IFR: The market has recently been influenced by events in the equity markets and the movement of break-even levels on some US TIPS, which have moved out and then retraced. How, in your opinion, will these events influence inflation-linked issuance going forward?
Gerhard Schleif (Bundesfinanzagentur): We have monitored the market for more than two years and felt in the Spring of this year that it was moving more towards an equal balance in terms of the different interests on the investor and issuer sides. That is the heart of our business because there is a natural conflict of interest that has to be resolved.
We came to the conclusion that it made sense to add Germany's name to the inflation-linked sector and in doing so, also add additional liquidity to the market. The long-run risk that the issuer will have to pay up compared to a nominal issue has been substantially reduced and the overall market condition could be favourable for the issuer as well as the investor. We will commit to this market and we will build up the curve over time to make this a regular instrument for budget funding.
IFR: Will you be considering further issuance within this financial year as suggested by some projections?
Schleif: No. We have announced that we will tap the outstanding issue two or three times to bring it to a final level of between €10bn and €15bn in order to ensure liquidity. We are in close discussion with the banks, which are much closer to the investor base than we are in this respect and we will follow their advice to a certain degree.
IFR: Given the ongoing development of this market, would you consider funding by indexation to the extent of the UK for example?
Schleif: This is a political question which I cannot answer as we are not responsible for tax matters. The most important reason for moving into this market segment is to add a new funding instrument to our toolbox that gives us more flexibility in terms of our overall activities. We need this flexibility and the ability to use all instruments available to us that do not raise interest expense compared to those instruments we are already using.
IFR: Do you think that the recent market turbulence and the uncertain sentiment with regard to inflation have served as a reminder to the attractiveness of index-linked securities?
Schleif: No, I do not think so. I think that this is the normal give and take between stock markets and fixed-income markets. This rise in volatility was driven by very specific factors, especially from the emerging markets, and I think this is a normal reaction. It looks a little bit overdone due to the fact that there were substantial levels of liquidity in the capital market worldwide, and there are always some investors making decisions as to where they should invest and whether price levels are acceptable or otherwise.
IFR: Benoit, would you particularly identify stock market volatility as a significant phenomenon in terms of indexation? Given that France's inflation-linked funding is running at around 15% of total government issuance, have you perhaps reached your target level?
Benoit Coeuré (Agence France Trésor): Firstly, I do not think that what is currently happening in the stock market should influence our issuance policy in any way. When you are a large borrower, you have to diversify issuance as much as possible, which is what we have tried to do by spreading the linker auctions over the course of the year. We also decided to add to outstanding linkers once a month.
We do not want to be perceived as exploiting market situations with regard to issuance, so in this respect it is helpful to have a certain margin for diversification. For example, we can decide to issue at the short end or the long end of the inflation curve and we also have the choice of issuing either French inflation or eurozone inflation-linked instruments according to market demand. Having this kind of flexibility is helpful to be able to tailor the auctions as closely as possible to demand.
It is more interesting for us as an issuer to be able to track the structural or long-term trends in the market. Since the beginning of this year, we have seen the continued diversification in the trend of the market on the demand side. This means that the structure of the inflation market has not yet completely stabilised; it is not a mature market and there is significant margin for progression.
There are still investors who need to be educated, not specifically those within the eurozone but investors outside the eurozone. As you may know, we have issued a four-year eurozone inflation linker, which we call the BTAN€i, and we have seen tickets from Asian accounts buying this instrument. This shows that by diversifying supply you can bring new investors to the market. The development of the European inflation market is by no means over.
IFR: With respect to the introduction of other sovereigns into this particular arena and investor
diversification, does linking to the Harmonised Core Inflation rate deter some investors? And do you expect other sovereigns to be going down a similar route in the future?
Coeuré: We definitely see it as a positive development for as many issuers as possible join the market as there are massive opportunities. Any new area of supply will create some demand, therefore the more issuers the better. This also applies to corporate issuers. Any development which would lead to more inflation payers in the private sector, not only through bond issuance but also through project finance or any kind of inflation supply coming from infrastructure financing would be a positive development for us because it would help to develop and to deepen the inflation market.
IFR: David, from an investor's point of view what thoughts do you have with regard to changing your focus on the UK index-linked market in terms of sovereign investment opportunities arising from the diversification of European index-linked securities?
David Millar (Scottish Widows Investment Partnership): For us, it would largely be a diversifier which would involve a trade out of sterling linkers into something else. The problem with having any sort of natural demand for other sovereigns' linkers is the difference in inflation rates. The size of the index-linked market in the UK mirrors the demand which is there because of pension funds or other investors whose liabilities are linked to UK inflation. For the time being, therefore, it would purely be in terms of diversification as an investment opportunity as a fund manager rather than being a natural home for asset allocation.
That is perhaps why there is less interest from the large UK inflation investors than sovereigns might like to see as they do not have this natural demand. Another thing is that for global funds there is still no recognised global inflation index. There is not great demand for global inflation in the same way as you have demand as a result of inclusion in the JPMorgan, Citigroup or other more conventional indices. It is not a big stand-alone product at the moment, although the growth in the US TIPS market may see UK funds starting to diversify as well.
I think there is plenty of scope for the development of the market as a result of natural demand. It is necessary to get to a level of issuance that is liquid, so that the market can operate efficiently, because otherwise if it remains too small and there is no natural demand, it will no longer serve its purpose as an indicator of inflation.
Is the break-even rate on inflation-linked securities in the UK a good proxy for future inflation? It depends if it is the day before an auction or the day after an auction and how successful that has been.
IFR: Do you find that the UK inflation market is still difficult to transact business in, and is this still a limitation?
Millar: You have to be very careful in executing orders in the inflation market as a lot of the bigger transactions now go through the inflation swap market. On the subject of the corporate bond inflation-linked market, it just has not happened in the UK because inflation never reaches the public marketplace as it gets siphoned off to the big investment banks, and the inflation swap side never comes into the market.
This may reduce substantial pension fund orders coming through at any one time, although it has probably operated a bit more successfully of late because the pension funds would normally use the investment banks to work those orders for them rather than coming into the market themselves. But we still look at the performance of the auctions: despite some having cover of two to two-and-a-half times, in the long run auctions can still fail from time to time. As an investor I do not mind; to me that is an opportunity for me to decide what to do, although I am sure for the issuers it is a little bit more difficult if they have a poorly covered auction.
IFR: Is there still a concern going forward that the liquidity, given the many years of issuance in longer dated UK Gilts, will remain a problem for new market entrants in relation to the high levels of liquidity enjoyed by conventional bonds?
Schleif: I do not think so. One of the targets is clearly to build up a liquid sector of the market. So we would issue only if we saw an opportunity to offer inflation linkers over the long to medium-term range in sizes that make sure that there are liquid secondary markets, without cannibalising our standard nominal benchmarks. So this has to be balanced, and this was a pre-condition for the decision to go into these markets, and the internal answer of the German Ministry of Finance and in the agency was clearly yes, as they believe there is potential to do that for the foreseeable future.
IFR: More generally what views do you have about the liquidity in inflation-linked securities in the context of investor's views of the evolution of the UK market?
Ziad Awad (Goldman Sachs): In Europe, liquidity has been developing steadily as issue sizes have grown. Obviously, France has been active in the market for many years and has been tapping outstanding issues for very large amounts. There are now more issuers coming to the market and more banks are getting involved and a wider universe of investors, which means that liquidity has gradually improved.
Obviously, there will always be the question of how much is perceived liquidity and how much is real liquidity when you try to execute very large size. It is true that the euro inflation-linked swap market has developed tremendously, in part thanks to a very active euro inflation-linked securities market. This has also in turn helped to extend the liquidity of the government bond market. So the two markets, the structured note market combined with the inflation swap market, and the government bond markets are feeding off each other's success. Some of these issues, like the inaugural five-year inflation-linker issued by Italy, was fuelled to a large extent by swap desks hedging the structured note market, which has been very active for a long period of time now in Europe.
Schleif: I completely understand David's arguments with regard to British inflation and customer needs, but I think what our French colleagues and our Italian colleagues have done before, and where we have followed has let us set a European standard already. We hear the same arguments from the big German insurance companies, for example, why should we accept that this is based on the Harmonised European index and so on? But being optimistic in terms of the development of the euro denominated capital market, I think there is potential for building up a real liquid segment of the market over the long term.
Millar: Will you continue to issue securities linked to euro-inflation?
Schleif: Yes. It does not mean that we do not have plans for example, to offer something different to the German retail customer one day if there is ongoing demand. But there we made a clear decision to join the standard Euro-linked market based on the Harmonised Rate.
IFR: Will the inflation-linked market remain an investment opportunity for investors from the more developed economies or might its appeal ultimately extend beyond these borders?
Zeina Bignier (Societe Generale): The majority of investors we see in the inflation-linked market originate from European, American and some Asian countries and to a certain extent a few countries in the Middle East. It is ultimately limited to the more advanced countries. We have started to see some Central European countries investing in inflation, but it is still not a very big part of their overall investment programmes.
IFR: Investor demand for duration in the UK market has led to an inversion of the yield curve. Does this phenomenon have any bearing on the development on the long-term debt market for other European sovereign borrowers?
Ralph Berlowitz (Deutsche Bank): I think you have to look into the facts to understand why the market is so inverted. It is basically because investors in the UK are more or less forced to buy the issues. There is no choice for investors because of very, very strict rules. There is the need to buy assets – which I think everybody agrees are far too expensive – which is a problem.
I think this is an example of where restricting the market or participants and forcing them to do something because of regulation can lead to distortions in the government bond markets. We do not have that sort of regulation in Europe yet, so I do not think we are going to see a situation in the European linker market similar to the UK market.
There are some regulations in Holland but we do not have any sort of regulations in Germany. With regards to France, it is very liberal. So I do not think the European linker market is anywhere near to being so manipulated by regulations. With regard to long additions to borrowers' yield curves, I think there will be certain accounts and demand for the ultra long product, but again I think it is a question of regulators.
If you force institutions to match liabilities with assets, then clearly you will see more buying at the ultra long end. But if accounts are not forced to participate we will not necessarily see interest on a regular basis in the ultra long product. France issued a nominal 50-year bond and it was very, very successful at the time allowing the deal to be tapped since its initial launch.
But it is not like there is demand for the ultra-long product every week. I am therefore a bit more cautious with regard to ultra-long issuance in these markets; both nominal and the linker market because when you look at investors, few of them have liabilities of 50 years. If you talk to insurance companies, their horizon is more like 15 to 20 years. So is there really a natural need for this 50-year product? To some extent, the answer is yes for pension funds, but it is not going to be so significant that it will force the development of a huge market in the longer term.
IFR: Nevertheless, there is still an inversion between the 30s and 50s in France which from its launch at plus 3bp to the 30-year, the 50-year security has tightened by 5bp to create an inversion of the 30s/50s curve.
Berlowitz: That is probably due to more and more technical factors. When we launched the deal there were some relative value arguments at the time involving convexity. The convexity of these ultra-long securities is far from being a 30-year security. This factor has also led to the inversion we see in the secondary market. So I think it is more technical factors than actual demand factors.
For example, we obviously have much more supply in 30-years than in 50-years.
Millar: The demand for 50-years in the UK is clearly led by pension funds. The life insurers, as you say, do not need to invest this long. The pension funds in the UK are to a large degree under-funded, whereas in Europe, for example, the latest numbers suggest the Dutch pension funds are 139% funded. The UK pension funds would love to be in that situation, but they are not. So it is not only regulation it is also the degree of under-funding.
What I do not know about the French and German markets is whether there are inflation promises in pensions in the same way as there are in the UK and the Netherlands.
Bignier: In France they are perfectly matched. In fact it has been the case since the very beginning where they were obliged to buy 70% of their assets in bonds. They have progressively increased their duration over the last year. So the French insurance companies seem to be perfectly matched as well as well funded.
Millar: So then the whole development of the inflation market is really a case of diversification based on the issuer and the investor, rather than as a result of this dreadful need that we have in the UK. Someone will launch a euro-inflation index and fund mangers will start trying to run retail-orientated funds on the back of that. This is something that will probably take some time to evolve.
Coeuré: What has been interesting is that, quite unexpectedly, the interest seen at the long end has turned out to be more about diversification than liability hedging. I basically agree with what Ralph has said about the functioning of this segment of the market. Demand for bonds, as we see it, is relatively lumpy in the sense that occasionally we have big tickets in the market, but there is certainly not the same sustained flow of demand that we have in the inflation market.
It is also worth noting that it is not only about liability hedging. It is also about diversification. As a matter of fact, when we first issued the 50-year bond, pension funds were not the major investors. We saw lots of demand from fund managers looking for a way to diversify their portfolios and to buy the convexity value that Ralph mentioned. We still have a lot to learn about the value of convexity.
If you look at what happened over the last few weeks, you will see more volatility in the market and you see the 30/50-year spread contracting rather than increasing, meaning that it is certainly not only about protection, it is also a result of the strategies of individual participants which we have to understand better. It’s quite an interesting market segment from a technical point of view and, again, as in the linkers market, there is an ongoing education process. So initially the convexity aspect was valued only by the most technical investors and now more people are awakening to this notion and might at some point be interested in buying a long bond just for the sake of buying convexity.
We will see how the market develops, bit in my opinion the market it is not going to develop as quickly and as deeply as the inflation market, but there is scope for further development.
Bignier: We have observed another phenomenon with the announcement of the OAT 2055. I think that we definitely need diversification but, as Benoît said, there is also the need to create liquidity in this market as we will see demand growing between 30-year and 50-years. We have seen also some demand in the derivatives market, in the 2040/2045 area.
Coeuré: The stripping dimension is an interesting one. We have now issued around €11bn of OAT 2055, and €1.2bn of it was stripped and at such a low level of interest rates. This is somewhat impressive. So with higher nominal rates we could expect even more interest for the OAT 2055 and a new development of the market at the very long end.
Millar: Once you have created a 30-year and a 50-year, you then have a very large gap in between. The UK has now put the 40-year in the middle and there are demands from investors to start filling the curve between them.
Coeuré: However, in the end we also have to keep in mind that it is more interesting for us to issue 50-year securities than 40-years. We certainly will continue to issue 30-year benchmarks because it is an important market segment and it is one of the pivotal points along the curve; we have to provide liquidity to the 30-year bonds. We have also had an interest in issuing 50-year bonds because it is economically beneficial for us, so it is not that clear at this stage that issuing 40-year bonds will make sense for us.
Awad: I think Benoit makes a good point, because we have been talking a lot about interest from investors. However when we are advising issuers on whether to issue an elongated or a super-elongated instrument, the benefit or otherwise, from the tax-payers point of view in 20 or 30 years time, will be an assesment made only with the benefit of hindsight. What we find surprising is how difficult it is to find issuers who are willing to take advantage of this situation.
Obviously Benoit says they have a very prudent approach to the market and do not want to be perceived as being opportunistic. You made the point that actually it is strange how it has inverted. One point that is clearly true is that it is difficult when we have the demand – which comes every now and then – to find an issuer who is willing to do this type of issue. Just as it is not a natural asset for many investors, it is even less of a natural liability for most issuers. Most issuers think that beyond 10 years they are overstretching themselves, not to mention 30 or 50 years.
Coeuré: Just to illustrate this point, when we tapped the OAT 2055 for the second time we issued it at 3.59% fixed rate for 50-years. So you can imagine that the French parliament was quite happy.
Bignier: As he has said there is a lot of demand we cannot fulfil today.
Awad: It is logical to expect that there would be greater demand for something that would be a little bit cheaper than the OAT55 because it is probably the most expensive bond in Europe on a Libor basis. If we could find an issuer, and I think there are maybe one or two borrowers who issue a bit closer to Euribor flat, the demand would outstrip the supply. But actually it is just as well as we are saying there is limited demand because the supply is even more limited.
IFR: Let's talk about auction versus syndication. This year, we have seen some low bid-to-cover ratios coupled with poor secondary market performances. Does the rationale behind auctions still stand?
Berlowitz: Obviously, as banks we would like to see more syndication.
Millar: Funny that!
Berlowitz: There are certain benefits of the syndication process that have to be considered. We often hear negative comments about syndications from issuers, such as fees and being forced to select certain banks for the syndication process. However, the benefits of syndication still stand. For example, the direct link between issuers and investors through the syndicate banks, which is not apparent in the auction process.
I think everyone who is involved in auctions knows that most of the paper is now coming onto banks' books initially and is then redistributed from there. Therefore there is basically no direct placement into the hands of end-investors. In a syndicated deal, an issuer knows where the bonds will go. I think the additional benefit is that the profile is far higher than an auction in most cases. Also, sovereigns use syndication as an opportunity to go on roadshows, tell their story and update investors about the country. As a result there is certainly a public relations impact as well, which you do not have in auctions. There are also benefits on syndicated yields.
That said, we do see the other side of the table as well. It is not necessary to do every tap on every deal using the syndication process, so the auction process certainly makes sense. Many sovereigns are using the syndicated route for special transactions, for example when Germany came to the market with the linker, it used the syndicated route and not an auction because it was a special project.
Would Mr. Schleif do the next 10-year Bund as a syndicated deal? Probably not and it is not necessary. But for certain projects it is necessary. France did the 50-year nominal, some of the earlier linker deals and longer-dated deals using syndication. But these were unique deals and I think it definitely made sense to use syndication.
But, at least for the core sovereigns, it is not always necessary, so both distribution methods make sense. For some deals, syndication is better and for others, auctions make more sense.
IFR: Germany has made some striking returns to syndication. What are your experiences of syndication?
Schleif: It has been a mixed experience. It was a clear decision for Germany to return to the syndicated model which will be used again in the future if and when appropriate. If we foresee a risk because we are entering a new market segment or a new maturity where we do not know the exact investor base and there is an apparent placement risk, we have preferred to set up a syndicate. With regards to the auction results, the numbers are all relative.
There are situations where market-makers are not prepared to take positions where they see a risk and the demand is therefore less aggressive than it would be in a more favourable market environment. That is a very natural situation and it is the difference as to whether you publish a big cover ratio for an auction of two billion or nine billion. There is a period where the bidders are on the winners' side and there are periods where the issuers are in a better position. In the long run, it is a case of give and take.
Bignier: Having a balanced approach between auction and syndication makes more sense from the issuers' point of view. For smaller countries such Portugal, Greece or Belgium, syndication can help raise larger amounts more easily on the first tranche than the auction process which usually raises on average €1bn or €1.5bn.
I do not share the view that syndication is more costly than auctions, mainly due to the fact that before the auction we see a lot of volatility in the market, and usually at the time of the auction, banks are paying more or less the right price. Ultimately, in terms of funding as we know, the market can behave somewhat erratically preceding the auction process.
Awad: I agree that a mix of syndication and auction has worked well for the issuer. One of the main arguments for syndications is to create an event in the market and capture investors' attention, although you run the risk that if you bring too many syndicated deals they may no longer be as effective, so there is a balance to achieve.
Also, the added value of syndication differs from issuer to issuer and from time to time. In the early days as we were entering the euro, syndication was used to a large extent by countries that had smaller borrowing programmes. This helped the borrowers, which no longer owned a domestic currency market to make their mark in the context of a single currency alongside high profile borrowers such as Germany and France.
During a bull market, where auctions could perhaps achieve the same result, it could be argued that the main value of syndication is advertising and PR. As we endure more volatile market conditions, as we potentially have this year with the ongoing bear market in European rates, the very practicality of syndication to get the size done in one clip is reaffirmed. In a difficult environment, the careful execution of the syndicated deal, the choice of the lead managers, of price guidance and of the timing is all the more crucial.
IFR: Has the overbidding by banks led to a reduction in the participation of the smaller investor?
Millar: Not overly. I take a purist view that the market decides. My personal preference is for auctions, except in the case of new instruments or when the issuer is establishing a new market. Also, if a smaller borrower is bringing a new benchmark, it is helpful if the borrower brings a larger amount to create liquidity, so in this respect syndication has its place.
As an investor, I do not object to buying in the secondary market or buying direct from the issuer. The auction process is essentially for the banks to decide how much they want to take on their books. While there is arguably a status play from some of the banks trying to be the biggest part of an auction, as an investor what I want is to buy at the right price, and I will determine in my own mind what I think the price will be it in the secondary or primary market.
Another aspect of syndication is it is very good at ironing out the short-term humps. I do not think there should be any particular embarrassment about auctions that are only one time covered, or that clear a few basis points away from they otherwise would. That is just the market mechanism working to find the right price.
We have seen uncovered auctions in the UK, particularly in the linker market. But I am sure over the long term the DMO will look at it and say it has been reasonably successful overall. But ultimately, if I do not like the price of an auction I will stand back and wait for it to fall and buy it in the aftermarket. If the banks want to participate and overbid and push the price up too high, then I will wait until they do not want it any more and try and sell it on to me. We should not try and artificially manipulate the market mechanism.
Berlowitz: Every investor you invite into an auction will ask why should I buy a bond at a specific time when it already exists in the market, and I can buy it when the market dips? It's a different story, however, with a syndicated new issue where a new line will be opened and you have to buy it, or else wait for the secondary market but not achieve the same size. The liquidity in the secondary market works and it works in Europe quite well.
With regards to the overbidding, I think the overbidding was only created because of syndication. It is a problem for the market and I would agree that some investors stay away because there is overbidding and it is too expensive. The overbidding in general has started because sovereigns have been forced to give mandates for syndication and there is huge competition in the primary dealerships.
Many sovereigns evaluate their dealers on how they do in the primary markets and in the auctions, which results in overbidding. In some smaller countries it has become extreme. Portugal and Austria are examples where overbidding could add as much as 25 cents to the market price. That is a problem for the market. Many banks, together with some sovereigns, have been thinking about how we can change the valuation system to avoid overbidding. But it has been very difficult and unsuccessful so far. It is my opinion that if we did not have syndications, we would not have overbidding.
IFR: Has this overbidding actually resulted in any mandates being awarded or will its success only be apparent in the longer term?
Berlowitz: If you overbid in every auction and increase your market share to be in the top three houses in the primary market, you will invariably increase your chances of being awarded a mandate. We have seen some very, very aggressive approaches from some banks in certain countries, and sometimes you see lead managers in deals which you would not necessarily expect there.
Coeuré: We have to view the overbidding issue in terms of market forces again, and it would be offensive to banks if we suggested that they are not acting in a rational way and not in the interests of their shareholders. If they are, however, willing to pay more at the auctions there must be a reason. And part of the reason is the expected value of receiving an issuance mandate and the material value of being in the top five of the league table. In a sense what would be the optimal situation would be to have no syndication at all and then there would be less overbidding.
It is probably not feasible in the European market because the market is fragmented. Even the larger issuers such as Germany, France and Italy have to do some marketing and be held to account by investors. If you can imagine a situation in say 15 or 30 years time, where there will be one single European issuer and this one issuer, acting on behalf of all European countries, would do exactly as the US Treasury does at present. It would never syndicate anything and there would be no overbidding. This is not the political configuration we are living in currently, so we have to find arrangements which are second best.
Awad: That is the situation we had before the euro where most European countries issued in their local currency and only used auctions. Syndications were really introduced in the run-up to the euro.
Schleif: No, until the end of 1998 there was a Bundesanleihen syndicate in Germany where any single auction was sold by a syndicate and the government paid fees for that. If you look at the structure of how banks behave in auctions, there is a relatively clear sign that you always see the same names in the same maturity brackets, some with big tickets and others with small tickets. So we have big players in the six month Treasury Bills and we have big players in the 30 years which may be different houses.
Of course to those names which are not so aggressive, we say okay, have your overbidding. But to the ones who are obviously specialising in a particular segment they are unlikely to repeat their wrong pricing and overbidding in the next auction. If they are sure of getting the size they want and are able to distribute the paper without losing money in the long run this will be their objective. This is much more specific than it has been handled in public discussions. There are many factors that play a role, also depending on the overall market trend and market environment.
Berlowitz: An interesting question for Mr. Schleif would be, since Germany syndicated a dollar deal, has the overbidding in Germany's auctions actually increased?
Schleif: Clearly, yes. That is one factor.
Berlowitz: That is a sign. Banks have realised that there will be syndicated deals in the future from Germany, and the overbidding problem was not that great in the past before you started doing syndicated deals.
Schleif: Basically the structure of the bids that are coming in, and we have been watching this for two years now, has clearly improved towards the side of the participants in the auctions because the bids are much closer to the existing curve than they had been before. Previously, we had a number of smaller participants in particular, who were placing their bids at a level where they thought there was no risk of being filled. So the spread between the highest prices and lowest prices was huge.
Coeuré: To add another dimension to the discussion, the fact that overbidding is just the outcome of market forces does not necessarily mean that it is a good thing. The worrying aspect of these market dynamics is that the overbidding might be the rational behaviour of the larger banks that compete for the mandates.
But what is more important is that this impacts negatively on all market participants, including the smaller banks. So there are a number of banks who have to pay the higher price without receiving any benefit. There may be at some point a temptation to move to a two-tier system where only the larger banks would be dealers and would participate in the auctions and the smaller banks would just be in the local loop and would buy the bonds from the larger banks for their clients, i.e. they would no longer talk to Treasuries.
This would not be a good market structure from the issuers' standpoint because we do not want to talk with only five or 10 global banks.
Awad: Just one word of caution, maybe to conclude on this point is, given all the discussion about the auction prices set by the market, it is important that investors are aware that auction prices can be influenced by all these other external factors. As such, the price from the auction cannot be used as a reference for fair value. It should not, for example, be used as a reference for marking a portfolio or for setting the price of a structured note, for instance. In some countries, the prices on the auctions are used to set the coupons on some short dated bills. That is something to be mindful of.
Bignier: There is, from my point of view, no clear link between overbidding and the presence of small and medium-sized investors. Before the implementation of the euro, when there was a domestic currency market, there was no overbidding and the small and medium-sized investors were not present in the auction because they could choose the right timing to enter the market. So I think that there is no link between this.
Millar: I very seldom participate in auctions. In many respects both syndication and auctions are distributed by the issuer to the banks because the investors tend to hold back and either buy before or afterwards. It is a matter of whether you pay fees upfront to do it as with syndication or whether you take the risk with the price and let the banks effectively bid on your behalf. To us as the investor, it is an activity we watch from the sidelines. If they make a bit of a mess of it and there is an opportunity afterwards, we are quite happy to take advantage of that.
Schleif: It is a similar process as it was before 1998. The syndicates that were in place at that time were completely based on the risk appetite of the participating banks. In those days we went to the Bundesbank, had a discussion there with the Ministry of Finance representatives, and decided on which banks would be involved in the issuance process.
Millar: I judge the banks that I deal with much more on their secondary market support than on their involvement in the primary market. I do not even look at the figures in terms of the primary market. I want to deal with houses that are going to be there before issues come to the market and afterwards in the secondary market.
Bignier: You are right.
Berlowitz: I would say there is a connection. With most countries you will find the strongest in the primary market are also the strongest in the secondary market.
Millar: Yes.
IFR: Given that certain banks actively seek to acquire market share, does this influence your view with regards to participation in syndicated deals?
Schleif: Market share is not the basis for our overall judgment in our relationship with the banks. We put our thoughts and ideas into the co-operation we receive in different fields and we take a medium-term view. The banking sector is a very lively community whose market share varies, and while some players remain in a certain range, the rest of the group has varied significantly over the years. Some are falling back and then you think, what is going on there? Then you see there is an in-house problem or that they are restructuring their business model, and two years down the line they are back on the scene.
IFR: So the numbers in themselves do not necessarily guarantee any particular elevation or ranking going forward?
Schleif: No, steadiness is necessary, and that we have the feeling we can rely on the relationship.
IFR: How much further do you think euro swap spreads can move, having widened in the 10-year maturity over the last year from a level of around 10bp to around 20bp?
Awad: There are a number of factors, most of them macroeconomic that have driven the widening of euro swap spreads. Firstly, it is fair to say that euro swap rates started from historically fairly tight levels around a year ago. Since then we have seen a flattening of the yield curve, as well as a rise in the short term rates by the ECB, also we have seen a general rise in interest rates.
All these factors are historically correlated with wider swap spreads and there are reasons for that: a flatter yield curve and a higher yield environment being two of them. While there is no consensus view on whether European swap spreads will widen more, our in-house view, which I personally share, is that they will widen further. We are talking about reaching a level of 30bp in 10-year swaps this is something we could see even this year in Europe.
IFR: Let us move to the impact that this has had in terms of the sub-Euribor levels which sovereigns are achieving. Within recent months Austria and Finland have issued at around 21bp to 20bp through Euribor. Based on the numbers we have been talking about, you think they will be issuing at 30bp through Euribor some time soon?
Awad: There are a couple of things to consider here. Within the issuers' universe there are some borrowers which I would call high beta, i.e., which are likely to widen almost as much as France and Germany as the swap spread widens; and some other issuers, probably as you go down the ratings spectrum, have lower beta and they will be more correlated with swaps and lag the widening move by a certain factor.
Then in the credit world, what will be happening is like an accordion, i.e. as a Triple As become richer to swaps, the lesser credit world will be widening along with credit spreads in general which will be widening. Therefore, Triple B corporates will be issuing cheaper to swaps while Germany may be going to Euribor minus 30bp.
Now, what happens to sovereign issuance as swap spreads widen is that the issuance levels of all the sovereigns, and also the quasi-sovereigns and the agencies, improve to swaps. You made the point about the lack of correlation with swap spreads. It is true that a lot of the issuers – even, I would say, the agencies or the sub Triple A sovereigns – have moved very much in lock-step with France and Germany, as opposed to tracking the swap curve. For example, Belgium, which is not Triple A, issued at Euribor minus 16.5bp a few weeks ago.
IFR: The dollar market has historically offered a more attractive alternative funding base for European issuers. Will the improvement in the funding levels available in the euro-denominated market detract from future dollar issuance in offering a more cost-effective arbitrage going forward? Will the extension of this argument see an increase in the volumes of euro issuance and can the market absorb this?
Awad: The euro capital market is now the largest in the world, and it adapts to the supply.
Berlowitz: I would argue that there is no limit. There is a price for all supply and I think it is clear that what we are seeing right now is that the market is distinguishing a bit more between credits. We have seen that for a long time swap spreads were extremely tight. I believe that Germany was trading as cheap as Euribor less 7bp last year. The spread between Germany and Italy was very small and it has now widened significantly.
If Ziad’s swap spread forecast is correct, it will probably widen further. But the market is big enough and the market will find a price. With regard to what you said about the accession countries, there is not a huge supply from these as most of them are very, very small. The market will still be able to provide them with significant amounts of money and cash for investment.
And what about spreads? It is more a question of how they perform fundamentally. I think some countries are facing some problems right now, for example Hungary has just being downgraded. If their fundamentals improve, spreads will tighten again. I do not think it has anything to do with the fact that they have issued more. For example, Poland and Hungary have been relatively stable with regard to international funding over the last three to five years and their spreads have continued to be volatile.
For a long time the trend was continually tighter but in recent months spreads have moved significantly wider. But there are fundamental reasons behind this; it is not a function of the amount they have issued
I think the market will pay much more attention to fundamentals and it will look at the discussions right now in all major countries with regards to deficits. Standard & Poor's for instance is taking a very long-term view now and they have announced some of their outlooks on certain countries in terms of where they would see them in 2050.
Sovereigns have to deal with their problems and investors will look at the way they deal with them very, very closely. The states where people think they deal with it well will see improving spreads compared to those where people think they will have more problems.
IFR: Before we just tie up on that, you seem differ from Ziad's view that we will reach levels of 30bp through Euribor in terms of core sovereign issuance.
Berlowitz: No, our view is that we will probably also see wider swap spreads, although not necessarily fixed to that 30bp number. In the medium term we will see maybe 25bp or so therefore it is not a fundamentally different view.
Bignier: The same for SG.
Coeuré: Another interesting question to ask is how this is going to impact the quasi-government issuance through agencies. You have these beta factors, as they are described; these agencies are widening to a lesser extent by definition than governments. I guess all or most European governments have had a tendency over the last few years to try to diversify their issuance.
If you take the governments as a group, you have state issuance but you also have agency issuance. We have tried to exploit the existence of different investor classes, different credit buckets in the portfolios, to diversify the issuance through agencies. But if we enter a period where the spread between the central government and the agencies is going to be wider for a distinct period of time, then at some point there might be a tendency to try to re-centralise issuance because it would become too costly to issue through agencies. We are not yet asking ourselves the question, but at some point this question will be raised.
Bignier: Over the last month, we initially saw asset swap levels of the main governments tighten significantly, followed by agencies. This has resulted in higher secondary volumes because of the anomalies it has created. For example, there has been an increase in volume through switches so an investor may diversify between pure government and agency bonds.
I would like to add one point with regard to asset swap levels. After the crisis last year in the auto sector and in a few other corporate sectors, we saw a lot of investors reducing their exposure to the corporate market and increasing their exposure to governments. I think that this was one of the factors that contributed to asset swap levels widening. This is important because investors moved from corporates into agencies and governments. So agencies, I think, will continue to improve. Over the next month we expect within SG to see the spread between the governments and the agency tightening quite significantly.
We share the view that there will be tightening of government asset swap levels by a further five basis points following what we have seen so far this year and that there is, globally speaking, a drop in the funding needs of sovereigns by three to four per cent. So I think that this has also been an important factor, globally speaking. On the syndication side there has been a drop of 24%, which is quite significant.
Coeuré: The picture you are drawing is a consistent one. We now have improving public finances in the larger countries, which will contribute to widening of swap spreads. With this widening there will be more credit discrimination and more intervention or monitoring by the market of the fiscal consolidation process, and that is a good way to go forward.
IFR: You are referring to European sovereign issuance?
Bignier: Absolutely, to the European sovereigns.
Berlowitz: Obviously the economic situation right now is far better than it has been in previous years. So obviously sovereigns are generating much more tax revenue right now, which brings down the need for funding.
Coeuré: And they are selling assets.
Berlowitz: The question is how sustainable is it? If we have very strong growth over the next two to three years, that would suggest even wider spreads though at some stage, if all the assets are sold and if the economy is not doing that well, the question then becomes, how will swap spreads react to that?
IFR: Is there a benefit for European sovereigns to issue in markets other than euros, for example as Germany did with its US dollar transaction? Will this diversification be an ongoing process?
Schleif: We hope so but possibly not imminently. The situation of May last year was attractive in two respects. On the one hand there was certain demand from the investor side for credit diversification in the dollar market, and on the other hand, there was a very special situation between the cash markets and the swap markets.
Since we were forced to swap the currency risk because of the outlines set out in the budget law, it was a special situation which would not normally occur in the market. The arbitrage enabled us to realise a very nice gain by swapping into euros, and this is currently not the case. We have always said this kind of activity in foreign currency markets is not a part of the regular budget funding process. It is an anomaly to come close to our funding target and this enabled us to reduce our funding cost. If we can at the same time meet investor demand, it is a wonderful situation.
Berlowitz: There is only one sovereign in Europe, which is Italy, which has a more programmed approach to the dollar market. I think for most sovereigns it is an absolute must to meet domestic levels on a foreign currency transaction. I think only Italy has this strategic foreign currency programme which involves them issuing in different currencies. You know, they like to see better funding levels than in the domestic market, but it is not an absolute must. So they are looking more to a programme approach into different markets, whether it is yen, dollars, Swiss Francs etc. Investor diversification is important but it is not the most important factor. I think the most important thing for most sovereigns is cost.
IFR: Spain, Portugal and Austria have been fairly regular dollar issuers over a period of time. Were they perhaps more opportunistic in their approach?
Millar: I get a bit worried when I start hearing the word "opportunistic" in the context of sovereign issuers because in a way they are the ones who are meant to be above all such opportunism. I have said to a sovereign issuer who has come to visit me in the past, "I am going to call you boring because you are meant to be boring because that is your job". So fine, be opportunistic in the dollar market, but it gets a bit worrying if they start being opportunistic in betting in your domestic market. It makes it more uncomfortable for investors if they have to second-guess what certain issuers are doing.
Awad: One thing that has happened since the Germany deal (which was supported by a huge amount of investor demand for Triple A sovereign dollar paper) has little to do with the investments themselves but it has made it less interesting for sovereigns to issue. The basis swap between euros and dollars moved significantly to make the dollar less attractive.
The swap spread in euros widened significantly because basically there was more buying in euros, making it more interesting for sovereign issuers to stay in their home market. The swap spread in dollars narrowed to some extent which had little to do with investors.
One thing which was to do with investors, and which is interesting and relevant, is that Asian investors who are and remain the main drivers of US dollar Triple A issuance have started to diversify their holdings. On one hand, within the dollar sector they started buying non-sovereign issues for example, and they also are gradually continuing to diversify from dollars into euros.
This is also part of the reason that the euro market is becoming bigger and swap spreads are widening. So there are a number of really fundamental factors which occurred last year, which increased the attraction of the dollar market to sovereign issuers.
IFR: Moving on to the final discussion point; do sub-Triple A countries trade at the right levels? How has the addition of the euro accession countries impacted the demand for other European sovereigns?
Bignier: There is a differential evolution of the asset swap depending on the countries. Portugal moves differently to Greece or Italy and, as Ralph said, Hungary or Poland. Investors will look at the fundamentals. For example, in the case of Portugal it is a small market, but the Portuguese government has addressed the right reform to their problems and this has been positively received by the market.
The spread has tightened continuously and I believe that this trend will continue. In the case of Greece, it is slightly different. Over the previous months we have seen a strong tightening of the asset swap though I believe that we have reached the limit of this narrowing and I think that the market will expect more reforms of fundamentals going forward.
Italy is more or less the same case. They were under pressure from Standard and Poor's plus the election period. I think that now they will have a break period for the swap to tighten. I think that we will continue to see a small tightening, but I think that definitely the investor will have a look at the fundamentals at a certain stage.
Berlowitz: I would say that there is no such right or wrong level; there is only a market level. I think if you believe in a functioning market that prices are the demand and supply dynamics. You see a lot of the new accession countries who trade at extremely tight levels because they have very small funding requirements.
A lot of demand from this huge European investor base is meeting very little supply. The prices are extremely tight and if you compare the rating categories, there is obviously a huge difference in the spread between these countries. It is a market where the supply/demand dynamics determine what the price is and this is still working out quite well
Millar: As an investor, it is interesting see the new EU accession countries and the spreads at which they trade compared to the established member countries. The weaker existing member countries, which traditionally may have traded a little bit too tight from a fiscal perspective, have widened in line with the accession countries whose fiscal position may actually be in a better shape than theirs.