When politics and bond markets clash
The rising wave of right-wing politics across the West has taken the public debt market by the throat heading into a series of elections across Europe, but some of the most prolific issuers remain confident they can work around the volatility coming their way.
France’s presidential election became a flashpoint of nervous headlines in early February – despite the French not due to fill voting booths until May – as one-time frontrunner Francois Fillon was embroiled in a fraud scandal, giving far-right leader Marine Le Pen an unexpected bump in the polls. Fillon denies all charges.
Investors responded by dumping OATs and buying Bunds, with 10-year French government debt yields moving 81bp wider to their German equivalents on February 20, the widest they had been in four years. The weakening in OATs is a move that investors say was overdue.
“Clearly, there is significant headline political risk,” said David Riley, head of credit strategy at BlueBay Asset Management. “One strategic view we have been trading since late last year is a fair spread between OATs and Bunds. The perception of political risk in France was too low – there needed to be a risk premium between France and Germany.”
Le Pen risk rises
It only got worse for Fillon after that, with opinion polls showing the politician crashing out in the first round of elections on April 23, despite his managing to fight off a rebellion within his own party at the beginning of March.
The scandal – which has placed Fillon under formal investigation for misusing public funds to pay his wife a wage for a job she did not do – temporarily saw the market price in a significant increase in the chance of a Le Pen victory.
At a 75bp–80bp spread between 10-year French and German government debt, this assumes “about a one-in-four, or one-in-five, risk of a Le Pen victory,” said Riley. “This could go wider if it becomes more uncertain.”
But the spread between the bonds tightened to a low of 58bp in the first week of March, according to Tradeweb, after a poll suggested Le Pen would struggle in the first round if former French prime minister Alain Juppe replaced Fillon as the centre-right candidate.
Juppe has since said he would not be running, which sent the spread between the bonds back to 65bp by March 7, with the 10-year French yield at 0.976% bid.
“Ultimately, this sort of action shows that people really have very little certainty and are just reacting to every headline,” said a syndicate banker.
Anthony Requin, the chief executive of Agence France Tresor, thinks that the spread between Bunds and OATs will move substantially tighter in the coming months – potentially burning investors.
“We think that there is room for 30bp–40bp spread-tightening between Bunds and OATs from the heights seen at the end of February once uncertainty is removed from the electoral period,” Requin told IFR. “There is the potential for a short-squeeze and I’m not going to be the guy to help the players that built these shorts to cover them.”
Nonetheless, investors were jittery enough to send the two-year German Schatz to a record low yield of –0.92% on February 28 during an auction, with the potential election of Le Pen again raising the notion of a break-up of the European Union that was last touted as a possibility when the UK voted to leave the bloc.
A spokeswoman for the government’s debt management office said at the time that it was the lowest yield ever recorded in the segment.
This is also substantially lower than the previous bottom of –0.75% for the German two-year debt auction on January 17.
The EU breaking up is still considered highly unlikely, with BlueBay putting the cumulative possibility, using a range of market indicators such as CDS levels and potential post-euro national currency devaluations, at around a 7% likelihood on a five-year view.
But it is not just France facing political upheaval. Dutch voters headed to the polls for a general election on March 15 and Germany votes on a federal election in September, setting up a year that could prove to be tricky for issuers to navigate. Results in the Netherlands, where far-right candidate Geert Wilders did not fare as well as some had thought possible, relieved fears to some degree, although the horizon remains far from clear.
“For significant borrowers with very large programmes to manage, any extended market disruption can be an issue,” said Lee Cumbes, head of public debt at Barclays “Front-loading is often an astute choice, when done with clear respect for the investors too.
“With important policy mandates to deliver, many public sector borrowers need to make sure they have accessed their funding as effectively as possible, but still minimising risk of a shortfall in volume.”
A funding official at a US issuer that prints debt across currencies agreed that it is a prudent move to complete deals earlier in the year.
“We can’t move too much around, but it makes sense to try and focus our efforts earlier in the year,” he said.
KfW reaps benefits
KfW is one major borrower that has benefited from the worry in the markets.
As a German public debt issuer, investors piling into assets perceived to be ultra-safe, such as Bunds, works out well, as without anything fundamental changing on KfW’s behalf, its bonds suddenly offer a more attractive spread over German government debt than they did before political fear tightened its grip.
“The markets are really good for us at the moment, as the Bund swap spread has widened,” said Petra Wehlert, head of capital markets at KfW. “Therefore, we can show attractive Bund spreads to investors and achieve good funding levels for KfW.”
KfW’s last 10-year trade came at a spread of 28.9bp over Bunds, which was 0.6bp tighter than where the issuer printed its previous 10-year outing for €4bn in March 2016, according to data on the issuer’s website. And the borrower has sped up its 2017 debt programme, albeit only slightly. KfW had printed €20bn of its €75bn programme as of February 24, with its latest €5bn 10-year bond on February 15 commanding a chunky €8bn book on a new issue premium of 2bp.
”We can stretch out our funding programme by a month or so and it is not an issue,” said Wehlert. “If the major markets are closed for longer, then it becomes more challenging. But we do have investors worldwide and we are a haven asset, so we have the option of going to the US dollar market if the euro market is shut – not every issuer can do that.”
KfW does not plan to be in the bond markets during the specific weeks of the European elections.
Wehlert added: “In general, the capital markets are working well, and SSA is a functioning market, so some of the worries about issuers having to front-load might be a bit exaggerated.”
One SSA banker reckons that the entire market is roughly 25%–30% through its funding programme for the year.
“This is only 5% or so more than last year,” the DCM banker said. “It’s not huge amounts. Issuers understand that investors can move pretty quickly, so are not as scared about needing to rush to the market.”
A syndicate official at another bank reckons that the minimal levels of front-loading might be down to the idiosyncrasies of each jurisdiction.
“If you’re a French issuer or you rely on French buyers, it might make sense to wait until the end of the year and hold off a bit now,” he said. “Once the election is out of the way, the market should find equilibrium fairly quickly.”
The DCM banker said: “The saying goes that it took three weeks for the markets to recover from the Brexit vote but only three hours from [the election of US president Donald] Trump. Any shocks that do come are likely to be short-lived.”
Preparing to fail
Investors are less convinced and are trying to decipher the best ways to protect themselves in the coming volatile periods.
“One way to mitigate the political risk is to take an active position on sovereign spreads,” said Riley at BlueBay. This is already being played out, with the spread between OATs and Bunds shifting.
“Another is to buy protection on the [itraxx] Main [index], which would see the Main widening,” said Riley. “This has not happened, but as we get closer to the elections, we will probably see investors begin to buy protection.”
The Main has only widened slightly since the beginning of the year. It was bid at 70.48bp on March 7, after starting the year at 68.376, according to Tradeweb.
But synthetic credit will likely not be a viable option for all SSA investors, who will be put off by the far smaller pools of liquidity than they are used to in SSA debt.
“The main attraction of my market for investors is the liquidity, and being able to come in and out easily,” said John Lee-Tin, head of SSA DCM for Europe, Middle East and Africa, at JP Morgan. “Synthetic markets are less popular with some investors because they are not as liquid.”