Wield the yield

IFR SSA Special Report 2019
15 min read

As investors survey the future, they are met with a view of low rates and below-target inflation as far as the eye can see. No wonder peripheral credits, offering a bit of additional yield, have been so well supported in their bond offerings in 2019.

The strength of the bond market in 2019 is masking the differences between peripheral credits and leading to some level of convergence. Greece, Italy, Spain and Portugal have all done deals in Q1, with all enjoying healthy order books.

It is a market in which few expect the European Central Bank to raise rates, given tepid growth and inflation that is projected to remain below target for years to come. Slowing growth in the EU as a whole has boosted bond markets, raising expectations for supply as governments look to plug holes in their finances.

True, it means debt levels will increase further, but investors want yield, and these credits are where they can find it. That calculation looks set to persist for the foreseeable future.

While the peripherals share the characteristic of offering an attractive pick-up in yield, economically speaking the credits are very distinct.

Luca Cazzulani, deputy head of fixed income strategy at UniCredit, said: “I am cautious about the term ‘peripherals’ for these credits because they are so different from each other. But as a group of issuers that offer a large spread, they all generate big demand right now.”

“The peripherals are the most compelling play in Europe at the moment,” said Louis Gargour, founder and senior portfolio manager at LNG Capital. “Italy and Greece are the credits with the highest risk and, as a result, with the highest returns to investors, therefore an interesting opportunity exists for investors.

”If one believes that Italian political problems can be overcome, and that the ECB will keep smoothing over the cracks in Greece – which we do – these are good investment opportunities.”

Looking at Greece specifically, this sentiment is understandable. Given the amount of time and money the EU has already invested in saving the country, it seems unthinkable that it would now let it default. Investors therefore regard Greek debt – along with the other peripherals – as having an implicit guarantee.

This allows them to gloss over Greece’s still ominous fundamentals. Although things have been improving, Greece remains in a league of its own in terms of the scale of the challenges it faces, particularly its public debt-to-GDP ratio, which stands at 188.7 %, according to OECD data. Italy’s, by contrast, is 152.6%, while Spain’s is 114.7%.

The market has been welcoming in both of Greece’s issues in 2019. First up was a five-year deal in January, raising €2.5bn from orders in excess of €10bn and pricing at the tighter end of the 3.60%–3.70% range set in guidance. This was followed up in March, when it came with its first 10-year deal in nearly as many years, raising €2.5bn with pricing at 3.90%, having generated orders of €11.8bn.

These issues have been more about creating a curve and fixing relationships with the investor community than actually raising money.

“Greece’s recent bond issuance shows excellent progress in ‘normal’, long-term market access,” said Lee Cumbes, head of public sector EMEA at Barclays.

”The sovereign didn’t really need the money, but the strategy is to develop the curve and rebuild broad investor confidence, to ensure everything is fully functioning in future as and when it is needed. This year’s deals are absolutely textbook steps towards creating a robust market.”

The sovereign has a long way to go before it succeeds in that task. While there is a repo market in Greece, it is used more for financing than for covering short positions in the GGB market, unlike other established euro government bond markets. And while there are auctions for bills with tenors shorter than one year, there are none for bonds with maturities longer than one year.

Closing in

In terms of the sizes of their markets, Greece and Italy occupy the two extremes on the scale of peripheral credits. But in terms of the yields paid on their 10-year government debt, no other EU credit has come closer to Greek levels.

Italian debt remains high, and, more importantly, there is still little indication of how it plans to get the situation under control. While other peripherals’ economies have been improving – even if very gradually – Italy’s has been deteriorating, while its populist government has added another layer of risk for investors.

But here, too, investors have been happy to brush any concerns aside. At the start of 2019, Italy had gross funding needs of €255bn for the year, and in January it got off to a great start, with healthy demand of more than €35.5bn for a €10bn march 2035 deal. This was despite the sovereign offering a slim, 1bp–2bp pick-up over its curve at the swaps plus 65bp reoffer level.

In February, it attracted even more interest, receiving more than €41bn of orders for an €8bn issue of long 30-year paper, its first at that tenor since June 2017. The paper priced at 18bp over the March 2048 BTP, though trading was poor in the aftermarket, perhaps due to its oversupply of long-dated paper.

Oliver Vion, managing director in the bond syndication team for SSA at Societe Generale Corporate & Investment Banking, said: “The level of daily volatility is one of the good measures of how attractive a credit is. Italy’s volatility is relatively high, showing there perhaps is a little less investor appetite for Italy than for some of its peers.”

Unlike Greece, Italy already has a healthy market, with large and well-functioning secondary and repo markets, auctions and syndicated transactions. Its economy is an order of magnitude larger than any other peripheral’s, and although debt is high, most believe it is manageable, especially with its thriving domestic market ensuring liquidity.

Italy also has the advantage of more established relationships with foreign currency investors than the other peripherals, owing to the sheer size of its bond market.

All peripheral credit issuance has overwhelmingly come in the euro market, which has proved deep enough to absorb as much supply as has been needed. The European Central Bank has also encouraged euro issuance, both by vowing to do “whatever it takes” to support the euro, and by embarking – belatedly – on its huge QE programme.

Despite this, Italy has made its forays outside the euro market. In March, it tapped the yen market, the first foreign currency bond off its MTN programme in over two years. The four-year trade raised ¥25bn (US$227m), pricing with a yield at 0.885%.

There have also been rumours of possible Italian issuance in the US dollar market – which it has not tapped for around 10 years. So far, nothing has come of it, but any issue would surely be well supported, even if it would likely constitute a relatively small proportion of overall debt.

The Iberian countries have come closest to leaving behind the “peripheral” label, to take their places as core European credits. In mid-March, Spanish 10-year paper was trading around 1.15% and Portugal at 1.25% – its tightest in 10 years. In recognition of this achievement, some talk about a “semi-core” group of credits, comprising these two borrowers, to distinguish them from Italy and Greece.

“The ratings agencies have been a bit slower than markets in terms of recognising the progress that the likes of Portugal and Spain have made, but recent upgrades at last show this is moving in the right direction,” said Cumbes.

Spain’s economy is growing above the EU average and, even among issuers that have seen healthy demand for their bonds, its success stands out.

In January, it broke records, attracting more than €46.5bn of demand for a €10bn April 2029 issue despite offering only 1bp-2bp concession at the 65bp over swaps pricing. In February, it took the unusual step of capping a 15-year print at €5bn, generating interest exceeding €43bn. The deal ended up offering a 3bp concession.

Particularly attractive

“Spain is particularly attractive – it offers enhanced yield relative to Bunds, but a strong economy, with 2.6% GDP growth, decreasing levels of unemployment and, in our opinion, lower risk than Italy or Greece,” said LNG Capital’s Gargour.

“Markets always overshoot, to both the upside and downside, and Spain has in the past shot overshot to the downside and is currently benefiting from an improvement in their underlying credit fundamentals. It offers very attractive returns for the risk being taken.”

Portugal has also made big strides in resolving its economic issues, though it is too small, when compared to Italy and Spain, to make meaningful comparisons. Holding monthly auctions creates liquidity for any credit, but Portugal has relatively little to sell and so does not hold such auctions. This makes its debt relatively illiquid.

Portugal tapped the markets in January, pricing a €4bn 10-year deal at 112bp over mid-swaps, with orders exceeding €24bn. But it has not issued longer-term paper this year, having done a 16-year deal in April 2018 – one of two syndicated bond deals that year. The April 2018 transaction saw it print €3bn at 102bp over mid-swaps, with orders of €16bn – 133bp tighter than its most recent equivalent issue, a 15-year bond in 2014.

Portugal has been thought to be considering an issue in April, though at the time of writing no further details were known.

UniCredit’s Cazzulani said: “It’s an especially favourable environment for short and mid maturities, but Spain and Italy have both issued extra-long maturity bonds [with 15-plus-year maturities] that received a lot of demand. Portugal has not [it has issued 10-year paper], but if it did I would expect it to be met with high demand as well.”

For all the different economic challenges these four credit face, ultimately the biggest risk is political.

“As long as the market believes in European unity, yield divergence – which is not huge by historical standards anyway – is not really a problem,” said Societe Generale’s Vion.

For now, the political risk, too, looks contained. Despite the political drama in Italy, there has been no suggestion it wants to leave the EU or the euro, a development that would certainly create significant volatility.

A glimpse of what that might look like came some months after March 2018’s Italian election, when the new government sparred with the EU over plans to increase its budget deficit beyond the agreed limit. At one point, Italian 10-year bonds were trading above 3.60%, on fears that Italy could ignore EU rules and trigger a constitutional crisis. But once the two sides had reached a compromise the debt quickly tightened to 2.70%.

This suggests that if the market were to sense the possibility of EU disintegration, peripherals would have a big problem. But for now there is no evidence of that prospect coming to pass.

If anything, the years since the onset of the sovereign debt crisis have strengthened the infrastructure supporting the eurozone and peripheral credits. The ECB in particular has arguably come of age in its handling of the sovereign debt crisis.

Cumbes said: “During the crisis, people questioned the capacity of the ECB to act like other central banks. That has changed, partly because of Draghi’s well-noted commitment to doing whatever it takes and partly because of the enactment of QE.

”What is more, Europe’s institutional arrangements have come on a long way too, with the formation of the ESM and efforts towards banking union, amongst other things. These steps have given investors the confidence in the eurozone.”

By rolling over the long-term refinancing operations and pushing out its forecast for the start of rate rises to the end of 2019, the ECB has given investors greater confidence to invest in peripheral credits. Indeed, the market regards the prospect of rate rises as even more remote that the ECB suggests, anticipating the move to come as late as 2021.

Of course, change is coming at the ECB, which might have been an excuse for investors to get jittery. But the market seems sanguine about that too.

“I do not think the change of leadership at the ECB will pose significant risks for these issuers. EU elections could create slightly more uncertainty but they are unlikely to cause a long-lasting deterioration in sentiment. Investors are used to dealing with political risk in Europe,” Cazzulani said.

If investors have to look out for one potential dark cloud on the horizon for peripheral credits, it might be the fact that German growth is slowing. If that continues, it could force yields on Bunds to rise. If investors could get their additional yield from Bunds, which are seen as risk-free, peripherals might lose their unique selling point. For now, though, the returns on offer will ensure demand for any peripheral bond issues.

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Wield the yield