Path of least resistance

IFR IMF/World Bank Report 2014
11 min read

The expected divergence between the Fed and the ECB, with the former entering its tightening cycle as the latter considers further loosening, creates an interesting backdrop for 2015. However markets respond, issuers will seek out the best opportunities like water finding cracks in a stone, with investor appetite for SSA paper as always insatiable.

European and US rates policies have not seen a marked divergence since 1997–98. At that time, higher rates in Europe than the US triggered a shift of activity into Europe. The possibility of a similarly dramatic outcome to expected rates divergence has triggered lively debate across financial markets.

Whether things will pan out similarly, but in reverse, partly depends on the basis swap market. But for the SSA market specifically, few expect much drama.

“Rising rates are not always disruptive to the SSA market because after a sell-off has stabilised, what’s left can be a more favourable entry point,” said Lee Cumbes, head of SSAR origination for EMEA at Barclays. Issuers tend to be comfortable raising capital in whichever currency makes most sense at any given time, and in this market, in particular, there is always liquidity somewhere.

The Fed is not expected to rush into its tightening cycle and will wait for confirmation that growth has taken root before risking choking it off. Growth is more established in the UK than in the US, said Zeina Bignier, global head of public sector DCM at Societe Generale, with good news interspersed with less impressive figures. And it is not just US growth at risk, raising rates too soon could undermine demand abroad and hurt US exports.

It is clearly dangerous to put too much faith in the accuracy of these kinds of predictions: the market expected US rates to increase in 2013 before they fell further. But if the central banks’ policies do diverge in the second half of 2015 the situation could last for around a year before they come back into harmony, said Bignier.

“By cutting rates the ECB has encouraged investors to look at different assets and even to extend along the curve,” said Cumbes. “Combined with other developments, we now see the range of issuance broadening, for example in the re-emergence of inflation-linked bonds, such as Italy’s first deal since 2011 and Spain’s debut in this market.”

“Issuers can’t ignore the divergence of the central banks but there is not a lot they can do about this,” said Michaela Seimen-Howat at RBC. “Investors might become increasingly uncertain, given also the current tight spread levels, but SSA issuers are typically global issuers and they can be opportunistic in their issuance depending on where the demand is.”

Issuers such as the EIB and KfW have such enormous funding programmes that they spread issuance out over the whole year. These issuers come most weeks, issuing wherever opportunities present themselves – in various currencies and tenors, as well as in the private placement market or via floating-rate notes, for example.

“The big agencies have very diversified funding programmes and the profile of their issuance can vary strongly from one year to the next, depending on where the opportunities lie,” said Seimen-Howat.

“This year we have seen a lot more sterling issuance, not necessarily because they needed sterling but because there was a lot of appetite in that market due to the supply gap created by the decline of issuer Network Rail, and because the cost was favourable.”

While liquidity can shift between markets and currencies, demand is always strong for SSA paper, regardless of rates and risk appetite. Investors always want a bedrock of safe assets in their portfolio, even if they increase allocations to higher-yielding assets in the search for yield, and SSA paper is always likely to be at the heart of that.

“The Treasury market may not return to previous notions of normal pricing until new issuance has seen the free-float in the market grow,” said Cumbes. “The Fed has bought a large amount of paper to-date. Regulation has also created new motivations for investors such as banks and money market funds to buy government assets, so this may help greater stability and a foundation for successful SSA issuance.”

New global regulations on banks that force them to increase their liquidity buffers reinforce this trend and will continue to ensure high demand. Central bank and money market fund demand can also be counted on, the only variable being on duration, with longer-dated paper typically preferred when yields are low to provide a little extra return, but shortening when paper gets more expensive.

While recent years have seen the creditworthiness of many sovereigns called into question, investor concern appears to have abated.

“European governments in particular have been under significant scrutiny in past years,” said Cumbes. “This sort of testing should help more robust investor confidence and insulate Europe to some extent, should there be an increase in generalised volatility.”

Europe’s supply squeeze

The question is whether supply will keep pace with demand. The European market looks set to see a further tightening on the supply side as governments look to rein in spending. SSA issuance is counter-cyclical, with issuance increasing when volatility is high but falling again when market conditions normalise. Between 2006 and 2012, SSAs saw strong growth in issuance, but this turned around in 2013 with the first decline in that period, and this is expected to be followed by another year-on-year decline in 2014.

European sovereigns have been working hard to reduce their budget deficits and push through structural reforms, which will have an impact on issuance. Next year will be the final year of redemptions associated with the debt raised at the height of the financial crisis, with a reduction of around 5% in European sovereign funding programmes. From 2016 the reduction will increase to about 20%, said Bignier.

As the crisis eases, the funding needs of European agencies should also decline, with banks increasing their lending and agencies free to scale back on new programmes. This should lead to a reduction of about 10%–12% in new issuance, Bignier predicted. This is natural after the explosion of public sector activity from 2008, when governments were forced to step in as lenders of last resort and a number of new agencies, such as the European Financial Stability Fund, were created specifically to deal with the fallout from the crisis.

“The European Financial Stability Facility and the European Stability Mechanism will be in the market refinancing existing support commitments; currently there are no new support programmes apparent, which would increase particularly the funding needs of the ESM,” said Seimen-Howat.

“The EIB and various development banks will continuously see demand from SMEs for financing but this is not as high as it was a few years ago now that alternative sources of funding are re-emerging. I don’t expect a dramatic shrinking of issuance but a gradual wind-down of the previous very large programmes.”

However, outside Europe issuance is expected to be more stable, with new countries, for example in Africa, entering the fray to offset the decline in Europe. Overall this should leave global issuance moderately up by 3%–5%, said Bignier.

This is likely to be concentrated in the early months of the year, as it has been in recent years, regardless of rates expectations. Issuers know better than to think they can time the market and they have little incentive to even try. If they did try to time the market they could end up being penalised for getting it wrong, and if they are right there is little upside. While private sector CFOs may get rewarded for making those kinds of calls, their peers in the public sector do not.

Getting the funding done

What does matter to SSA issuers is getting their funding done.

“SSA issuers typically do around 35% of their funding in the first few months of the year, which allows them to be more selective later in the year,” said John Lee-Tin, head of SSA issuance at JP Morgan.

“Since 2007 we have always seen issuers complete 35% of their funding in Q1 and between 50% and 70% by June. The only exception to that is if market conditions are so favourable in Q4 that they pre-fund for the next year.”

Spreads are expected to tighten for most credits, while duration should also increase.

“I was surprised we didn’t see more of an increase in duration before June in response to the low rates environment, but maybe the EFSF will trigger this trend,” said Bignier.

Such sweeping generalisations are always dangerous, yet conditions among SSA issuers tend to be more correlated than most. Tight spreads are in evidence around the world, as much in the US and Asia as in Europe. One interesting exception to that rule has been the Canadian provinces, which remain wider than other issuers, perhaps because they proved themselves a case apart while other issuers were struggling at the height of the crisis.

Issuance sizes are also likely to remain larger, continuing a trend that has persisted in recent years. Where large issuers used to do benchmark deals of US$1bn, they regularly do deals of up to US$3bn now. This has been supported by the wave of interest seen from new types of investors, with central banks now joined by bank and corporate treasurers and asset managers.

While the market will watch to see how the divergence story unfolds, for now it is tempting to call it business as usual in the SSA market.

“We are close to the pre-crisis environment right now, with low volatility, collapsed spreads and back to historical relative value between issuers,” said Lee-Tin.

“Things should be more stable for SSA but it is impossible to predict the future,” said Seimen-Howat. “Among others, there could be problems associated with Russia or new geopolitical challenges that could have implications for this sector. It furthermore remains to be seen how, for example, Green Bond issuance will be taken forward and if and how SSA issuers will become involved in the plans of the EU to revive the securitisation market in the EU.”

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Path of least resistance