Sovereign borrowers are more than ever having to juggle their sources of funding to find the best mix between seeking duration, offering liquidity, managing investor risk perceptions and taking funding opportunities in choppy markets. As 2011 came to an end, a fifth element to the equation greater flexibility looked key to success in the year ahead.
With auction success far from guaranteed and syndications all but impossible towards the end of 2011, some sovereign borrowers turned to privately placed medium term notes and commercial paper to fund quickly and opportunistically.
Sovereigns that had benefitted from an investor flight to quality in MTN and CP markets were small, highly rated countries such as Belgium and Finland, with the more highly rated countries enjoying better MTN and CP demand.
By early December, Belgium had raised only 730m in MTN funding. It had targeted 2bn and planned to fund the rest through OLO auctions. Finland, however, raised 3.7bn worth of what it described as MTN funding a number that exceeded the issuers expectations. The Netherlands was also awash with demand. It posted negative yields for its commercial paper, which dealers said was a CP market first.
Still, flight-to-quality issuers felt the strain of market volatility and will continue to lean on MTNs and CP in the next year.
"The market turbulence we experienced shortens the time horizon during which an investor makes a decision," says Anne Leclercq, director of treasury and capital markets at the Belgian Debt Agency.
"It will create more uncertainty about the outcome of planned issuance. Investors are finding it harder to give us a clear indication whether they will participate in a syndicate because volatility is too high. We will need to be more flexible in our application of structured products. The MTN market will help us capture issuance opportunities that our standard products cannot."
At the beginning of October, market volatility also drove Belgium to issue short term funding through the commercial paper market instead of through its usual treasury bill auctions. Belgium now has 11bn of outstanding commercial paper with an average tenor of three to 3-1/2 months. In the year ahead, commercial paper will continue to be useful to sovereigns as a hunt for liquidity shortens the tenors that investors want to hold.
"Investors want flight-to-quality assets and they also want liquidity," says Michael Amorgianos, director, debt syndicate, head of European MTNs at Standard Chartered. "Investors dont want to tie their funds up for a long period of time, especially in illiquid private placements unless they have specific requirements.
"Commercial paper provides a good medium through which investors can satisfy their investment requirements by buying short dated notes. For example, they can buy CP with three to four week maturities on a rolling basis, so that investors arent stuck holding paper if they need to exit the market quickly."
Yet as investors and issuers pile into short dated paper, sovereigns will find themselves competing not just with new pan-European agencies such as the European Financial Stability Fund, but with agencies that have been shut out of the US money market such as Frances Cades.
"There will be additional players in this space to compete," says Kentaro Kiso, managing director, global MTN syndicate and public sector global finance at Barclays Capital. "With the majority of AAA issuers having their ratings scrutinised, there will be a lot of crowding out happening in the short end."
Other sovereign MTN placements could be forthcoming. Romania launched a 7bn MTN programme in June. Auckland City Council launched a $2.5bn MTN programme secured on the councils property tax rates in December. Dealers say investors would also welcome central and eastern European issuers Poland and the Czech Republic would all find willing German investors if they issued Schuldschein.
Sovereigns therefore need to be much more flexible if they wish to complete in the year ahead.
They may even have to print in structured forms that they would hitherto not have considered, such as puttables. Some sovereigns showed that they could be responsive in 2011 Belgium sold 400m of fixed puttable MTNs maturing in 2021 with the option of extending them to 2031. Two were done through ING and a third through Credit Suisse.
However, because of resource constraints, sovereigns are more likely to print in less complicated structures, such as callables, puttables and constant maturity swap linkers.
Commercial paper served another crucial purpose in 2011 by allowing sovereign borrowers to take advantage of an extremely negative euro-dollar swap to fund cheaply. Sovereigns could print in dollars and swap it back into Euribor at negative rates.
As dollar funding became more and more problematic, sovereigns that were still well regarded used privately placed commercial paper for funding by arbitraging in different currencies.
Using commercial paper allowed Belgium to target central banks with dollar reserves. Sovereigns could also diversify into other currencies using private placements. The Netherlands added Norwegian kroner to its CP programme, which already sported a portfolio of dollars, sterling and Swiss francs.
Opinion is split on whether advantageous swings in the euro-dollar basis swap it moved to its lowest levels since 2008 towards the end of 2011 would coax more European sovereigns into printing commercial paper in the year ahead.
Some dealers say that the political backlash would stop bigger European sovereigns from taking advantage of changes in currency basis swaps. Should France or Germany ever be seen to borrow in dollars, it could be taken as a sign that they had lost faith in the euro. However, dealers say that investors would understand why core European sovereigns would want to print flexibly in commercial paper. Furthermore, core sovereign CP would be posted at levels on a par with KfW.
Another challenge that Eurozone sovereigns must face in 2012 is a changing investor base. While sovereigns can still rely on retail investors to buy their paper, some may lose a degree of interest from domestic institutions as banks look to deleverage and shrink balance sheets.
Sovereign borrowers therefore need to keep courting foreign investors in the year ahead. But that will be a difficult task. The further away from the Eurozone crisis an investor, the less inclined it will be to increase investment in European borrowers. As investors become risk averse and uncertain, the more unwilling they are to venture out of their own borders, investing only in what they understand well. Fund managers also perceive that they will be less penalised if they buy their own government bonds.
"One French and one German asset manager recently told me the same message about their current asset allocation in these uncertain times no ones going to fire a German fund manager if he buys Bunds and no one will fire a French manager if he buys OATs," says Benjamin Lamberg, global head of MTNs and private placements at Crédit Agricole CIB.
Dealers say that as governments find it more difficult to print new issues, sovereign borrowers could also tap benchmark bonds with privately placed MTNs, raising debt while offering flexibility and liquidity prized by investors. But some sovereigns baulk at the idea, saying cross-fertilisation of private placements and benchmarks would create too much uncertainty surrounding their yield curve.
"A private tap of a standard bond would create too much opacity in the market," says LeClercq at the Belgian Debt Agency.
"And when it comes to a sovereigns standard product, you generally need a level playing field between primary dealers and issuers. The market needs to know what you are going to do so it can prepare for the additional supply that is coming so it can have the least possible effect on your curve."
MTN dealers say that one way for sovereigns to gain more flexibility would be to set up two product lines with two different curves one as a reference and another as an opportunistic curve.
The reference curve would be calculated from a series of benchmarks with sizes of between 3bn and 5bn.
These benchmarks would not be tapped, remaining the standard curve for a sovereigns price. The second would be calculated from a series of smaller clips of between 500m and 1bn and sovereigns would be free to tap deals on that curve with private MTNs.
"If sovereigns want to gain in flexibility and raise more funding, developing a second curve for opportunistic, more private placement-like deals is a smart way for diversifying funding sources and gives them the right tools to adapt to prevailing market conditions," says Lamberg. "You can see it as one more tool in the funding armoury."
Sign of weakness?
But many dealers also warn not to expect a flurry of new issuers in the year ahead.
Even as core European governments find funding harder to come by, the stigma of being seen to have to resort to MTNs and CP funding rather than larger benchmarks stymies any incentive from core Eurozone sovereigns to develop private placement programmes.
For a large country such as France, the news that it would have to resort to opportunistic private placements carries too much of a whiff of desperation peripheral economies such as Portugal and Ireland used private placements to fund in 2010 and at the beginning of 2011 before being shut out completely.
Should a core European sovereign venture into a new market, dealers say, it would have to work extra hard to establish a presence there and build relationships with investors in that market. Anything less would compromise its reputation and reputation will be a big issue for sovereigns in early 2012.
Most government debt agencies do not have the resources to maintain such a relationship. The average size of private placements is also too small to help with the large funding needs that core sovereigns have.
"For big triple-A countries, executing a one-off opportunistic MTN deal would send a very awkward message to markets that might backfire," says Kentaro Kiso at Barclays. "Its not a problem for a small country. Finland and Belgium are starting to establish positions as rare high grade sovereigns that can respond quickly to frequent reverse enquiries. As small countries, they can do that. Small is beautiful."