Duration bid set to grow in 2006
The high grade euro bond market welcomed a new maturity in 2005 — 50 years — but it also became more sophisticated in less obvious ways. Frequent issuers had to carefully balance size and price in the battle for investors' wallets, while structured finance and structured note issuance proved popular. Neil Day reports.
The place to be in the euro market in 2005 was the long end of the curve. Although sovereign issuers like France and Germany had long ago established references as far out as 30 years, the long sector was reinvigorated last year, by issuers and investors alike.
From the time the Kingdom of Spain gathered a Eu17bn order book in the second week of the year to create a Eu6bn 2037 Bono it was clear that 2005 would be more than just another year at the long end.
Through the auction of the new 2037 Bund later in January, the sale of Eu5.228bn of 30 year paper by the Dutch State Treasury Agency via a Dutch Direct Auction in April, to the Republic of Italy's Eu6bn BTP in mid-October, issuers moved the 30 year sector to the centre of their funding strategies and were rewarded with bulging order books.
"There was a clear and unequivocal bid for duration in 2005," says Sean Taor, head of the frequent borrower syndicate at Barclays Capital in London, "and it was greater than anyone had forecast at the beginning of the year."
Agence France Trésor showed this most starkly and stood out from the crowd by launching a Eu6bn 50 year OAT in February. Led by Barclays Capital, BNP Paribas, Deutsche Bank and HSBC, the 2055 bond deserved the kinds of accolades that are usually mere hyperbole.
"It was definitely a fantastic trade," says Ralph Berlowitz, head of frequent borrower syndicate at Deutsche Bank in Frankfurt, "and given that it was the first ever 50 year transaction it was tapping absolutely new ground and created a new market."
After extensive preparations the Trésor tempted some 200 accounts from 22 countries to boldly go where they had not gone before, having built an order book of Eu19bn.
"This has been an extremely successful transaction and we are proud of having contributed to opening this new segment of the market," Benoît Coeuré, deputy CFO of the Trésor, told EuroWeek at the time. "We are very happy, the banks are happy, and we are confident that investors are pleased, too."
Underpinning the long dated issuance was the move to liability-driven investment, as institutional investors in general and pension funds in particular shifted funds towards assets that more closely matched their liabilities.
Piggybacking on top of this were other investors aiming to take advantage of the trend. "People expected the 10s-30s curve to flatten because of the structural demand that is coming in at the long end," says one frequent issuer syndicate manager. "If you look at the overall issuance, there is much more 10 year supply than 30 year supply.
"So when you look at triple-A sovereigns, they have inverted curves between 10 and 30 years, and this is nothing more than a reflection of the structural overhang of demand at the long end."
Other investors were acting on more basic instincts. "There have been a lot of structural reasons for investors putting money to work at the long end of the market," says Rob Whichello, co-head of European syndicate at BNP Paribas in London, "but there have been other factors involved. Investors have been struggling to pick up incremental yield and as a result have been forced down the curve to get that yield."
Longing for more
Structural demand is forecast to continue to buoy the long end into 2006. "Dutch funds alone intend to buy between Eu115bn and Eu215bn in 30 year equivalent over the next several quarters," said analysts at ABN Amro in their supply outlook for 2006. "Swedish funds should also be active from Q1 2006 in the euro long end to aid mark to market regulations risk control. The evidence of such flows is already being felt on the long end and in the volatility markets.
The ABN analysts say higher supply in 2005 offset the bid, but the strength of demand for duration in 2006 is likely to flatten the curve, especially if long dated euro government bond issuance dips.
ABN Amro forecasts that there will be Eu10.5bn less supply in 15-50 years in 2006 — although Portugal and Ireland are expected to launch inaugural 30 year benchmarks.
There was talk after the Trésor's landmark of other countries following France's lead, but expectations have died down. "There are still only two other candidates," says one frequent issuer DCM official in London, "Germany and Italy, simply because they are the only ones with sufficient funding volumes to contemplate a new benchmark point on the curve beyond 30 years. It would not make sense for anyone else.
"Germany has said that they are not going to look at this sector. Although Italy has said that they are not looking either, they remain the most likely candidate."
Not just a government game
Soon after France's success, DCM officials were scouring the market for non-government issuers to bring to the ultra-long end of the curve. But only Telecom Italia from the corporate world strayed so far along the curve, and it found life there difficult.
But the one major non-government benchmark that was launched in the 30 year sector was an unquestioned success.
In May the European Investment Bank launched a 30 year Euro Area Reference Note (Earn) via Barclays Capital, BNP Paribas, HSBC and Morgan Stanley. With Eu11bn of orders in the book, the supranational was comfortably able to lift the size from a minimum Eu3bn to Eu5bn.
The EIB was also able to price its groundbreaking issue at 2bp over mid-swaps, the same level at which it had in July 2004 launched its first 15 year — at the time the longest dated Earn. The issue's success was seen as a reinforcement of the EIB's claim to be a sovereign-class credit and its performance since then has further backed up this status.
"The deal traded very stable for a long time," says Carlos Ferreira da Silva, head of funding, euros, at the EIB in Luxembourg, "but by December it was trading at between 4bp and 5bp through, which is a wonderful performance. It is trading at around the same level as the 10 year, but trades tighter than the 15 year.
"That is something we are definitely happy about because a common feature of government yield curves is a small inversion at the long end. This suggests that our Earns really do share the same trading patterns as government bond markets."
Benchmark issuance from other supranationals and agencies so far along the curve did not emerge, as the long duration is unsuited to the assets of many issuers. But the 15 year sector did see some supply.
For example, OBB Infrastruktur Bau, which is responsible for financing the Austrian railway network and has taken over Schig's funding role in the capital markets, chose the 15 year maturity for its inaugural euro benchmark, a Eu1bn October 2020 transaction led by Credit Suisse First Boston and Deutsche in October. The triple-A rated and zero risk weighted issuer is guaranteed by the Republic of Austria.
And the 15 year maturity played host to one of Cades's most successful issues, when the French social security deficit financing agency launched a Eu4bn trade via Barclays, CSFB, Dresdner Kleinwort Wasserstein and SG CIB in May, the week after the EIB's 30 year. Cades enjoyed the same enthusiasm for duration as the supranational had.
"It is clear from the fact that we were able to build a book of Eu8bn that there is still unsatisfied demand for long dated paper, as has already been demonstrated by the successful 30 year trades that we have seen," Patrice Ract Madoux, Cades's chairman in Paris, told EuroWeek at the time of the transaction.
The exceptions to the rule
One minor concern at the EIB's move so far along the curve was that it might have forsaken traditional benchmark maturities — it had not launched a new 10 year Earn since 2003. However, the supranational launched a Eu5bn October 2015 deal in mid-September via CSFB, JP Morgan, SG CIB and Unicredit Banca Mobiliare.
The Earn proved a success despite weaker demand for duration and pricing of 2.5bp through mid-swaps, which was in line with the EIB's curve but tighter than its previous 10 year benchmark. "To do a Eu5bn 10 year is not an easy trade in any market and, at these sub-Libor levels, to have a successful deal is an impressive result," said a banker at one of the co-leads.
The EIB's regular use of the Eu5bn size was questioned by some market participants, who argued that it would be better served by taking a more flexible approach to the market. KfW, for example, reduced the minimum size of its benchmarks to Eu3bn for 2005, but nevertheless ended up raising more through all its euro benchmarks last year: a Eu4bn 10 year in January, a Eu4bn five year in June and a Eu5bn three year in September.
"Our main focus has been to fulfil the demand that we have seen and — with the flexibility we announced at the beginning of the year, to be prepared to increase deals to Eu4bn or Eu5bn when appropriate. That is exactly what we have done," says Horst Seissinger, head of capital markets at KfW in Frankfurt. "This flexible approach was really appreciated by the market.
"Investors have felt that our bonds were priced according to market conditions and that the volume reflects the actual demand, so they have a high degree of confidence that the transaction will be executed properly, with all the bonds sold by pricing. This gives them confidence that there will be outperformance."
But having issued successful Eu5bn trades in what can be more tricky maturities, the EIB sees no reason to change its policy, although Ferreira da Silva stresses that the supranational is not dogmatic. He points to the 15 year Earn that was launched in 2004 at Eu4bn and upped by Eu1bn last year to enhance its liquidity.
"Since the 15 year was increased to Eu5bn and became tradeable on EuroMTS it has tightened," he adds. "We are the only borrower to complement government issuance with Eu5bn sizes from three years out to 30."
The supranational even went to the lengths of engaging in a three month consultation process before adding Eu474m to its Eu5bn October 2008 Earn in mid-March through an auction to dealers with short positions, to safeguard investors' interests.
Aldo Romani, managerial adviser and deputy head of funding, euros, says the Eu5bn size has helped the EIB build up a "confidence premium" for three reasons.
"Firstly, on a Eu5bn deal bookbuilding and pricing have to be fully transparent, so this size is something of an assurance of fair pricing in the primary market and stable secondary market performance," he says. "You cannot be opportunistic with a Eu5bn trade.
"Secondly, the market knows that for an issue of this size no re-opening will be needed shortly after launch. And thirdly, the size is an additional incentive for us to choose the right timing."
Telling it like it is
Size was also an issue for other frequent issuers in 2005. Hans den Hoedt, head of public sector origination at ABN Amro in London, says that whereas in previous years syndicated sovereign issues have been increased on the back of large order books, last year's momentum was to a large extent dependent on clarity about size.
"When we announced that the final size of Finland's five year issue in May, for example, was going to be Eu5bn, the dynamic of the deal definitely changed," he says. "After we had made that announcement the transaction went from a good deal to a great deal.
"Investors feel more in the driving seat these days and are willing to fully commit to a trade, only after they know what the final size of the deal will be."
The Finland issue, led by ABN Amro, Barclays, Deutsche and Dresdner Kleinwort Wasserstein, was priced at 6.5bp over the Obl 146, equivalent to marginally inside Germany's curve — something that some market participants said had never been achieved before.
The spread was towards the middle of the 6bp-8bp guidance, reflecting another trend of last year. "A lot of transactions used to have wider guidance and extremely large order books, and the leads would then attempt to drive spread guidance to the tight end of the range and price the issue through outstandings," says one sovereign, supranational and agency syndicate manager. "But nowadays everybody knows how to price a syndicated sovereign transaction and we all know what is fair value.
"This means that investors will no longer commit to a deal that they felt could be pushed too far through outstandings and will only come in when the spread guidance is quite narrow. Sometimes the tight end of guidance had to be removed to make issues successful last year."
Another sovereign benchmark that was priced in the middle of its range and proved a success was a Eu5bn five year OLO for the Kingdom of Belgium in January. BNP Paribas, Dexia and Nomura priced it at 9bp over the Obl after guidance of 8bp-10bp over.
Anne Leclercq, deputy director, treasury and capital markets at the Belgian debt agency, told EuroWeek that this was particularly pleasing since it was the tightest pricing the kingdom has achieved against the German curve in the five year maturity.
A two-way market
But while euro zone sovereign spreads have been converging since even before the single currency was created, the Financial Times in early November was a catalyst for concerns that price differentiation could increase, when it reported that the European Central Bank would refuse to accept sovereign debt rated below A- as collateral for repo purposes.
The news led to spread widening on some euro zone sovereigns and the Republic of Portugal, which was in the middle of marketing a Eu3bn deal via Banco Espírito Santo, Goldman Sachs, Lehman Brothers, SG CIB and UBM, had to widen its pricing by 1bp. Portugal should have been immune to the report, as its debt is rated AA-, but it had suffered in the wake of the news.
"Our overall curve was affected in maturities up to 15 years by between 1bp and 1.5bp, even though we are far from being included in the ECB's rating level of A- and our level of debt to GDP is quite low compared to the European average," said Franquelim Alves, CEO of IGCP, Portugal's debt management office, at the time of the deal.
"Also, the rating agencies have a positive view about the government's commitment to consolidating the fiscal situation in the country, so there are good fundamentals supporting the credit perception of Portugal."
Analysts at ABN Amro said the subject of the FT story — which was confirmed by Jean-Claude Trichet, president of the ECB — could affect spreads in 2006. "We would anticipate further near term spread widening between core [and] periphery," the ABN analysts said. "In the medium term, markets will be more apt to respond to budget news and [its] impact on ratings.
"Finally, the process will also cement greater differentiation between issuers via EMU exit risks, even though this technical change has little direct bearing."
With some of the countries that only joined the European Union in May 2004 hoping to join the euro as early as next year, the funding competition between sovereigns can only intensify. And new members raised their game in 2005 to take on established players.
In January, for instance, the Republic of Poland launched a Eu3bn 15 year Eurobond, the largest in one shot from central and eastern Europe and the first benchmark from the region longer than 10 years.
"A deal size of Eu3bn puts Poland in line with the other EU sovereigns we have seen so far this year, and this is the scale of deal that investors who buy EU governments want to be involved in," said Carlyle Peake, syndicate director at Dresdner Kleinwort Wasserstein in London, one of three lead managers together with BNP Paribas and Citigroup.
Polish representatives were pleased with the spread of 27bp over mid-swaps. "Before we launched the issue I thought we would need to pay a premium to bring such a large deal, but this proved not to be the case," Andrzej Ciopinski, deputy director of the foreign policy department at Poland's Ministry of Finance in Warsaw, told EuroWeek.
Poland then increased the issue twice, so that by May it had become the first bond from a new EU member to reach the Eu5bn necessary for EuroMTS eligibility.
Eurostat's "No" to ABS
In an effort to trim their budget deficits, several sovereigns have attempted to take liabilities off balance sheet by using securitisation and an example of this technique created one of the largest transactions of 2005.
In June the German government securitised pension payments for retired postal and telecoms workers in an Eu8bn trade that was priced half way between government agency paper and top quality ABS.
Launched through special purpose vehicle German Postal Pensions Securitisation plc — and therefore 100% risk weighted — the deal raised funds for government agency Bundes-Pensions-Service für Post und Telekommunikation (BPS-PT) and was backed by the agency's claim against Deutsche Post, Deutsche Postbank and Deutsche Telekom for pensions it pays to their former employees.
The deal was triple-A rated because BPS-PT is supported by the government. "As defined in a special law, the Federal Republic of Germany is obliged to cover any shortfalls in BPS-PT's ability to fulfil its various obligations," said Moody's in its presale report, "including those under the particular guarantee for the securitised claims. The provisional ratings are therefore based primarily on this obligation and the Aaa rating of the Federal Republic of Germany."
Deutsche Bank and Morgan Stanley priced the issue around 10bp outside KfW and about 10bp inside the tightest ABS, which ensured that the deal was heavily oversubscribed. The book was said to include a variety
of accounts — some typical ABS buyers, some agency buyers.
However, the use of such securitisations could wane as Eurostat, which gives the official EU verdict on whether or not countries have broken the terms of the Growth and Stability Pact, has tightened the rules on such structures. The GPPS trade will not count as off-balance sheet — which had been one of Germany's goals when choosing a funding route that offered investors a large pick-up over Bunds.
While asset based structured finance might decline in importance for governments, issuance of structured liabilities by sovereigns as well as supranationals and agencies was on the increase in euros in 2005.
The EIB, for example, sold Eu8bn of structured euro trades in 2005, more than double its figure for 2004. Sovereigns launched unusually large structured notes, mainly linked to the constant maturity swap (CMS) rate.
The Republic of Italy launched a Eu2bn 15 year note in June, paying 85% of the 10 year CMS rate annually, with a floor of 2% and a cap of 7%. Deutsche Bank and Lehman Brothers led the issue, which was later increased by Eu500m.
"The benefit to the Treasury is significant because the structure gives us a sizeable arbitrage to BTPs," said a spokesperson for the Italian Treasury. "Of course we are not interested in keeping CMS exposure, and we looked at putting it into a plain vanilla Libor-linked exposure, which provides us with 6bp through the BTP curve.
"Given the size of the deal and the size of the arbitrage, this represents a considerable saving."
Investors were keen to get involved. "A lot of investors were seeking incremental yield, whether by moving out the curve or by taking on more rate structures," says David Shasha, co-head of frequent issuer origination at Deutsche Bank in London, "and there was a huge amount of CMS or curve steepener product.
"It followed a trend in 2004, where you would see a lot more publicly offered structured notes. Instead of private placements for single investors, it would be a bond that was publicly syndicated, sold to a wide variety of investors, and would trade in the secondary market."
Inflation-linked issuance took a back seat in 2005, but could prove one of the highlights of 2006. Germany's plans to enter the market were stymied by depressed interest in the structure and the volatile political situation, but bankers are confident that it will issue inflation-linked bonds this year.