this a return to market sanity. But the outlook for many European sovereigns is bleak, and there is little evidence politicians have the will to address the continent’s underlying problems, meaning this caution could be around for some time yet. 

While an abundance of good news and low volatility prevailed in the first quarter, more recent events have demonstrated that this caution makes investors trigger-happy at the first sign of trouble. They will be quick to adapt their portfolios, so further volatility spikes are likely. 

Neither is it clear what the Spanish fallout means for the prospects for further issuance. Supply could be poor, but that is to be expected, considering issuance in the first quarter was higher than expected. 

Credits such as Belgium had such good luck in the market in the first quarter that it came to market three times. Its €4bn 20-year transaction in March would have been hard to imagine a few months before, demonstrating how much markets had improved. Belgium’s three syndicated OLOs came with new issue premiums that steadily declined as the quarter progressed – from 10bp on the 10-year, to 5bp for the 20-year and finally 2bp for the seven-year.

“The seven-year OLO we did for Belgium saw extremely strong international participation  from real money investors,” said Guy Reid, head of public sector DCM at UBS. Domestic investors can usually be relied on to provide a base level of demand, but international investors are more discerning and tend to only get involved when their confidence in an economy is high.

The 20-year deal for Belgium suggests that duration is possible for the right names issuing euro deals. For the names feeling more pressure, locking in 20-year money at the current levels is probably unappealing, so whether they have hypothetical access to the market is a moot point. 

Similarly in the sterling market, the UK is now potentially looking at issuing 100-year Gilts, to exploit investor demand and the historically low yields currently on offer, said Taor. 

However, European sovereign issuance in the dollar market has been a no-go. The economics do not make sense when their liabilities are in euros and the euro market is open and offering cheaper funding. And it remains to be seen where the crisis leaves the smaller, yet traditionally important and regular issuers such as Liechtenstein. 

Timing is everything

“There is a lot of cash in the system but investors are worried about spread volatility and the ongoing problems in Europe,” said Bye. “Achieving success in this market is about picking the right windows when sentiment is positive. The smart borrowers pre-funded heavily in the first quarter because they knew the markets could shut down at any time. Conditions proved to be very constructive in the early part of the year for the majority of SSA credits but there has been an underlying concern over how long the beneficial impact of the Long Term Refinancing Operation will last.” 

Indeed, it may be less surprising to witness the volatility of the Easter break than it was to see the level of optimism of the preceding period. “We have all been taken by surprise by just how positive sentiment was,” said Guy Reid, head of public sector DCM at UBS in London. “Historically January has been a good time for issuers due to the large redemption flows. This year there were also substantial cash balances left over from the preceding quarter as it had been so difficult.”

“The difference between where the markets were in December, when confidence was on the floor, to where the markets were in March, is dramatic,” said Sean Taor, head of DCM at RBC Capital Markets. “Confidence had returned, and it was hard to find bad news.” 

Spain and Italy at that time were carried on the wave of optimistic sentiment by the index trackers, said Reid. “Those countries went from 7% to 5% in the first three months of the year, and the index trackers cannot afford to miss out on such a large rally, considering their weighting in the indices.”

With smaller European countries there is less opportunity cost as they are smaller components, he said. “Investors still had to believe there was a basis for the rally, but once it was heading up it was hard for them to stay sidelined.” 

Clearly, the long-term solvency issues that underlined a lot of the panic we saw are still not fully resolved,” said Taor. “We are a long way from the bull-market liquidity of 2007, with the huge order books and tight generic pricing you saw back then.”

Before the global crisis investors were not as discerning about the credits they bought, but that indifference has not returned – and probably never will, said Taor. “That isn’t necessarily a bad thing though – it is a return to a more sustainable reality. It is right that investors do more credit analysis of their own and rely less on the ratings agencies.”

But at the same time, even taking into account the turbulence around the Spanish sovereign market, the situation still looks much healthier than it did in late 2011, said Reid. “I feel quite optimistic,” he said. “The supply outlook is lower than expected in January, with many sovereigns ahead in their funding schedules. The spread outlook is good and risk appetite is increasing. Nobody was expecting a home run for the remainder of the year, there will be periods of volatility and we will not see one-way spread compression and political risk remains elevated.” 

It is too early to say for sure, but the hope is that the problems of mid-April prove to be nothing more than volatility within a longer-term upward trend for the market. The alternative is unthinkable: bailout packages for Spain and Italy would require a financial commitment of a different order of magnitude to anything that has come before, while fundamental reform within Europe to address imbalances appears to be no closer than it was at the start of the crisis. 

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