Sterling, the surprise package

IFR SSA Special Report 2019
10 min read

Despite the chaos of Brexit, a benign basis swap and a reformed Libor replacement rate have seen a boom in sterling-denominated SSA issuance in the first three months of the year.

Britain has dominated business headlines around the globe this year, albeit mostly for the wrong reasons – its perpetually fumbled attempts to leave the European Union. But amid the political chaos, one market has quietly boomed: the sterling bond market.

In particular, sovereigns, supranationals and agencies have flooded into sterling since the start of the year.

“Sterling is off to a flying start and [showing] resilience this year,” said Jonathan Peberdy, head of syndicate at NatWest Markets. “Demand for sterling assets remains very strong and sterling is an attractive funding choice for international borrowers.”

Issuance is up 60% year-on-year with around £23bn of paper sold up to mid-March, compared to £14bn in the same period last year, according to RBC Capital Markets.

So, what has happened? First and foremost, there has been a shift to replace the discredited London Interbank Offered Rate (Libor) with the considerably more robust Sterling Overnight Index Average (Sonia).

The move is being driven with the regulatory stick and the capital markets carrot. Last summer, UK financial regulators made it clear that Libor was on its way out and that the transition must complete by the end of 2021. At the time, Andrew Bailey, chief executive of financial regulatory body the Financial Conduct Authority, drew a line in the sand.

“I hope it is already clear that the discontinuation of Libor should not be considered a remote probability ’black swan’ event. Firms should treat it is as something that will happen and which they must be prepared for,” he said.

In actual fact, the transition has, to all intents and purposes, already happened.

As Sean Taor, global head of public sector at RBC Capital Markets, noted, around £180m three-month Libor contracts a day are now traded, compared to £48bn a day for Sonia. He describes it as “a robust rate to benchmark against”.

EIB blueprint

What has definitely sweetened the transition was the deliberate move by the European Investment Bank to price a bond linked to Sonia last year via HSBC, NatWest Markets, RBC and TD Securities.

On solid demand and a decent book, it printed £1bn June 2023s at Sonia plus 35bp. This was in line with initial price thoughts and offered a 3bp premium over EIB’s Libor curve to boot.

“The choice of referencing the Sonia benchmark removes the need, for both issuers and investors, to consider any future changes to Libor for this bond,” said Bertrand de Mazieres, director general of finance at the EIB.

A runaway success in more ways than one, it has become the blueprint for Sonia issuance, although it was not actually the first Sonia-linked bond ever.

In fact, the EIB had priced a £300m Sonia deal back in 2010, but that was what Thomas Schroder, deputy head of division and managerial adviser in the capital markets department at the EIB, at the time called “a novelty”.

One banker picks up the story. “When we did that deal in 2010, we learned that the plumbing was not in place. But by this time last year, the documentation was in place. After EIB did the first reformed Sonia deal last summer, issuance really picked up in the second half of the year,” he said.

And Sonia issuance has continued into 2019. Of the £23bn SSA issuance that had been seen until mid-March, £6.5bn of that references Sonia, according to RBC Capital Markets.

Not all about Sonia

But that is not the sole reason for the upswing in issuance. If you look at this year’s SSA issuance in sterling and take out Sonia deals, it still stands at £16.5 – up 20% on last year.

The reason quite simply is the basis swap. SSAs are sophisticated borrowers when it comes to pricing and have the flexibility in their funding programmes to issue in the most cost-effective markets.

“Sterling is always hard to anticipate as a funding vehicle. But if demand is very strong, then you know that the basis swap should be attractive,” said RBC’s Taor.

Typical is the World Bank. At the end of January, it priced a £1bn September 2023 benchmark on books that topped £1.2bn. The 1.25% paper printed at 99.757% to yield 1.301%, which equated to equivalent Gilts plus 40bp.

“Since issuing its first bond denominated in pound sterling nearly 68 years ago, the World Bank has developed a deep partnership with pound sterling investors in the UK and around the world,” said Jingdong Hua, World Bank vice president and treasurer.

The market roundly applauded the deal. The general view was that to get £1bn away in a five-year tenor is a difficult feat at the best of times, but to do it with an intense competing pipeline and political volatility is an achievement.

But familiar agency names have also printed in volume in sterling. To give just a handful of examples, by early April, German state-owned development bank KfW had already printed £5.05bn via six taps and three benchmarks. That is more than three times more than the £1.65bn it raised in the same period last year.

Dutch bank and local government funding agency the Bank Nederlandse Gemeenten printed £500m 2021s via Bank of America Merrill Lynch, Deutsche Bank and RBC. And Rentenbank, Germany’s development agency for agribusiness and rural areas, first came with a £150m tap of its US$325m 1.375% 2025s at Gilts plus 46bp, and then returned with £250m December 2024s that priced at 43bp over Gilts.

To put the cost savings into perspective, the pricing on that last Rentenbank deal equated to around 17bp through Euribor, which is much tighter than where the agency trades in euros. No wonder that one DCM head reiterated the point that “the sterling market is attractive on a relative basis and supply guarantees a decent income”.

But if the issuers are able to cut the costs of their funding, the buyside enjoys a decent pick-up in sterling too, specifically at the shorter end of the curve.

“Short-end issuance in euros is scarce at the moment. Euro rates are so low that it is just not appealing to investors,” said Damien Carde, head of frequent borrowers group DCM, NatWest Markets.

It all becomes clear if you look at the yields on Bunds. The five-year remains resolutely in negative territory and even the 10-year has come in more than 20bp since the start of the year. It had a yield of 0.242% in January but had dropped below zero by the end of March. In comparison, the five and 10-year Gilt yields were at 0.75% and 1%, respectively.

And there is little chance of an interest rate rise in Europe any time soon. European Central Bank president Mario Draghi has made it clear that he has no intention of abandoning the comfort blanket of his targeted longer-term refinancing operations. More to the point, his refusal to give details on how much the ECB intends to commit, suggests that the era of cheap money is not remotely over.

Treasuries to the fore

Much of that buyside demand is coming from bank treasuries, an investor base that has grown, according to a number of bankers. Partly, this is because of Brexit, the UK’s attempt to withdraw from the European Union. Treasuries have increased their portfolio of liquid assets to prepare for the worst.

And figures from NatWest back this up. Of the SSA sterling benchmarks to date, some 78% has gone to treasuries, a figure which rises to 88% of bank treasuries for Sonia-linked deals.

But, as NatWest’s Peberdy points out, it is not just bank treasuries buying sterling bonds.

“The UK has a broad community of sophisticated investors with a structural need for sterling. We see international demand for sterling ebb and flow a little as the currency fluctuates, but the core structural bid for sterling assets is very resilient,” he said.

The elephant in the room, however, remains the spin of the roulette wheel that is Brexit. The old City adage has it that the only thing that bankers hate is uncertainty. While they might therefore be expected to be warning of doom and gloom, there is in fact relative quiet. If not ebullience, then there is certainly an element of positivity surrounding the situation.

There were concerns, a number admit, about a hard Brexit – the UK crashing out of the European Union with no deal in place. But at the time of writing, with the likelihood of a soft Brexit or even an extension to Britain’s departure, markets remain comparatively calm.

“A stable stock market and a stronger pound – the resilience of Britain plc is good,” said one banker. There are some even who see it in a positive light. If there is a delay or transition, then sterling will rally and that could lead to an increased offshore bids for strong assets.

It might even, said another banker, be sterling positive. “A good divorce could lead to more demand for sterling,” he said. It is certainly something to think about.

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Sterling, the surprise package