Investors have fled many government bond markets and not just Italy and Spain but countries like Belgium, Austria and even France have suffered from the volatility of the sovereign debt crisis.
Further, the primary dealership business model which these countries rely upon to distribute the bulk of their bonds lies in tatters. Banks are under pressure to deleverage meaning there is less balance sheet available to support government bond business and that which remains, is expensive to use. Banks claim they are losing money supporting overbid government auctions as they vie for market share. But there is little profitable derivative or syndicated business to win with that league table position to make back the money lost in auctions.
Over a lively debate, delegates discussed the future of the primary dealership business and what part the buy-side and Euro-bonds might play in it as well as getting to the heart of the sovereign crisis itself.
Participants in this roundtable were:
Romuald Balax, head of frequent borrower group syndicate EMEA, Royal Bank of Scotland
Charlie Berman, head of public sector, global finance group EMEA, Barclays Capital
Carl Heinz Daube, managing director, German Finance Agency
Guy Dunham, global head of fixed income, HSBC Global Asset Management
Ove Sten Jensen, head of government debt management department, National Bank of Denmark
Teppo Koivisto, director of finance, State Treasury, Finland
David Lloyd, head of institutional portfolio management, fixed income, M&G Investments
Peter Nijsse, head of cash management, issuance and trading, Dutch State Treasury Agency
Bill Northfield, head of sovereign, supranational and agency originations, Deutsche Bank
Christophe Pella, senior investment manager, active global fixed income, State Street Global Advisors
Angelo Proni, head of new and domestic markets, MTS
Ulrik Ross, global head of public sector global markets, HSBC
Robert Stheeman, chief executive, UK Debt Management Office
Nathaniel Timbrell-Whittle, co-head of SSA debt capital markets, BNP Paribas
Ralph Sinclair, SSA markets editor, EuroWeek
EUROWEEK: How are changes to bank capital requirements likely to change bank behaviour at government auctions?
Ulrik Ross, HSBC: Based on regulatory changes, I would say that we anticipate more demand for less risky government debt. This will to some extend indirectly support some government bonds. On the other hand, I am a little sceptical about having regulation determining which bonds that banks or other regulated investors should buy as their liquidity buffer.
Teppo Koivisto, Finland: In Finland, weve seen a lot of participation from bank treasuries in our transactions over the last two years and I think thats because they have been going through changes. But also, these changes have diversified the triple-A sovereign universe into its own hazard sub-classes.
Robert Stheeman, UK: We have noticed for some time increased appetite from the UK banking sector for short-dated and increasingly, medium and longer-dated Gilts for capital adequacy and balance sheet purposes. According to Office of National Statistics and Bank of England data, Gilt holdings by this sector have been growing steadily since the end of 2008. Over the past two years the increase has been particularly sharp in market value terms up from £34bn at the end June 2009 to £76bn at the end June 2010 and £124bn as of the end June 2011. Banking sector holdings of Treasury bills are also rising, in the first half 2011 these have risen from £10.7bn to £19bn.
EUROWEEK: If banks are forced to buy triple-A assets how does that affect what are already, in many cases, heavy loss-making primary dealership businesses?
Charlie Berman, Barclays Capital: We need to think very carefully about the market architecture surrounding the whole European government bond zone. I dont think its a particularly controversial statement to say that the government auction process is very complicated. It varies across the whole region. Everybody has their own way of doing things and, therefore, my biggest concern is the focus on bank balance sheets to support primary market activity when the focus should be on investors and how investors participate in primary auctions. What banks think should be academic unless there is a situation where bank treasuries themselves, independently of the primary dealer function, decide that they want to put in orders to buy bonds for whatever reason.
The focus of all of this should be on how we engage end investors in the process in a better way. Im happy if people disagree with me and think that the process functions correctly but I think the process whereby the expectation is that primary dealers bid for and hold on risk paper first is a flawed system.
Ross, HSBC: I think were all agreed on that. One good example, if we go back to 2008-09, is when we saw the covered bond market being heavily scrutinised when liquidity dried up very quickly and the discussion moved from the inter-dealer market to what end users want to buy. You cant just force something through the market. We must focus on how we engage with good investors and how we channel the demand from investors back into the public sector issuer base.
I think another aspect is, clearly, that our industry is changing. I think we all recognise that CRD IV and Basel III are having an impact on behaviour within the banking community. A lot of banks have been publicly announcing deleveraging of their balance sheets.
Clearly, those dynamics between which bonds are and are not accepted as collateral will have a huge impact on an individual basis. I think we have to re-think collectively which model is the right one between banks, investors and issuers because we have liquidity charges that are going through the roof. The cost of funding is also getting higher.
US dollar funding has been a challenge throughout the years for a lot of market participants. That is potentially going to be even more costly going forward. We also have Credit Support Annex discussions where mark-to-market exposures are becoming an increasingly large factor. This will also affect the way that we price-up risk going forward. All of the above is either directly or indirectly linked to the primary dealer systems, as it will potentially affect a banks choice of risk taking and capital commitment.
We have to rethink liquidity costs, we have to rethink capital costs and we also have to rethink the allocation of capital usage. Some industries will be affected more than others.
Everything is up in the air right now and we need to find out how we channel the best dynamics between investors and issuers and how the banking industry will fit into that equation in a new paradigm.
Stheeman, UK: It is important to note that not all primary dealerships are loss-making. Even at times when overall profitability is low there will be some banks who may find such trading conditions more suitable to their business model than others and who will be doing relatively well.
Sovereign borrowers can help themselves by having clear, open and fair rules for all primary dealers so that as much as possible a level playing field is encouraged.
One should also bear in mind that in the UK the GEMM franchise is often part of a banks wider franchise in global government bonds as well as other sterling fixed income businesses and is often used to leverage access to other areas of business such as customer dealing counterparties and borrowers, not just in fixed income but also derivatives and other markets. The implementation of a programme of fee-carrying syndications in the UK in which only recognised GEMMs can participate as managers may also have made PD status more attractive to banks.
Carl Heinz Daube, Germany: Our institutional investors appreciate the Deutsche Bundesbank Bund Bidding System as the most transparent system in the market for sovereigns in the Euro area. The main advantage is the prompt and close to the market method of allocation. We maintain a very transparent, very reliable and very predictable issuance policy and we have not changed it for the last 10-15 years.
Ive been asked during the crisis why we dont do more syndicated deals. Even in very stormy weather our approach has a value in itself, and its valued by the international investor base. So therefore my recommendation is to keep it as it is. Never change a winning system.
Peter Nijsse, Netherlands: The question implies that primary dealerships are already loss-making and I want to challenge the banks attending here as to whether thats the case. To me, it doesnt sound very credible that we have 16 primary dealers eager to be so and more firms willing to come into a system that is a loss-making business.
Now, I can imagine that if theres overbidding, that there are direct costs involved, but I cannot believe that, overall, what the primary dealership brings to the banks can be permanently loss-making. I want to challenge the way the question is formed.
What I see for the future, if indeed the benefits of the primary dealerships are not big enough, is our markets would automatically drive down overbidding in auctions. Also in the derivatives pricing, with regard to the Credit Support Annex argument, all round we still see very aggressive bidding from the banks. So I think that, depending on the business model of the bank, this can still be attractive business.
There lies another discussion: secondary market levels around auctions. I also see some cheapening before auctions which in combination with overbidding during the auction does not necessary result in expensive auctions, I think, that the government bond market is not a traditional Adam Smith-style market with many suppliers and many bidders. In an auction there is only one supplier and only a relatively small group of bidders. During auctions, it is not always a perfectly efficient market with many buyers and many sellers where the price is continually at equilibrium.
Romuald Balax, RBS: The traditional set-up of a government bond desk has always been to play the role of a loss leader. It doesnt mean that government bond desks were structurally losing money, rather it means that those desks were designed to attract flows by providing ultra-sharp pricing with next to zero margins. They aimed to make money on information gathered and their own trading views all the while being seen as relevant via turnover figures, market shares etc.
On top of that, the P&L of a government bond trading desk could not be looked at in isolation. You had to look at ancillary businesses such as derivatives that can be done on the back of sovereign issuance which bring syndication fees, etc.
What we are seeing now are two phenomena going in the same direction to compress banks margins. On one hand we have increased costs, as was mentioned just now, with regulation going only one way. On the other hand we now have decreased revenue opportunities.
I think that overall, at the scale of the entire European bond market, the wallet that is available is actually shrinking and shrinking relatively fast.
The issuers we have here today are not representative of the current average quality of what we see in the bond market in Europe. A lot of derivatives transactions that used to take place are not taking place anymore and those that do have to be costed differently because of the cost of CSAs, for example.
So you cant look at the government desk and only look at overbidding as being the cost of this activity. It is only the loss-making portion of the business. The problem we are facing is that the economics of the ancillary business is really in question right now and, going forward, it does look like some may step away or reduce their commitment. We dont see it right now but I think we will.
Bill Northfield, Deutsche Bank: I agree with that in the sense that the volatility were seeing right now has caused havoc with a trading desks ability to wear positions for long periods of time. I think, as Charlie suggests, were not actually there to warehouse positions to maturity. Were actually there to intermediate between the buy and sell side. Our job is to disseminate the risk as soon and as effectively as possible. As the markets remain very headline sensitive, we are in danger of having a bifurcated system where we have the triple-As at this table enjoying relatively consistent support and, yet, those that are not triple-A will be perhaps more prone to greater volatility, and a greater crisis of confidence around their names that could undermine the whole EGB business.
Ove Sten Jensen, Denmark: One could ask what the role of primary dealers is then. Very often, at least in our case, we get more direct comments from investors than before. So if banks cant do any profitable business and they cant put anything on the balance sheet, then what is the role of primary dealerships?
I appreciate the debate about regulation. Im myself somewhat worried that some of the regulations point in the wrong direction for getting a very flexible and liquid bond market, and that it can become an expensive business for banks. I can see that debate from your side.
But what is the future of primary dealerships? We have been working with ideas like having more flexible auctions, so you can get the investors to determine which bonds they want so there isnt the need to warehouse too much on the banking side. Its actually the investors who determine somewhat whether they want two year paper or they want 10 year paper. That gets rid of the problems with the banks limited balance sheets.
It is important not to overburden primary dealers with to many duties. I also appreciate that. You shouldnt make banks obliged to bid just for biddings sake.
Berman, Barclays Capital: As I mentioned earlier on, were not talking about one issuer, with one auction mechanism or even one credit. So it is very hard to generalise about individuals and your individual experiences are going to be very different, particularly, with the group of people around this table.
It is a question of looking at it as the market as a whole, as the EGB zone in its totality.
The point of this market, surely, is to get your bonds into the hands of investors and that is the key focus we should all have. We have a couple of investors around the table and Id certainly love to hear what their views are on the way this market functions and any observations, thoughts, or recommendations they might have.
Teppo Koivisto, Finland: I sense this discussion is also leading to the old classic question of whether the auction is the better way to issue to make sure that your debt is in good hands.
I agree with Rom that banks, when they are considering the primary dealership, they have to take a sort of holistic view but, during the financial crisis, the banks tend to have a habit of looking at just a few transactions and saying its getting more costly.
I think, especially looking at our primary dealership, with 15 primary dealers, the holistic view is still in place, with the sense that the market might be changing a bit but one key issue, how we have survived these last few years, is that we have been trying to combine the auctions and syndications and we have been able to show the banks that Finland is still a sensible business case.
We havent heard many complaints that there should be business they wont do anymore. I think a sort of hybrid approach, as an issuer, to the market is probably the right way. Also, its very important to communicate very well with the banks and try to emphasise what kind of service you need, what are you main objectives for the whole business and, only after that, I think we can find a supply and demand driven way to do business together.
Nathaniel Timbrell-Whittle, BNP Paribas: I think Charlies point though is very valid. All of the issuers sat around the table today are very fortunate to have very good investor demand but I think, when we go down the ratings ladder, thats where it becomes harder for the banks.
There is a lot of paper coming to the market every single week. Investor demand is drying up and the responsibility is left with the banks. Now, at the moment, its very, very costly. I think a lot of banks are investing for the long term, hoping that one day the sort of privatisation, consolidation mandates will be out there for them to take. But I think, at the moment, its very, very challenging. Were certainly looking at all our primary dealerships and having to re-evaluate everything going forward.
Christophe Pella, SSGA: As an investor, for us its a bit of a side issue; the big issue is what happens in the Eurozone bond market. Its a bit ironic that government regulation is making safe bonds all the more in demand at a time when a big chunk of the government bond market is no longer safe. That pushes the spreads between Germany and the periphery even wider.
For us, as active investors, the difficulties of dealers give us hints of when the European Central Bank might step in with support measures: when brokers can no longer make a market, you know it is time for the ECB to offer some help. So brokers difficulties are a direct concern for us. They are more an indicator of the policymakers actions.
David Lloyd, M&G: Yes, I concur with whats just been said. Were in a very, very fortunate position at the moment. Were sitting there with most of the cards and we do not even have to play a hand. We can sit on the sidelines.
Certainly, from our point of view, the mechanism at the moment works perfectly well. Were pretty indifferent as to whether stuff comes through syndication or through auction. Syndication is a better mechanism for price discovery, if youre producing a new point on the yield curve for example, but these are just details.
Really, we spend all our days saying that its all very well having a discussion about whether you want a blue car or a red car but, actually, lets discuss the main point, which is if the engines going to explode. Were still not sure yet that the engine isnt going to blow up on us.
I feel almost guilty sitting around this table because Im looking at a bunch of guys whove got some very, very serious issues, particularly around the use of bank balance sheets in the origination process and were sitting there, certainly as institutional investors, saying actually this is all working reasonably well for us.
Guy Dunham, HSBC GAM: We treat the banks like a supermarket, effectively. We expect to be able to walk in when we want, to buy what we want and for it to be on the shelf, ready for us to take away. The problem that you guys are facing is stacking the shelves and actually running that inventory.
Lloyd, M&G: It would be insane if the profound changes that weve seen dont lead to people behaving in a different way. Just in the same way that the almost infinite liquidity that these markets used to have and the ability for banks to put their balance sheet to work, should they choose to do so, has all changed. That resulted in markets behaving slightly differently, particularly around the volatility within markets. Forget about the overall level of the market but the volatility within markets is something that investors, I think, have moved very quickly to exploit. What we spend most of our time doing is using these stresses, sometimes absolute dislocations, in the market as something that we can exploit. Some of the problems that were talking about are for us a profound opportunity. In many respects, I dont want them to go away because all this volatility that is being produced on a daily basis is low-hanging fruit for us. It really is.
You can see this if you look across the performance data of long-only investors. They are a heck of a lot better now than they were in the 2004-05 low yield, low spread, flat yield curve, low volatility days.
It was more difficult for us to make money then but now weve got a situation where these dislocations make it comparatively straightforward, if you know what youre doing, to achieve client targets. So long may these problems continue!
Dunham, HSBC GAM: And the other thing we dont have is a constantly increasing pool of money. We have a fixed amount of capital to invest and we can pick and choose off the shelf what we want, whereas there is a continual flow of supply. So there needs to be an intermediation of some description.
Nijsse, Netherlands: If you sort of pick this low-hanging fruit as a result of dislocations, does that mean that there is always a price for which you are willing to buy the government bonds?
Lloyd, M&G: So long as the answer to the question of whether you are being properly rewarded for taking the risk is yes, which is obviously the question all the investors are asking all the time.
We all have our different perspectives, depending on what sort of products we are running and what kind of client were running money for but, yes, clearly, theres a price for everything.
But, as weve already said around this table, were all very comfortable in the triple-A space and theres plenty of volatility within those markets for us to exploit. I think that leaves the weaker borrowers more and more detached from the rest because we dont need to invest there in order to achieve what our clients are asking us to achieve. Were not in a maximise returns business. Were in a target return business. So I can often say, as Im sure quite a few people around this table on the investor side can say, I dont need to get involved in a peripheral market to achieve what clients are asking me to achieve.
Thats a big problem for the weaker borrowers. A bit like if an errant husband tells his wife hell stop drinking and hell stop gambling. Fine, he can stop drinking and he can stop gambling. But if his partner says Its alright actually, Ive already found somebody an awful lot nicer and its of supreme indifference to me whether you stop drinking and gambling because Ive moved on. Well, thats kind of where we are.
Northfield, Deutsche Bank: In terms of the health of the auction system and the primary dealerships for the triple-As, I dont necessarily see that being tested or pushed or pressured unduly by regulatory developments or investors being wary. Its more what I was saying earlier. The potential to have a stratified market and having two tiers of issuers issuers who are lesser-rated, who dont necessarily have the same access or reliance on bank balance sheets makes it very difficult and I think thats when we come to the question of Euro-bonds. The crisis of confidence around headlines and volatility are what probably affect the lesser rated sovereigns more than they do our existing clients here.
Lloyd, M&G: Absolutely.
Dunham, HSBC GAM: I think its not just a focus on the lesser rated or the lesser quality borrowers though. It can become an issue for smaller, higher quality issuers. Again, there is no need for me to go and buy something which, if Im managing against an index, constitutes less than 0.5% of that index. The opportunity cost of not buying it is fairly small whereas the cost of buying it and it going wrong is much greater and theres a liquidity risk as well whether I can unwind a mistake that Ive made. So its not just about quality.
Pella, SSGA: Liquidity risk is a very important concern for us. We decided to stay away from all government issuers likey to drop off the indices in the following months: the risk of having to sell at a distressed price is simply too high. For example, Greece was still included in some government bond indices at the end of 2010. Its percentage weight was small but Greek bonds were so volatile that when they tightened back, they impacted portfolio performance. At the time, and I guess many people made the same decision, we said we wont touch Greece. We dont want to touch it because, even if we buy it, we are never going to be able to sell it at the right price when things turn bad and/or when the issuer exits the index. That was the correct decision over the medium run and I think thats the problem where those markets have broken down and theres no liquidity. The right price is so much lower because of the lack of liquidity.
Ross, HSBC: But I think what were discussing here basically comes back to the same question that is being asked in many different ways. What is it that you want to have on your balance sheet? How much can you have on your balance sheet? What is it that you have on your shelf that you can offer out? Do you still want to have thousands of names that youre offering out? Do you want to have fewer names that you offer out but in greater depth? How do you use your balance sheet in a clever way to support the business you really want to support? What do the banks bring to the table and do we have enough on the shelves?
The answer is that we need to find the right balance between capital and balance sheet usage and be even more focused on how we service our clients better in this new environment. The banking industry is being forced to be more selective on what business it can support.
Northfield, Deutsche Bank: And the answer to that question also involves investors. As Charlie was saying, wed welcome your thoughts on what products you want, who you like, who you dont, to guide us on what the product shelf life may be and where do we pre-order because you guys, down the line, will want more of Product A or B.
That type of engagement is going to have to be much more institutionalised rather than just a five minute conversation. We will probably have a more ongoing dialogue with senior investment managers in terms of portfolio management and risk allocation. We need to know how to prepare.
Jensen, Denmark: I still wonder what these low-hanging fruits are, that we were talking about. Are you saying you went in and out of triple-A bonds at the right times but you do not really want to go into some of the more troubled countries because there is too much risk in these bonds?
Where are these low-hanging fruits?
The people who put money into you expect something from you because of interest rates. They can be pretty low in triple-A markets. Or is that what you think the future of interest rates is?
Lloyd, M&G: I manage money for people whove already decided that they want to hold this asset class. So the fact that fixed income has wildly outperformed equities and has produced some kind of impact on the pension deficit is undoubtedly a problem but its one for somebody else.
Somebodys decided that they need these government securities. It is my job to beat the return on those. Now, for everything youve just said, there is a very, very good reason why Tesco and Sainsburys dont trade at the same price. Theres a very good reason why Germany and all the other sovereigns dont trade at the same price. But there is no reason on earth why one security, issued by the same issuer as another, should keep doing this. It has to revert to the mean.
So, if youve got sufficient volatility at that very molecular level to produce the target that your clients asking you for, why on earth would you speculate about what the worlds going to look like next year?
Jensen, Denmark: Is the volatility not pretty big though compared with something more stable elsewhere?
Lloyd, M&G: I dont want to stabilise it. I want the volatility. That is what produces the relative value opportunities that we exploit. Those are the high probability strategies. I dont care or rather I do care but, as I said, this is a pub conversation about what the world is going to look like in 12 months time. Thats a great conversation in the pub but am not I going to put my risk budget on the line for what the worlds going to look like in 12 months time when I can actually produce what our clients want by exploiting mean-reverting volatility? Id be nuts.
Jensen, Denmark: I didnt say you shouldnt do that. Thats not my point. My point is that it seems that, at least the establishing effect of what youre doing is so far away from the mean because there is so much volatility. So at first you go in, but prices are far from the mean. That must be what is happening now, and so I cant understand it because the volatility is still big and not reverting to the mean.
Balax, RBS: I think theres another point beyond the volatility. Banks are fighting with each other in this government bond market to print their clients ticket. And its even more competitive now because client turnover has actually gone down, due mostly likely to the volatility and the immense pains of anyone involved in peripheral market trading.
But when you have a group of dealers fighting with each other to print the one ticket that is available common sense and prudence vanish, and then mean-reverting volatility can be executed because as a premium account customer you will be able to print at mid when you call the bank.
In theory, you shouldnt be able to. In theory, the dealer should say, no thanks, I will be 1m down, and that would be the end of it. But, because you are who you are, you are afforded a degree of liquidity not commensurate with the actual market liquidity. You are able to print tickets that should not be there because of the cut-throat competition between dealers. Thats why government bond traders have to be excellent. Not only do they have zero margin, it is worse than that, because of competitive pressures, they start from behind.
Lloyd, M&G: It happens way too much. Were perfectly well aware I mean, were not daft that we are getting this stuff done way too cheaply. Everythings being priced at mid all the time. So weve got no dealing costs.
Balax, RBS: And thats being generous.
Lloyd, M&G: Yes, it is.
Balax, RBS: I am pretty sure we can find inverted markets here.
Lloyd, M&G: Wed be daft not to exploit it while it lasts. The sell side has been obviously not averse to leaping on a profitable opportunity when it sees it but, yes, I mean it cant be sustainable. It cant be.
EUROWEEK: Wheres the change going to come from then? Should it come from banks forcing the buy side to accept their terms for dealing or is it going to come from issuers? Does anyone have any views on whos best placed to make this market a more balanced one if, indeed, that is desirable?
Berman, Barclays Capital: For as long as Ive been in this business, which is quite a long time, people have always talked about the consolidation and the shakeout. Now, I work for and represent a firm that has 17 EGB dealerships. They are the bedrock of our business. Thats not going to change.
I think there are some serious questions for peripheral bank players as to whether or not they have a place in this market. And the noise that comes from those players is not helpful. It is not a healthy market if, ahead of an auction, were in an environment where investors correct me if Im wrong are able to shop around in advance of the auction to ask how much of a discount banks are going to give them.
There are a lot of participants in these markets who dont make any money and, again, I dont think we should generalise and say nobody makes money. One only has to look at the results of different banks to see that some people are good at doing this and are able to do it and others arent.
The regulatory recession that is now beginning is going to have a big impact on that. Over the 30 years Ive been doing this, it is going to force that consolidation or that change anyway.
Nijsse, Netherlands: Were a strong believer in markets and maybe one of the last in this world but if there is no business case for some banks, then automatically prices will go up for issuers and come down for banks. They will never be able continuously to keep a loss-making business and that will, along with investor discounts, somehow disappear.
What Ive seen in the past is that there have always been cycles of overbidding, aggressive competition and less aggressive competition. I think 2009 was a very profitable year for many banks where many sovereigns had to increase, in a short time, their issuance and sovereigns paid new issue premiums to get their bonds sold. At the moment you have overbidding at auctions. So youre already the other side of the cycle. But is there then so much of a problem? I challenge whether there is going to be a shakeout because I think that prices will adjust rather than the number of banks in the markets. A number may stop or may continue but, if prices adjust, there will be more of a business case for primary dealerships.
Daube, Germany: First of all, financial markets are following economic developments. Markets refocus on fundamentals. Investors are increasingly differentiated among individual sovereigns, especially within the Euro zone.
Germany, as the core benchmark issuer, has in this regard gained from its strong fundamentals high liquidity, transparent and reliable issuance policy, best hedging opportunities, complete coverage of yield curve but in times of uncertainty, it is always a good idea to give investors a bigger picture of what an issuer is planning to do.
Diversity, both with regards to funding sources but also investor groups has proved valuable. In order to maintain the well-diversified investor base Germany went on more non-deal related roadshows, increased relationship management with sovereign analysts, primary dealers or trading floor visits, and provided more information both print and online.
Berman, Barclays Capital: If we look at some of the structural things that change, whats different now to the past? My personal view of the problems we have today are a function of the post-9/11, injection of hyper-liquidity and not draining it when it shouldve been drained.
We had a situation, for those of us who were around when the credit market was starting in Europe, where we thought we were going to get a much more US-style bond market, the proportion of loans to corporates would be reduced and there would be far more bond issuance. That was not killed but hugely slowed down by the hyper liquidity. The banking system which made banks the most efficient way for corporates to fund themselves was loans.
Now, that is going to get drained out of the system much more and in a much less organised way than it would have been had they started back in 2002 or 2003 and I think people have got to understand the impact of that, plus the changes in capital requirements.
Lets not forget, weve got a situation where the senior wholesale funding market is closed. There is over 400bn of wholesale bank funding maturing next year and the market isnt open. All banks can do at the moment are covered bonds. We shouldnt close our eyes to this. Thats got to make a difference to the way banks operate and what they can do.
Weve had these conversations before, over the time Ive been working, and its always just reverted back to the norm that everybody just kills each other. I do genuinely think its going to be different this time because all of those factors combining mean that weve got a different base from which banks can operate and that has to cause a change in the way that the markets operate.
Balax, RBS: Yes, because for one you have prospectively a much higher cost of capital and severely reduced return on equity. As a consequence, the degree of commitment to any business inside a bank has to be reassessed. Unfortunately, in times of crisis, there is a tendency of looking at business on a standalone basis, instead of looking at the full picture and at all the potential interactions between desks.
Thats suboptimal because that might lead some to actually step back even more than they should from a given area. But we all know that in the case of government bond trading, that there are too many banks, that structurally balance sheets overall are still too big despite a few years of semi-deleveraging and therefore that were going to have a serious right-sizing eventually leading to better economics for the ones still standing after the fight.
Berman, Barclays Capital: Its not all gloom. This has been a fabulous month in corporate bonds an incredible month. Weve had 40 year issues, 10 year issues, taps, big benchmarks coming, investors cant buy enough, the new issue premium has eroded over the course of just one month.
Thats incredibly healthy.
Meanwhile, some corporates in certain parts of Europe, who have enjoyed very favourable lending rates have been told theyre not going to get those anymore and so they are terming out commercial paper by issuing bonds. We are returning to a much higher, faster pace of bond issuance from European corporate issuers. Thats healthy. Thats really, really good.
Nijsse, Netherlands: In 2009 we had a short moment when we had investors in the auctions and then, quickly thereafter, banks jumped on the markets because there was money to be earned so there was overbidding again and I think investors shied away because it was cheaper probably to buy in the secondary market. Isnt that a solution automatically, if competition is too big or the bidding is coming down, that it becomes more attractive for investors to come to the auctions, or the taps?
We have the Dutch Direct Auction the hybrid between the syndication and the auction. The DDA comes relatively tight because the banks themselves are getting relatively aggressive, also with giving discounts to end investors. Not all investors think it will be an attractive deal but will it not be automatically a more attractive deal again if, for balance sheet reasons, banks cannot bid as aggressively and its going to be an investors auction again?
Timbrell-Whittle, BNP Paribas: But I also think youre going to have a situation where some of the peripheral players move to the sidelines but there is still going to be a core group of banks that want to participate in this business and see the endgame. Our competition is not suddenly going to drop off overnight because, as Charlie was alluding to, there arent that many other businesses that are that attractive at the moment.
While there are issues with the EGB business, there is still a business. There is still money to be made and, a lot of people see the bigger picture as well whats going to happen in the next 10 years. No one really knows but youve got to think, certainly in some of the peripheral countries, we are going to see consolidation and there will be fees away from just the normal syndications and the primary business.
Jensen, Denmark: What we shouldnt do is to enforce too many obligations upon primary dealers. We shouldnt force people to bid and so on. Denmark has no obligation bidding. If you force people to bid, its a problem because then the banks sit there with some bonds it really doesnt want. You want people to bid if they have investor demand or if they want to put it on their own shelves.
We dont post too many lead tables up and say to banks that, if they are the number one, they get the business.
Koivisto, Finland: From what weve been hearing, we representing a rather small group of triple-As here might slip off the radar screens but at the same time, the banks are feeling the pressure of being primary dealers.
What the small issuer really can do is just to be as dull as possible. Just make sure the banks are keen to offer their business and try to keep yourself on investors radar screens. The challenge is liquidity.
Nijsse, Netherlands: I totally agree. Part of being dull is, I think, being predictable, having an auction calendar and being in the market regularly. Be a regular there and, if there is no market, well, then you auction a bit less. If there is more of a market then you auction a bit more but the key is not to disturb the markets and not to have too much prize money on offer.
Koivisto, Finland: Its a dilemma to be very dull and boring and try to keep a very low profile but at the same time you have to market your debt.
EUROWEEK: And would you say thats the biggest problem you face, as a group of smaller highly-rated sovereign borrowers maintaining that profile amid everything else thats going on?
Koivisto, Finland: Well, I think we havent really felt the heat, in a way. I think the most challenging thing at the moment is probably low yields, which of course might cause some investors not to look at these levels but, otherwise, being dull, very creditworthy, with sound economic fundamentals Im not talking about the political fundamentals but the economic fundamentals is all we can do.
Jensen, Denmark: But there is the other side of it. We have to do other marketing. Thats why we have our web pages, travel around, try to show our faces in as many places as we can.
As a small issuer, we have to show our face sometimes and we are a little more dependent on having rating agencies to rate us. There is the debate about rating agencies, but we are dependent upon having someone, who analyses us, so people can read about us and our economic situation.
Northfield, Deutsche Bank: And that then begs the questions of the investors; do you feel that youre getting enough information about the triple-As or about any of the European sovereigns?
Lloyd, M&G: Whether this is true of other firms or not, I cannot say, but weve taken it upon ourselves to make our own analysis.
Ive been doing this for nearly 30 years and, on the buy side, in sovereign debt markets in the developed markets at least we had no genuine credit analysis of those borrowers. They were just triple-A sovereign borrowers.
Now weve allocated resources to it properly because, very obviously, theyre not all the same and, also, the people that we, in a soft sense, relied upon in the past havent necessarily covered themselves in glory in terms of rating these entities.
So, yes, were doing it ourselves and its been a real learning curve or, rather, its been a sharp job to resource up.
A firm like M&G which I think can look the sell side in the eye and say we know more about corporate credit than you do, or at least as much faces the challenge to replicate that strength and depth of analysis in the sovereign space.
Up until a couple of years ago nobody wouldve spent a penny putting that in place. And now were having to really dig into this stuff and its a big deal.
Koivisto, Finland: Have investors been tailoring their benchmarks in the last two years after the financial crisis and could that offer a potential advantage for a small issuer?
Dunham, HSBC GAM: Our clients have certainly been doing that. These things which werent really on clients radar screens a few years ago certainly are now.
I have an increasing number of discussions about the detail of individual issues, and its not so much a case of European government bonds now. It very much is a case of these are the five issuers I want or these are the two, three, seven issuers I want.
Ross, HSBC: I think were actually coming to a very, very interesting point in this discussion because now were actually discussing whether we have a credit market or a rates market.
In the good old days, we called this market a rates market and right now I think we have a rates market that is represented by the borrowers around this table, plus a few others, and the rest is basically starting to migrate into a more volatile market, which has the characteristics of credit trading.
I think we have to ask ourselves how we differentiate between growing and shrinking economies as well as developed and emerging markets. The borders are being broken down. We were also touching upon corporates before. Were seeing some of the investors in the public sector space buying 12 month corporate credits for the first time ever.
We are migrating into a universe where we have to ask ourselves if we need to further differentiate between the rates market and the credit market. How do investors staff for that? How do treasuries staff for that? How are they educated on those migrations and how do we find the right balance between the commitment that the banks and the investors and issuers are making to develop and protect themselves in this very difficult environment. I think we are touching upon how the bond market, both rates and credit, will develop in the future.
Koivisto, Finland: Are the banks then viewing still the primary dealerships as sort of rates businesses? What you are saying at the moment is that maybe the primary dealership is diverging a bit into the credit business and the rates business.
Northfield, Deutsche Bank: Yes, absolutely. Thats what I was talking about in terms of stratification. The triple-As will remain a rates business. Low volatility, low headline risk for most of them.
Its the lesser rated ones that you have to pay much more attention to, as you say. You have to do more handholding with your trading desks both primary and secondary to educate them on what comes with the name. From that perspective, I think the primary business model is a core foundation of the rates business for the banks here.
Koivisto, Finland: So the jury is out.
Northfield, Deutsche Bank: Correct.
Jensen, Denmark: It is a little amazing, when you look at the correlation between bond markets, that you have European markets which are negatively correlated now. There are a lot of negative correlations that you couldnt imagine a few years ago.
Pella, SSGA: I think we get enough information about the peripheral bond markets but thats precisely a part of the problem! The fact that we need information is the problem.
Government bonds were supposed to be insensitive to information, a safe asset investors could buy with closed eyes as far as credit risk is concerned. We should not have to worry about their creditworthiness.
In our experience, clients have removed exposure to the lowest-rated issuers irrespective of their original starting points. Clients that had tier three periphery, they only have tier two now. Clients that had tier two only have core and we even have at least one client that held only France and Germany and now it holds only Germany.
Berman, Barclays Capital: Yes, but isnt everything a credit market now?
Lloyd, M&G: That is the point.
Pella, SSGA: It should not be like that.
Berman, Barclays Capital: You said, David that in the past you did not have a sovereign credit department. Weve moved on. Lets be honest with ourselves; the US got downgraded this year. If that doesnt mean that everything is a credit market then what does?
Lloyd, M&G: Yes, a government bond, up until the crisis, was basically an instrument that you used to express a rates view and now, actually, youre investing because of the characteristics of the issuer. Its totally, totally different.
Balax, RBS: Comparing government bond trading and credit trading is not very nice. Its not very nice for credit these days, to be honest, because the volatility were seeing on government bonds is totally staggering well in excess of almost any other asset class at times for what was supposed to be the slow mover segment of the fixed income universe.
You do not need to watch your Bloomberg like a hawk during the whole day when youre playing credit fearing that some official somewhere who is going to come up with yet another bombshell and move your entire curve by 25bp-50bp
Weve had a crisis thats been mishandled from the start and that is in stages getting worse and worse. We will get resolution at some point, once we look over the edge of the precipice for the last time. It might come very soon but, in the meantime, we have sections of the government bond market which are just not functioning anymore.
Jensen, Denmark: Not all government bond markets are that volatile though. Some are still buy and hold markets.
Balax, RBS: You can see entire curves move significantly with next to no bonds being traded. Its a total remarking... except if you are a top account, call a dealer, and youre going to make him print.
Northfield, Deutsche Bank: Thats part of the problem.
Angelo Proni, MTS: Some of the illiquid bonds are more stable in the prices on the screen than the most liquid bonds. Electronic bond trading has its advantages particularly in volatile markets, as price discovery can still happen.
Balax, RBS: Yes, it can be the repo trading special or any number of reasons like old issues parked in retail accounts and if there is no liquidity, it wont move until somebody makes it move.
Berman, Barclays Capital: I think the analogy Guy gave about the supermarket is a critical one. Investors have got used to and this is not a criticism of being able to do exactly what they want when they want to do it.
Lloyd, M&G: How times change!
Berman, Barclays Capital: But thats the issue and you asked earlier what the primary dealers do, what the banks do. Banks are there to service that and, I can tell you, if any of the gentlemen around this table dont get to do exactly what they want to do when they want to do it, the phones burn. That is the pressure.
At the same time weve all got health and safety inspectors coming into our supermarket and saying, you cant stack the shelves that high, the temperature in this cabinet is wrong, you havent got enough car parking outside, you shouldnt stock that many sugars. Thats whats happening.
Lloyd, M&G: Just so were absolutely clear, we know. Were absolutely well aware of the fact that were in a nice place at the moment.
Berman, Barclays Capital: I thought when you bought a bond you took a view on that and got a return for a credit risk rates markets or government markets.
I cannot quite understand, over the last two or three years, the sheer horror that is expressed every time we talk about bondholders maybe losing money.
In equity markets, investors have been on occasions wiped out. We have to have market discipline, people understanding that when you buy a bond you are taking a risk. Youre taking a market risk.
Youre also taking a credit risk. In the context of this company that is probably not a relevant statement but, in general, as a bond market discipline, lenders have to take some responsibility as well about the things that they buy and the realisation that if something goes wrong they may lose money.
Pella, SSGA: Yes and no. I think the market is adapting to that or has been adapting but I think the financial world still needs a risk-free asset and thats why theres such high demand for triple-A worldwide, not only EGBs. Investors need something we can buy without credit analysis and the striking thing is governments are just going the other way.
Lloyd, M&G: Well, I dont think any of us would claim that weve got a right to a risk free asset. It certainly is something thats very nice to have when you want to sit in the lay-by for a couple of months but I dont claim that weve got a right far from it.
But for a long time when we were investing in this stuff, the concept of losing money was much more around mark-to-market risk, around duration, and it never occurred to us, when buying 30 year securities, that sometime between now and 30 years hence you aint going to get your money back. How do you price that possibility? That really is something that, in the developed markets, is new. I dont think the market, as a whole, knows how to price that yet.
EUROWEEK: Do you think that should speed people towards a common European government bond issuer? And is that desirable? Is that the risk-free asset that everyone wants?
Stheeman, UK: If they happen it will obviously be highly significant for Eurozone sovereigns and in theory should mean access to better funding rates for some, although the benefits to other Eurozone issuers may be a little more hard to establish. I suspect the impact on the UK will be relatively limited given that we will remain the monopoly supplier of AAA sterling denominated sovereign bonds.
Lloyd, M&G: I think thats a very interesting question but I think the issue of Eurobonds is a much more politically driven question than it is a sovereign investor one.
I think there is a very strong likelihood that these things will see the light of day at some point, before weve stopped using the word crisis. But I think its driven very much more by a political narrative than it is by us saying that we want Eurobonds. After all, we can invest in Bunds or Gilts all day long.
Nijsse, Netherlands: In terms of that risk-free asset that you were looking for, I doubt that that exists because, even in the US the US Treasury bond, which is considered a risk-free asset, has the same risks as the bonds here in Europe, except the credit and inflation risks are more difficult to distinguish.
Lloyd, M&G: Well, thats the great difference, isnt it?
Nijsse, Netherlands: But you can run the printing press.
Lloyd, M&G: But the risk is still there.
Nijsse, Netherlands: The value of your investment is still in doubt and it can be hurt by inflation or by credit risk. In Europe not every country has a strong currency so countries can default, in theory... and maybe in practice.
So you have to add up the credit risk and the inflation risk where you have a risk-free asset because maybe the credit risk is transferred into inflation down the road. Is that really more beneficial to you?
Pella, SSGA: Yes, I think so because inflation risk is a easier to manage for investors. Thats a standard bond management issue whereas, for Greece, say, we went, in less than one year from default being unthinkable to a 21% voluntary NPV loss to a 50% voluntary haircut. All that is a result of a political process, not a macroeconomic one. Thats a new kind of challenge for investors in the major bond markets..
Lloyd, M&G: But its not a default!
Pella, SSGA: Its still not a default, actually, which makes it even worse. Those who use CDS to hedge, found out that their hedge is not working, that policymakers do not want their hedge to work! Introducing unprecedented political uncertainty, risk with binary outcomes, into the government bond market is playing with fire.
Nijsse, Netherlands: I would say that European common bonds are not inevitable but it is possible. It would require quite some constitutional change in Europe to make that happen and its certainly not inevitable.
Would investors prefer to have a lower rated but more liquid common bond in the supermarket or to have your full menu available of differently rated products that you can buy off the shelf?
Lloyd, M&G: Well, I think its the underlying point thats key. There are many investors now who wont buy certain borrowers but they will buy them if they are guaranteed by somebody else. So it isnt so much the case of would we prefer this common bond to Bunds. The answer to that, for most people, Id have thought, would be a resounding no. It just means that we will and speaking very generically buy certain borrowers that we wont currently buy because theyve been underwritten by people that we will. Now, what that means for the pricing of common bonds, I think, is just a fall out from that.
Jensen, Denmark: But then were also saying that its more a political problem. Its difficult to say that there is a magic tool called a common Eurobond because the whole thing is to have the fiscal policies in place. How do you co-ordinate that in this case? Thats the whole big, big question in this.
Proni, MTS: I think its a very simple issue. Someone has to explain to me why Germany should stand behind Greeces debts without having any say in how Greece spends the money it borrows with Germanys guarantee.
That brings into the picture sovereignty of a country, which is a hugely emotional issue in Europe for historical reasons. It is a very political issue.
MTS has certainly the technology for a common Eurobond and as the facilitator of the European fixed income market, we would be ready with our technology to facilitate.
Koivisto, Finland: The official stance of the Finnish government is that we are not very keen to look at this kind of transfer union at the moment. But in theory, I think, first, there should be a fiscal union a sort of structure for how to make a common European fiscal policy. Only after that, can you implement a Eurobond.
Lloyd, M&G: Its the other way round, Teppo from our point of view. When you owe money, you either pay it back, you dont pay it back or you get somebody else to pay it back. Simple as that. There are no other ways out of it.
So, if we are in a situation where were talking about somebody who cant pay it back themselves, youre down to two. Either you dont or you get somebody else to pay it back. I share absolutely your reservations about whether this is politically deliverable. I kind of doubt it.
Proni, MTS: Do you think any politician with a time horizon of about three to five years, depending on when their next election is, is going to alienate his voters to that degree in Europe?
Lloyd, M&G: Jean-Claude Juncker gave the best quote of the entire crisis which was "We all know what to do, we just dont know how to get re-elected after weve done it." So its fairly simple.
Balax, RBS: Eurobonds were mentioned right at the beginning of this whole crisis as a potential solution. However, every decision taken took us away from this route replacing this idea by entities like the EFSF in its different shapes and forms and ESM later. Eurobonds can work but as it has been said time and time again there has to be fiscal integration first which is really a major undertaking.
Proni, MTS: My personal view is that maybe the crisis becomes so deep that it actually triggers that kind of leap of faith.
Pella, SSGA: To me that would be the best case. We have to remember, the ECB is the only thing that has prevented Italy from suffering a liquidity crisis. Given the self-fulfilling panic we had in July, without ECB intervention, Italy would have lost the ability to fund itself in the market. Were talking now of banks putting up capital for the defaults of the third largest and fourth largest economies in the Eurozone. This is surreal. Indeed, our best guess would be, when theres no other way its either a default of Italy in a very messy way or...
Lloyd, M&G: Or somebody storms the ECB which means switching on the printing press.
Pella, SSGA: A lot rests on the ECB. Its a personal bet: they might well have to buy bank debt next year, if the crisis goes on like this.
Lloyd, M&G: I certainly agree with the sentiment; we shouldnt be ruling out anything, absolutely not from serious write-downs to more widespread defaults. I think the least plausible of the scenarios is its all going to be OK.
Koivisto, Finland: Ruling nothing out in the long term which is one week.
Lloyd, M&G: That seems to be it at the moment.
EUROWEEK: What could the sell side be doing better to service end investors in sovereign bond markets?
Stheeman, UK: Fundamentally the DMO has been supplying many more Gilts so the size of the market has doubled in the past few years to £1.1tr. Turnover is up aggregate daily turnover was almost £21bn in 2010-11 up from £18.5bn in the year before. Feedback that we receive from investors is that they are generally very happy with liquidity and access to the Gilt market, especially relative to that available in various other government bond markets recently.
This has been helped by the increase in the number of GEMMs, up from 15 at the start of 2010 to 22 now two of which are specialist retail GEMMs and the maintenance of competition between them. Of course, recent market volatility and pressures on banks to reduce their balance sheets could impinge on PDs abilities to warehouse inventory on their books, but so far, Gilts appear to be maintaining their allocation levels as the sector has been regarded as more of a safe haven core product. The Gilt market has also embraced various B-to-C electronic trading platforms like TradeWeb and Bloomberg ALLQ and volumes here are reported to be consistently increasing on a monthly basis.
EUROWEEK: Then what are your one or two biggest fears about the future of the EGB market then? If they even can be summed up in one or two points.
Proni, MTS: Well listening to what most European commentators are saying, I would say disorderly default of one country or other in the Eurozone, potentially triggering a chain of CDS contracts that could seriously jeopardise the solvency of a number of large players in the market, at which point its very difficult to imagine what the consequences would be.
EUROWEEK: I wasnt planning to acknowledge the apocalypse necessarily but if thats a genuine fear then, I suppose, we should.
Proni, MTS: Personally, I have a genuine fear that there may be a disorderly default of one or the other Eurozone borrowers because I do, to an extent, get the feeling that European political leaders are still sleepwalking and going through motions that apply to a world that no longer exists.
Jensen, Denmark: But if you look at the political side, isnt it amazing how much politicians have been doing from a historical perspective?
Proni, MTS: Yes, although the timing, in this context, is still behind what they should be doing. I think there is a little bit of timidity on their part
Northfield, Deutsche Bank: But then isnt that a reflection of the institutional framework? Theyve got 17 different parties round the table.
Proni, MTS: It is indeed. Im not saying that makes it right though.
Northfield, Deutsche Bank: No, it doesnt. I think wed all appreciate it if theyd done it, US-style. Boom, boom, boom, three people in a room. Get it done and we give the markets three months breathing room.
Proni, MTS: Yes, and that was impeded by the institutional set-up of Europe and the fact that anyone, however large or small they are, can veto a proposed solution.
But also when I hear about leveraging the EFSF, I get the impression that the idea is to create a huge CDO, which as some of you may recall is one of the products that started this whole dogs dinner of an economic mess. Im not sure whether that really is the way forward.
Lloyd, M&G: The people whose scepticism about the single currency was economically, rather than politically, based made the observation that it was one institution or one institutional framework short of being able to work the fiscal part was missing. In the current conditions of such stress, introducing some kind of fiscal mechanism seems a politically hideous thing to deliver.
My worst fear is based on the idea that the operational independence and the mandate of the ECB isnt cast in tablets of stone and can be taken away by politicians.
Italy has the third biggest stock of sovereign debt on the planet, after the US and Japan so default is unthinkable. Its amazing how peoples views on what the ECB should do might change under circumstances in which an Italian default looks plausible. I still wouldnt rule out the ECB printing press being switched on big style.
Pella, SSGA: Yes, and they dont even need a change of law. Just by doing nothing, politicians force the ECB to act. Thats what happened when they started the SMP in the first place. Just by doing nothing, politicians leave the ECB as the first line of defence and it is forced to act.
Proni, MTS: I personally believe thats where were headed. The implications are that the crisis will get deep enough and we can look forward to one or two decades of Japan-style growth and interest rates.
Pella, SSGA: That is only if you dont restore confidence.
The thing thats making Greece a basket case is the fact that people dont know whether the currency will be the same. People dont know whether the banks will be bankrupt or not or the government for that matter. If you restore confidence, I think that the economic outlook will improve markedly.
Proni, MTS: If you look over the past 10 years, with the possible exception of Germany, no ones done that great in terms of growing their economy in Europe. Im not sure that confidence would be enough to really change that.
Pella, SSGA: Yes, it would just put us on the weak growth path we had before.
EUROWEEK: Has this whole crisis made sovereign CDS look a bit ridiculous? Youve effectively got this huge Greek write-down coming but there is a clear intention by its planners not to trigger CDS. Therefore, what is the point of holding credit default protection? Has the Greek scheme undermined CDS as a product?
Lloyd, M&G: Yes, of course it has.
Berman, Barclays Capital: If it hasnt, I dont know what would then. People have been paying a premium for nothing.
EUROWEEK: The ISDA decisions committee applies its rules to the situation but someone has to refer the thing to the committee in the first place.
The only way a voluntary scheme can result in a credit event is if it binds all bondholders. The Greek private sector initiative scheme wont bind all bondholders, therefore, it is purely voluntary and, therefore, its not a default, according to the best interpretation of the ISDA rules.
Balax, RBS: Thats a clever job by the lawyers.