SSAs: Political risks linger, but the ECB trumps all — for now
Thanks to quantitative easing, sovereign bond markets have been impervious to political volatility in recent years, getting through 2017’s shocks and surprises in serene style. But that could all be about to change as the European Central Bank starts to wind down its vast bond buying programme. Craig McGlashan reports.
According to the national stereotype, Germans do not understand irony. But the country’s voters delivered heavy doses of it in September. For much of 2017 investors had worried about French credit because of fears that the country could elect a far-right president, but by the end of the year it was a strong performance by a far-right group in the German election that had upset markets the most.
When the Alternative für Deutschland party won seats (94 of them) in the Bundestag for the first time at the expense of the mainstream parties, it left chancellor Angela Merkel with the almost Sisyphean task of forming a coalition with some unlikely partners. By early December, she had still not formed a government.
The political impasse in Germany means the outlook for Europe as a whole in 2018 is less certain. But from a public sector bond perspective, there has been remarkably little impact on yields. That suggests the European Central Bank’s quantitative easing programme — despite being halved to €30bn of purchases a month from January 2018 — overshadows all else.
“Participants at the IMF meetings in October were talking about how, in the short term, the political environment is still volatile,” says Sean Taor, head of European debt capital markets at RBC Capital Markets in London. “There are issues in Spain over Catalonia’s independence drive, there are elections in Italy in 2018, a potential new German election, plus there is Brexit. It’s also fair to say that Emmanuel Macron’s next six months as French president will be more challenging than his first six months, not to mention Donald Trump’s ability to stay as US president.
“None of that is going away, but markets have been very supportive for issuance. Given where QE has driven yields, investors have little option but to put money to work at rates that are unlikely to remain so low for so long.”
QE’s effect is clear from the strong performance of eurozone periphery sovereign bonds last year (see graph).
“The big mover in yields over the last few years has been southern Europe,” says Taor. “It’s been pretty range-bound around 1.5%-1.75% and I don’t see that changing, despite the political risk.
“There’s a lot of bad news around, but the ECB trumps everything.”
But even with such a big buyer in secondary markets, bankers warn that issuers should not take too much for granted.
“One of the themes we felt was a takeaway from the IMF meetings was complacency,” says a head of supranational, sovereign and agency DCM in London. “Everyone seems to think that markets are going to be as good in 2018 as they were in 2017, which did feel like the best year since the financial crisis. There were no failed deals.
“But there’s always going to be some black swan risk we’re not aware of. Last year we told issuers to get in early — and they did — because the French election could shut things down in euros. We saw that from Asian accounts — they are very focused on risk and turn off the tap early.”
Riddle of a chain reaction
Other SSA bankers warn that even the known risks, such as the Catalonian independence movement, still have the potential to disrupt the market in 2018 — although with a low contagion risk.
“Catalonia is very far from a non-event, but it’s something that’s Spain-specific and that can be managed through,” says a head of SSA DCM in London. “There’s always the risk that it can get messier, but if something is to really disturb the broader market it will have to be more substantial — European or eurozone-wide — that starts a chain of events that threaten to cause other regional disputes.
“I don’t see how that chain reaction works just yet. The tail risk is always there — is it big enough to affect markets, in spite of what the ECB is doing, the strong demand from investors, the reinvestment flows and the upward trajectory in ratings?
“As long as people start to feel the economic recovery, it takes away some of that tension.”
But that tension could still manifest itself in some eurozone countries, while the big beast of the ECB’s QE programme could also come into question if some trends strengthen, says Taor.
“There is still a lot of political unrest, and while the eurozone economy is growing strongly, its starting point is lower than other developed markets,” he says. “One thing that could cause concern this year is inflation. Inflation expectations, both spot and forward, are very low, and it could well be that actual inflation numbers come in materially higher than expectations.
“The ECB’s QE programme has driven short yields materially negative, however, higher inflation numbers would put pressure on the short end and may force the ECB not to extend QE beyond its current September end-date as some expect, and to consider interest rate rises.
“However, that scenario is more likely to come the next year. Currently it’s hard to be too negative for the year ahead as the QE programme will remain supportive for issuance.”
Breaking the chain
One area for political optimism in 2018 could be from the country that in 2010 started the chain reaction of the eurozone sovereign debt crisis: Greece.
The sovereign is looking to return to capital markets normality in 2018 after launching a €3bn five year benchmark in July last year and then watched its yields crunch in ahead of a debt exchange later in the year that aimed to normalise its outstanding yield curve.
In November, the sovereign offered holders of 20 small bonds maturing annually over a 20 year period — issued as part of the country’s debt restructuring in 2012 — the chance to swap into five larger bonds maturing over the same period.
“The new benchmarks offered through the exchange are reflective of more market standard issuances by sovereigns and move away from the existing, more structured, and less liquid ‘strips’,” says Stelios Manetas, head of liability management at BNP Paribas. “As such their future trading should normalise and reflect the prospects of Greece in the international markets.”
Other sovereigns that found themselves caught up in the debt crisis also enjoyed a restorative 2017.
Portugal’s rating from Standard & Poor’s bumped up to BBB- from BB+ in September, giving it investment grade status from one of the big three rating agencies — and its spread over Bunds rallied heavily as a result (see graph). Spain and Italy also received upgrades last year, while a new electoral rule in the latter should be welcomed, particularly as it reduces the chances of populist parties taking power at this May’s election.
“The upgrade for Italy was welcome and arguably overdue,” says Lee Cumbes, head of public sector DCM and risk solutions for EMEA at Barclays in London.
“In addition, the political noise from the country has been calmer, while there were some extremely strong cashflows that came due in the last months of 2017.
“The Italian elections will naturally receive much focus, like any large country, but with the electoral reform and some positive momentum behind the bond market in Italy, market confidence is far higher around the prospects for this event.”
If there is one country that sums up the idiosyncratic nature of political risk in Europe, it is the UK. While Brexit dominates the political and media landscape of the country, and early in 2017 was seen — alongside Trump’s election as US president — as a potential bellwether for populism elsewhere in Europe, its impact is having little effect on market conditions elsewhere.
“Brexit is a problem for the UK but not for anybody else,” says a head of SSA DCM in London. “When I’ve met investors in Asia, they’ve asked a little about it in terms of what it means for the European Investment Bank, but generally people don’t care. Nobody in Europe talks about it — it’s not top of the agenda.”
Brexit concerns had little impact on the UK Debt Management Office’s ability to place bonds last year — as evidenced by its regular breaking of its record syndication book sizes. With UK investors making up the overwhelming amount of its orders, that is unlikely to change this year.
But the UK’s divorce from the European Union could have a positive effect on the sterling market for other issuers.
The EIB has been the largest sterling issuer outside the UK for some time because it has sterling needs for its UK lending. As it appears the EIB has reduced its UK lending as the UK is expected to leave the organisation, it will end up needing less of the currency.
“The volume of EIB’s lending in the UK gave it a natural need to issue in the sterling market and to keep the proceeds in sterling,” says Taor. “That sterling requirement meant it could be more nimble on the price it paid, particularly for its large £1bn deals. Going forward, if its lending in the UK falls substantially and it will no longer need sterling, it may see the sterling market as more of an arbitrage rather than strategic market.
“If it is less active in the sterling market this year the investor demand for its paper will have to look at other alternatives, and that may give other issuers the opportunity to fund in a more cost-effective way in sterling. For other issuers, having a large borrower being less active in the market is clearly a benefit to them.”