Bank bid now crucial element in SSA funding plans

With Basel III’s liquidity rules phasing in from 2015, bank treasury buying has grown to as much as 50% of some sovereign, supranational and agency new issues, according to SSA DCM specialists. This compares to typical pre-Basel III shares of 15%-25%. 

The investor breakdown of the Bank of England (BoE)’s recent $2bn three year trade underlines how important bank treasuries have become to the distribution of new sovereign debt. While central banks were its largest single group of buyers, banks took 30% of the deal. 

Of course, banks have long been buyers of sovereign debt and other SSA instruments through a variety of their businesses. These include their trading books and swaps operations. 

But Basel III has made banks especially significant investors in the sector since the new capital regime requires them to hold their liquidity coverage ratio (LCR) in high quality liquid assets (HQLAs). According to the Basel Committee on Banking Supervision, the LCR seeks “to promote short term resilience of a bank’s liquidity risk profile by ensuring that it has sufficient HQLA to survive a significant stress scenario lasting for one month.” 

Banks may hold their entire HQLA buffer in Level One assets. These comprise sovereign, supranational and guaranteed agency debt with a zero risk weighting or, if not zero-weighted, in the sovereign and holder’s domestic currency (or the currency where liquidity risk is being taken). This debt must also be “traded in large, deep and active repo or cash markets characterised by a low level of concentration”, “have a proven record as a reliable source of liquidity” and not be the liability of a financial institution. Cash and withdrawable central bank reserves also qualify. 

In contrast, no more than 40% of the buffer may be in Level Two assets. These are subject to a 15% haircut. They comprise 20% risk-weighted SSA debt, plus double-A rated covered bonds and corporate debt (including commercial paper, but excluding bank debt) — all subject to Level one liquidity provisos, with ‘proven record’ defined as not falling by more than 10% during a 30 day period of “significant liquidity stress”. 

Local regulators also have discretion to allow Level 2B assets to contribute 15% of the buffer. These comprise double-A rated residential mortgage-backed securities haircut at 25% and investment grade corporate debt and blue chip equities haircut at 50%, with somewhat looser reliability parameters. 

Dealers confirm the scale of the new bank appetite for sovereign debt, as well as for that of other premium SSA credits. “Different banks have taken different approaches, but overall Basel III has meant that high quality liquid assets have had a significant bid from bank treasuries. We have certainly seen increased demand,” notes Kerr Finlayson, head of SSA syndicate at RBC Capital Markets in London. 

“Their share is higher than in the past, but not dominant,” believes Zeina Bignier, global head of DCM public sector origination at Société Générale CIB in Paris. 

Issuers too have noted the development. “They have been important investors for years, but we have seen an increase in bank treasury interest in our issuance in the past two to three years,” agrees Anu Sammallahti, deputy director at the Republic of Finland’s state treasury finance division. 

“In general, we have noticed strong safe-haven demand for Austrian debt in the past months. This includes demand from banks, as well as from other investor groups,“ adds Martha Oberndorfer, managing firector, treasury/markets of the Austrian Debt Management Office. 

“Our advisers seem to flag bank treasury interest consistently in their advice,” Finland’s Sammallahti observes. Lead managers may have come to recategorise some bank orders as treasury demand, she believes, since apparent demand from the sector has been fairly consistent since before the Basel III era. 

Banks’ allocations of the Nordic EU sovereign’s issues have stayed at around 30% since even before the Basel III era. They took 33% of a five year issue as far back as 2007, for example, when Finland was only offering a single syndication each year. 

Recent ‘disconvergence’ has seen banks switch out of expensive Bunds into cheaper Level One assets. While German benchmark debt offers enormous liquidity, further aided by its futures basket eligibility, as Europe’s key reference it trades at demanding price levels.  

This shift has seen banks shedding a common conservative bias in initially assembling their buffers. With risk-aversion falling in the broader market too, particularly over the past six months, peripheral sovereigns have been notable beneficiaries — especially Spain. 

“We have a special market situation. Yields are pretty low overall and spreads are narrow. So investors are massively on the hunt for spread and yield,” notes Achim Linsenmaier, co-head of European SSA syndicate at Deutsche Bank in Frankfurt.  

More conservative institutions have also been buying core sovereign names such as France, bankers report. 

Smaller sovereigns have benefited from the rise in bank buying, argues Finlayson at RBC. “It increases their natural investor base, moving them beyond the usual domestic support. That’s a good thing.”

In February the Netherlands saw banks and trusts take up as much as 54.4% of a highly successful jumbo €3.37bn 30 year benchmark. While this investor category extends beyond bank treasuries, it underscores the strength of their appetite even for longer dated sovereign debt that offers significant liquidity. 

The Dutch State Treasury Agency will increase the deal through further Dutch direct auctions and taps to a minimum size of €10bn. Moreover, the issuer aims to “guarantee” its liquidity through a repo facility for primary dealers. 

How much has bank treasury buying altered sovereign spreads? Some SSA specialists dispute that it has. According to SG’s Bignier, the large size of most sovereigns’ outstandings means that banks’ impact “is not observable”.

Although it was an “extremely important” driver in 2011, 2012 and, to a lesser extent, 2013, Basel III is now only a marginal influence on sovereign debt, she argues. This is because many institutions assembled their new portfolios well ahead of the 2015 “rendez-vous” (the LCR will be formally introduced in 2015, though the Basel Committee requires only a 60% minimum then — rising in equal annual increments to 100% in 2019). 

“It is true that buffer players have brought additional liquidity, participating in syndicated transactions and the secondary market. But I don’t believe they have really affected sovereigns much,” Bignier says.

Rather, their greatest impact has been on the rest of the SSA universe, she insists. “We have seen a strong narrowing of spreads for KfW and EIB, for example, as liquidity for agencies and supranationals has improved.” 

Even now, though, relative value may still lie with agency and supranational debt that is likely to qualify for Level One. “For banks which are generally facing pressure on profitability and net interest margins, some of the agency and supra names are comparatively cheaper and therefore offer more value than, for example, the sovereigns at the more expensive end of the spectrum,” notes Deutsche’s Linsenmaier. 

Which agencies and supranationals make it into Level One? While the rules leave banks and their local regulators some discretion, only the biggest names appear certain to qualify.

“It is common market understanding” that national regulators will accept banks they supervise treating the debt of large agencies and supranationals with very sizeable borrowing programmes as surrogate sovereign assets appropriate for Level One liquidity, judges Linsenmaier at Deutsche. 

In Europe the likeliest names include Caisse d’Amortissement de la Dette Sociale (Cades), the European Financial Stability Facility (EFSF)/European Stability Mechanism (ESM), the European Investment Bank and KfW.

“Looking at large agency or supra issuers like KfW or EIB, for example, with typical €4bn-€5bn deal sizes, zero risk weighting and the development of a liquid secondary market, nobody has currently any doubt they are candidates for Level One,” Linsenmaier affirms. 

But it is far less clear how regulators will treat second-tier SSA credits such as the German federal states or smaller agencies, including those lacking explicit sovereign guarantees. 

“It’s definitely something we’re discussing,” says Finlayson at RBC. “It perhaps creates an uneven playing field. But borrowers have always paid a bit more if they have no explicit guarantee or a 20% risk weighting.”

There is still some uncertainty about the treatment of a number of market segments. “At the moment ESMA has made suggestions — at the same time, though, there is still a lot of lobbying going on,” Linsenmaier adds. 

Initially, most buying for bank liquidity buffers appears to have been around the three year maturity traditionally favoured by conservative SSA investors like central banks. But now bank treasuries are shifting down the yield curve in search of better returns. Seven and 10 year debt is attracting increasing bank interest, while some institutions are moving liquidity into even longer dated paper.

“In a low spread and low yielding environment many investors have been pushed out on the curve. Who had bought three years before buys five years now, five year investors move to seven years and seven year investors to 10 years,” says Linsenmaier at Deutsche. 

“For assets that should be able to be liquidated very quickly in times of market stress, that is a bit counter-intuitive from my perspective. Intuitively you would say one to three years, maybe five, offer best liquidity in case of markets getting tougher.”

The Basel Committee is unequivocal. “Assets are considered to be HQLA if they can be easily and immediately converted into cash at little or no loss of value,” it states.

The move longer reflects banks’ cost of funds, which makes holding low yielding shorter dated debt expensive — particularly since the end of the European Central Bank’s long term refinancing operations, which were a significant support for bank treasury buying. Lenders’ muted operating performance due to deleveraging and limited economic recovery also plays a role, some DCM specialists suggest. Generating a higher yield on their liquidity buffers should help their efforts to increase net interest margins. 

Bank treasuries’ increased appetite “has introduced a new investor segment that is somewhat price-sensitive, particularly in relation to Libor and Euribor,” Finland’s Sammallahti judges. “I have the impression that [bank treasury] interest becomes more significant when we are talking about Euribor-plus levels.” These levels occur more commonly on Finland’s 10 year benchmarks, which it has priced at between Euribor minus 2bp and plus 6bp since 2010. In contrast, the sovereign’s trio of five year deals over the period have emerged at levels of Euribor minus 16bp to minus 31bp.  

Similar considerations are also leading some banks to consider covered bonds for their buffers, bankers report. 

“Buying has gone from one extreme to another in line with the sentiment in the market. With risk off we see a flight to quality, but when the tone is good we see a real yield hunt. Eventually we’ll arrive at a happy medium,” says RBC’s Finlayson. 

Although lobbying may yet alter some details of the ultimate LCR regime, issuers and DCM specialists expect the final version to maintain the current approach. Accordingly, sovereigns and other SSA credits seeking to diversify their investor bases should aim to accommodate bank treasury demand, most argue. 

“Maturities are an important factor for where that demand is going to be,” notes Finlayson. He also emphasises the need for sovereigns — particularly lesser rated names to which investors are now returning after sometimes long absences in search of yield pick-up — to update analysts on their reforms and credit strengths. 

“Issuers can take into consideration where demand is,” agrees Linsenmaier. “If they see decent demand in seven or 10 years, they should monetise that by doing a larger deal to capture more buyers.”

Some dispute sovereigns’ receptiveness to targeting bank demand. “Once parliament votes for their programme in December, sovereigns have their strategies to try to feed all of the curve and all investor pockets. They don’t change for one group or give them different treatment,” argues Bignier at SG. 

More broadly, issuers “are generally in a pretty strong position,” argues Linsenmaier. “At the same time, some of them have to accept changed demand patterns triggered by the expected LCR classification and have to get funding in nevertheless. Some of them are benefiting a lot from bank demand, but those who are under some pressure from unclear Level One status have seen spreads widen a bit. They sometimes have to pay a little higher new issue premiums.”