Sovereign, supranational and agency borrowers face a tough year ahead. Not because yet another Eurozone nation is teetering on the brink of demanding a bail-out as we have come to expect in recent years, but because the long-awaited economic recovery is here, at least in the US, and that means that central banks are winding down their quantitative easing programmes. For SSAs, that means rising yields.
The Federal Reserve is expected to end its quantitative easing programme by the end of this year, and it can’t conceivably be too long before the European Central Bank looks to do the same thing: having the two largest central banks in the world on divergent courses can’t last.
The rising yields that will result from central banks turning off the liquidity tap is going to cause SSAs months of pain both in terms of rising borrowing costs for the non-Libor based borrowers and in terms of offering more to encourage buyers which would prefer to sit on the sidelines while yields rise until the market stabilises.
For years now, the top quality SSAs have been able to raise debt at extremely low yields. Record breakingly low coupons have become commonplace. That’s nice for the borrower but painful for investors, and clearly an unsustainable situation.
It also meant that at the first hints of yield rises to come last year, investors began to shun the sector. Investors have of course had some months to grow used to the prospect of rising yields and the first month of a new year often sees investors just trying to put cash to work anywhere it can find a home.
There are also buyers which will have to invest to meet US and European regulations that require financial institutions to hold more high quality assets. Most SSA paper qualifies in this regard and that will ensure a strong base of demand.
Nonetheless many investors will be mindful of the fact that they will likely be paid a lot more for their investments later in the year.
But a yield rise is a good thing. It will mean SSA risk is being priced more sensibly, and that’s a healthy development for the market. It means that more investors overall will eventually be willing to buy SSA paper.
The first few months of 2014 could be a year of painful readjustment, but the market as a whole will reap the benefits of higher yields further down the line.