The market for euro denominated sovereign bonds may sometimes seem like a staid and conservative place. The last 18 months, however, have seen a euro-govie renaissance, as the structure of demand has changed and sovereign borrowers have expanded the products on offer, trying new methods and maturities. Neil Day reports on a sustained and imaginative period of reinvention in the once stolid EU sovereign market.
Early last year, portfolio managers restricted to euro zone inflation-linked debt led a pretty unexciting existence. With only two French government bonds linked to the euro zone index, there was only one decision to be made. Do I prefer the 2012 OATei or the 2032 OATei? For those lucky enough to be able to dabble in French inflation, they could also compare the outlook for the domestic and euro zone measures.
But since the beginning of 2003 inflation-linked issuance has exploded and investors are now faced with a wide variety of choices. The Hellenic Republic and the Republic of Italy have entered the market, France has offered further supply, and, as well as government bonds, investors can now take exposure to euro zone inflation through Réseau Ferré de France and Italian inflation through Italy?s Infrastrutture.
?The growth of the inflation-linked sector has been one of the most exciting developments of the past year,? says James Garvey, head of the European frequent borrowers group at Goldman Sachs in London. ?A number of borrowers have committed to support the growth of the market.?
However, Garvey points out that issuers have responded to increased demand from the buy-side. ?Activity has definitely been driven by the underlying needs of investors,? he says. ?At this point in the interest rate cycle, they are concerned about asset price bubbles and are looking for assets which can outperform in a bear market.?
Alongside the short term advantages to investors of protecting themselves against inflation, structural changes are also pushing money into the product. ?A lot of pension funds and other accounts need to hedge themselves against inflation,? says John Fleming, global head of European syndicate at Credit Suisse First Boston (CSFB) in London. ?And when breakevens are at around 2%, investors see inflation-linked bonds as offering a pretty good hedge against inflation, particularly at the long end.?
While such arguments have clearly won around many investors, bankers are having difficulty persuading more sovereigns to enter the market.
The swap market in inflation has boomed alongside government bond issuance, but is not yet liquid enough to enable swapped issuance in size. The issuer base has therefore been restricted to those with a natural ability to pay inflation, with governments being the main candidates. However, not all governments are convinced of the merits of inflation-linked issuance.
One country that does appear to have been won around is Europe?s biggest. Germany?s finance agency, the Bundesrepublik Deutschland-Finanzagentur, had hoped to win the right to issue inflation-linked bonds last year, but was unable to push it through in the budgetary plans for 2004. But bankers are optimistic that it will have the option in 2005.
?We saw the guys from the finance agency a couple of weeks ago and they are quite keen to push through the project internally,? says one sovereign origination official in London. ?The budgetary process kicks off mid-year and will run through to December, and they are hopeful of getting it high on the agenda for discussion.?
Analysts say that Germany?s entry into the inflation-linked market would take it to another level. ?That would be terrific as it would not only add more supply, but it would send a strong signal to the market about this product if the benchmark European government starts issuing,? says one.
In the meantime, the trio of euro zone inflation-linked governments ? France, Greece and Italy ? are pushing the market forward. The French government added a third point to its euro zone inflation-linked curve in January. BNP Paribas, Deutsche Bank, Goldman Sachs and SG led the Eu4bn July 2020 deal.
The new issue allowed the French to bridge the gap between the 10 and 30 year areas of its curve. ?When we began issuing euro zone inflation-linked bonds, our decision was to build a yield curve in the product,? says Bertrand de Mazières, chief executive of Agence France Trésor in Paris. ?We did that through our focus on 10 and 30 years, and we were able to further our strategy through the launch of the 2020 OATei at the start of the year, which filled in the gap in the 15 year part of the real yield curve.?
Bankers had expected France to follow such a strategy, particularly after the arrival of Italy in the market with its debut inflation-linked transaction in September. That issue proved impossible to ignore, with Banca IMI, MCC Capitalia and Morgan Stanley leading a Eu7bn five year deal.
Since then the sovereign has twice increased the transaction, in October by Eu3.15bn and again in March by Eu3.25bn. And alongside the Eu13.4bn five year, Italy also now has a 10 year point on its curve. Launched in February by Barclays Capital, BNP Paribas, Citigroup, Goldman Sachs and UniCredit Banca Mobiliare (UBM), at Eu5bn, the issue was upped to Eu8.5bn in April.
For the time being, Italy is likely to remain in the shorter part of the curve that it has already accessed, says Maria Cannata, director general of public debt management at the Italian treasury in Rome.
?We are studying the possibility of issuing a longer dated inflation-linked bond, but have not yet made any decision,? she says. ?There are some signs that there is demand for such paper, but we are not yet sure about the stability of this demand. We prefer to enter new segments of the market only when we are confident with regard to potential demand, and so we would not expect to issue a longer dated inflation-linked bond in the near future.?
A longer curve
Italy did, however, show that demand for very long dated paper in the nominal market was undeniable when it launched a syndicated 30 year government bond the week after its inaugural inflation-linked trade. Citigroup, Deutsche Bank, ING, JP Morgan and UBM were able to build a book of Eu15bn for the trade, enabling Italy to launch a Eu7bn 2034 bond.
?The appetite for 30 year paper is huge, as demonstrated by the massive size and quality of this order book,? said Philip Brown, managing director in debt capital markets at Citigroup in London, at the time of the deal.
The deal originally had a Eu3bn minimum size and an expected volume of Eu5bn. ?We were almost obliged to increase the deal to Eu7bn, given the amount and size of the orders that we had from high quality accounts,? Cannata told EuroWeek at the time. ?It would have been more of a problem keeping the deal down to Eu5bn.?
The issue was the first syndicated euro government bond 30 year and after its success bankers were forecasting that more would come. ?The 30 year maturity has been almost untouched by European sovereigns through syndicated issues,? said one syndicate official in London at the time.
?But the phenomenal success of this Italy transaction will probably make others look closely at syndicated 30 year deals.?
The next syndicated 30 year issue proved to be an increase to Italy?s deal. Caboto IntesaBCI, Deutsche Bank, ING and JP Morgan added Eu4bn to the issue in January. But the prediction was given stronger support in May, when the Kingdom of Belgium launched a Eu5bn 2035 OLO via Deutsche Bank, Fortis Bank, JP Morgan and SG.
The longest dated OLO outstanding had been Belgium?s March 2028 issue, but Anne Leclercq, head of front office at the Belgian Debt Agency in Brussels, told EuroWeek that a new 30 year bond made strategic sense and was opportune. ?Firstly, we want to extend our yield curve and a 30 year issue has strategic value,? she said. ?It will be a new benchmark point on our curve, alongside five, 10 and 15 years.
?Secondly, and just as important, there appears to be quite a lot of demand in this part of the curve. We have seen successful issues from Italy, with its syndication, and France, in its auctions, for a longer dated maturity.?
However, some bankers warned that demand at the very long end could change rapidly and that Belgium should not read too much into the success of its peers. They were especially cautious given that the two weeks in between Belgium announcing and launching the issue were an uncertain one in terms of the outlook for interest rates and the global economy.
Such fears were overcome when it quickly became clear that there was a large appetite for the new 30 year benchmark. Ralph Berlowitz, head of frequent borrower syndicate at Deutsche Bank in London, says that the deal was in fact helped by the market environment going into the trade. ?The curve has been flattening, the 30 year part of the curve suffering less than five and 10 years,? he says, ?so a lot of clients are putting on flattening trades, buying the very long end and selling shorter maturities.?
On top of this, the yield on offer ? particularly coming out of last year?s environment of historically low interest rates ? proved tempting to many. ?As long as you offer something that yields around 5%, as we did with Belgium, there is a lot of natural demand from real money guys who are trying to lock in those sorts of levels,? says Berlowitz.
But as in the inflation-linked market, more fundamental forces are also at play, shifting the demand and supply outlook for the euro zone government bond markets. ?There are structural changes going on in the European fund industry, in the pension and insurance industries, that are creating more demand for long dated paper,? says Berlowitz, ?and that has clearly driven the activity we have seen beyond 10 years.
?For some time no one was really issuing in 30 years, but now we have seen a couple of countries focusing on that part of the curve again, and that follows on from the successful development of the 15 year sector in the past two years.?
Hans den Hoedt, global head of public sector origination at ABN Amro in London, says that he expects the growth in demand for long dated paper to continue. ?Especially in Holland, but also in other countries, there is quite a large mismatch between assets and liabilities in terms of duration and a lot of the pension funds in Holland and also the insurance companies in France, for example, have to offset that by buying into the long end,? he says.
?Reforms in Holland alone should spur demand at the long end in the next few years to the tune of more than Eu150bn. That in itself, given the limited supply, is going to be enough to make the very long end tighten.?
The impact that pension fund reforms can have on the shape of the yield curve has been most visible in the UK, although den Hoedt says that it is too early to tell whether the euro yield curve will invert.
?The demand/supply imbalance in euros is not as big as it used to be in the UK,? he says. ?There, as a resut of regulatory changes, demand was so strong and there was so little supply at the time that the curve shape could only go one way. Will 10s/30s flatten in euros as a result of the reforms we are seeing? Certainly. But will it invert? We will have to wait and see.?
The answer will clearly depend on two factors: demand and supply. While demand is certain to increase, it is important, say bankers, to realise that the impact of many pension reforms under discussion will not have any effect on the market until several years hence. A flood of government supply at the very long end might therefore be premature.
Sovereigns may also find that there are other factors that argue against 30 year issuance. ?It clearly makes sense for the bigger governments like France, Germany and Italy to do it, but even they are not totally convinced,? says one banker. ?Germany is in fact shortening the duration of its debt, which has supported its spreads in 10 and also 30 years.
?Looking at the smaller sovereigns, their funding requirements may not be big enough for a 30 year to make strategic sense. If they have limited issuance, then they may want to concentrate their supply in, say, five and 10 year benchmarks.?
Bankers are, however, hopeful that when sovereigns do decide to enter the very long end, they will do so through syndicated government bonds rather than auctions. They argue that the advantages of syndication are particularly acute in such a part of the curve.
?The thing about syndicated deals that issuers really like is that it allows them to lead investors to the price that they want,? says one head of syndicate, ?whereas in an auction you just have to take what the market delivers. With syndication, you have the flexibility to reduce the size to a minimum if there is lower than expected demand, but at an auction, if no-one shows up, then you see auctions fail.
?Demand at the very long end is unpredictable and as there is even greater execution risk than normal, you want more control over the process. You want to be leading investors to the right price rather than having them tell you where they want to buy it.?
Even more exciting for bankers is the prospect of Germany choosing to use syndication should it proceed with an inflation-linked deal, and not just because of the better execution that might result.
?There are people who argue that syndication would be a very good thing for the Germans,? says one head of origination. ?They have a different primary dealer system to other sovereigns in that the number of banks involved is far greater, but at times it is difficult for them to get true sponsorship from that group when they have nothing to offer them in return. You don?t see the same kind of carrot and stick dynamic that characterises some of the other government programmes.
?Dealers would feel a far greater duty and responsibility towards the sovereign and more positively inclined from a commercial perspective to engage in the Bund market if they knew there was the potential for some payback. After all, that would be quite some mandate.?
Competition among banks for business may be healthy in many cases, but overbidding at auctions by primary dealers can at times disrupt a market and result in less end-investor participation. Such thinking prompted the Dutch State Treasury Agency (DSTA) to find a third way between auctions and syndicated deals and resulted in the creation of its Dutch direct auction (DDA).
First employed in June 2003, the technique allows investors to place orders through primary dealers on the basis of spread guidance given out by the DSTA, following advice on the market from banks acting as advisers. Under the rule-based system, orders from banks are treated equally, and real money accounts are given preference over trading accounts, once orders wide of the final re-offer level have been excluded.
The DSTA believes that such a system would attract end investors that had shied away from its auction. ?In the last few years we have felt that during some of our traditional tap auctions the level of end investor participation was lower than we wished,? Rits de Boer, head of strategy, risk management and investor relations at the DSTA, told EuroWeek ahead of the latest DDA in March.
?Our response has been to produce a transparent, rule-based issuance methodology that provides a level playing field and brings back the competition for our issues to the level of end investors instead of the banking community.?
Some 85% of the Eu5bn five year Dutch State Loan (DSL) launched though a DDA in June 2003 was sold to end-investors, but the price guidance had to be widened, leading to criticism of the system. But when the DSTA came with its follow-up in March, it attracted total orders approaching Eu30bn, Eu15bn of which held firm at the re-offer. The issue was then sized at Eu5.1bn and priced inside initial guidance.
?We hoped that the deal would be successful, but the level of demand was way beyond our expectations,? said Erik Wilders, head of money and capital markets at the DSTA. ?The success of the issue is a tribute to the enthusiasm of the primary dealers. The first time we did a Dutch direct auction, everyone was very focused on getting to know the process, but this time everybody had a better understanding of it and that helped tremendously.?
Officials at other debt management agencies in Europe congratulated the Dutch on their success and have been keen to find out more about the way it worked.
Bankers do not, however, expect other sovereigns to follow the Dutch example. ?Those who are already doing syndicated deals have no need to change to a DDA style system, because all the aspects in the direct auction which would help them are already in a syndicated transaction,? says one DCM banker. ?And as the fees for a DDA and a syndicated deal are similar, there is no economic incentive to make the switch.
?And those that don?t syndicate at all, like the Germans, don?t seem to have a reason either to go for it, as they don?t believe there is anything wrong with the pure auction style.?
Whether through syndicating new issues or, in the Dutch example, innovation, euro zone sovereigns are grateful for any way of winning the market?s attention given the competition between them. And such competition is only set to get fiercer with the arrival of the European Union?s 10 new members on May 1.
Throughout the year the accession states have been setting out their stalls ahead of membership. In January, for example, the Republic of Hungary launched a Eu1bn 10 year issue via BNP Paribas and Citigroup. And since joining, the pace has not slowed. As this report was going to press, the Slovak Republic was putting the final touches to a Eu1bn 10 year issue via ABN Amro, Dresdner Kleinwort Wasserstein and Morgan Stanley, while the Czech Republic was preparing to enter the euro market for the first time with a similar deal later in May via Deutsche Bank and Morgan Stanley.
The sovereigns are using their new membership as the catalyst to win over accounts that might previously not have been able to buy their paper. ?What I find with names like Slovakia is that historically they are traded off emerging market desks and attract emerging market investors and are looked at by emerging market analysts,? said one banker who worked on the Slovak deal, ?as a result, the perception of liquidity and the breadth of understanding of the credits is minimal.?
Slovakia was able to overcome such obstacles with the help of an extensive roadshow, and the liquidity of such credits has been reinforced by the creation of New EuroMTS, an electronic trading platform for government bonds issued by central and eastern European countries. In February, Lithuania increased its Eu400m 2013 deal to Eu1bn. Part of the rationale was to achieve a listing on the new EuroMTS platform, which has a minimum size of Eu1bn.
But the Eu1bn threshold ? less than the Eu3bn minimum for most euro zone sovereign platforms ? suggests it will be some time before the new members? activities will threaten the funding programmes of the larger EU veterans.