Investors were a nervous bunch about rising yields coming into 2014. That was understandable given the sell-off that took place when former US Federal Reserve chairman Ben Bernanke merely mentioned last year that the central bank would start at some stage to unwind quantitative easing.
However, the delay in the launch of the tapering process and then the move by incoming Fed chair Janet Yellen to lay down a steady path for the withdrawal of stimulus did a lot to calm those nerves.
US Treasury yields have rollercoastered, rising sharply through the summer of last year, falling back after tapering failed to materialise, rising in anticipation of December’s decision and then dropping back again.
By late February yields were lower than where they started the year and lower than where many investors think they will end it, according to Toby Croasdell, head of MTN syndicate EMEA at Barclays in London.
“Coming into 2014, there was an expectation of rising yields,” he says. “But we’ve actually seen the opposite. Investors may not particularly like the yields currently on offer but in some cases have little option but to invest.”
Jérôme Stoll, head of SSA and covered bond trading at Société Générale, says the need to hedge against higher rates appears less compelling than last year. “It is not like we are seeing some panic hedging at this stage from a wide range of clients.”
Issuers have also noticed plenty of demand for traditional fixed rate bonds. Joakim Holmström, vice president and head of funding at Municipality Finance (MuniFin) in Helsinki, says that 2014 has seen a “ton of liquidity” looking for places to be invested.
“There has not been that much supply this year compared with last year for instance and it seems to me that all the trades, at least if they are priced correctly, have been hugely successful regardless of maturity.”
Canada sold a tightly priced $3bn five year benchmark in February, its first debt issue in the currency for two years. The deal attracted around $8.8bn of orders and the Treasury spread translated to 1bp through mid-swaps. A month earlier, the World Bank sold a $4bn 1.875% March 2019 bond at 4bp over mid-swaps.
SSAs are now trading much closer to their benchmarks then they used to, says Emanuel Brefin, head of SSA trading at RBC Capital Markets.
“That’s why some of these issuers are not in a rush to issue because they are waiting for tighter spreads,” he says.
Slow rising tide
But it is clear that rates are likely to rise again, which poses challenges for SSA investors who may be cautious over choosing fixed rate investments as the US and global economies continue to expand.
Issuers and bankers believe that investors are looking ahead to higher yields over the course of the year. Five year US Treasury yields that were below 0.8% in February 2013 had almost doubled to 1.5% a year later.
Some issuers note that different groups of investors are adapting to the new climate in contrasting ways. Investors such as central banks that provide the mainstay of demand for traditional SSA paper will continue to seek out fixed rate investments.
Central banks historically have sought bonds with a duration of around three years, and given the position they had been in with rates being so low they had to extend that duration to get hit yield targets.
But now they are retreating back down the curve.
“Traditional investors who have in the past been focused on the longer end of the curve now go down the curve to look at two or three years maturity because they expect yields to rise,” says Holmström.
Kerr Finlayson, head of SSA syndicate at RBC Capital Markets in London, agrees that this process has gone into reverse. “Given the moves in rates we have seen a lot of our investors move back to the more traditional three year space.”
However investors such as asset managers and bank treasuries that are less concerned about the underlying coupon or yield are still extending.
“They are more spread buyers so they look at the margin and most of them swap the proceeds into floating rate notes,” says Holmström. “Their view is that the longer dated trades offer a better pick-up and a higher spread.”
Floating voters
Investors such as bank treasuries and central banks that need to buy SSA bonds are more likely to look at floating rate notes (FRNs) in a rising yield environment.
There was a rise in interest in the final months of 2013 amid the tapering debate, according to Brefin at RBC Capital Markets. “I am pretty sure that if people believe that yields are changing much faster in an upward direction we should see demand for FRNs increase again,” he says.
“It has grown a lot because it is a perfect product to buy for the liquidity buffers of the banks.”
The US Treasury began issuing two year FRNs in January 2014 with an opening auction of $15bn that was heavily oversubscribed.
Another popular issuer is Kommunalbanken (KBN), which opened four new dollar FRN lines with a combined size of $4.2bn outstanding.
RBC Capital Markets’ Finlayson believes that FRNs will increasingly become akin to benchmark products. “They used to be a rinky-dink $100m here and $200m there but we have seen a number of benchmark sized issues over the last couple of years and, given the US Treasury has started to issue FRNs, it’s inevitable that the product will become more of a mainstream benchmark,” he says.
“A lot of the central banks that we speak to aren’t able to properly account for FRNs but that’s all being looked at and we are seeing some demand for names. If you are looking for tailored products I think FRNs is the best example of that.”
Tactical game
The lack of a typical surge in yields that would come with a cyclical economic recovery has meant there has not be a pronounced rush in demand for MTNs or other tailored products such as callable bonds, or private placements.
“On the MTN side it was a little bit lighter than we would have expected because of the rally in rates since the start of the year,” says Croasdell at Barclays.
He says that this has made investors more selective about the issues they have bought and the tenors they have purchased in order to generate returns in their portfolios.
“People are being more tactical about their investment this year as they look to generate alpha against a low spread, low rate backdrop.”
SSA borrowers are likely to use a greater range of private placements to diversify their funding sources while at the same time allowing for smaller sized and structured payouts tailored to investors’ particular needs.
SSAs provide a good support for structured products as their high creditworthiness allows investors to focus more on the rate strategy they want to put in place and less on the credit risk of the issuer. This is particularly the case for long dated products.
But investors are also willing to consider new names that may offer more return than the traditional SSA crowd. Issues by Latin American agencies such as Corporación Andina de Fomento (CAF) and Central American Bank for Economic Integration (CABEI) have proved popular.
Last year CAF printed a €225.7m 15 year note with a 3.31% coupon. CABEI tapped the Swiss market with a Sfr180m 1.875% February 2022 bond in January 2014 following a Sfr275m dual tranche deal for three and six year paper in November.
Croasdell says that investors are looking “further and further afield” for investment opportunities, considering different geographies, sectors and even heading down the ratings spectrum. “Names that offer a little more yield, even if they are outside the usual universe, have become more interesting,” he says.
Investors have also started to show more interest in niche currency markets. The order book for the International Finance Corporation’s three year Dim Sum was more than three times the Rmb1bn ($163m) that the supranational finally raised on the London Stock Exchange in March.
However, MTN activity has proved less conducive for central bank investors in the wake of the narrowing of the euro/dollar basis swap spread. Following the 2011 eurozone crisis when swap spreads widened to 100bp and close to 2008 records, central banks would have looked at dollar assets from Europeans.
Many central banks hold large amounts of dollars and that swap spread made some issuers very appealing, Croasdell says. “With dollars being the core reserve currency, the attractive pick-up achievable from the euro/dollar basis over the past few years made front-end dollar MTNs appealing.
“That swap has narrowed a lot, which combined with the broader credit spread tightening, has resulted in a much lower spread versus Libor — and in some cases negative spreads.”
Regulations’ role
However the rising tide of financial regulation on both sides of the Atlantic could push some investors more towards benchmark issues and away from niche structured products.
The decision by the US authorities to include sovereigns and supranationals in the tier one liquidity basket for Basel III but not mortgage-based products will attract investors to SSA debt who might have looked to take mortgage-backed assets before the financial crisis.
“But still there is going to be a focus by banks and central banks on triple-A rated SSA credits because they are tier one liquidity, high quality liquid assets and that feeds into Basel III and the CRD,” says Isabelle Laurent, deputy treasurer and head of funding at the EBRD. “We have this new range of investors that are coming in for regulatory reasons.”
The main determinant regarding the dynamic of the market and the evolution of the spreads is the implementation of the Liquidity Cover Ratio (LCR), according to Stoll at SG CIB.
“We have really seen an increase of interest from bank treasuries over the past few months and it is linked a lot to both the building and the fine-tuning of the LCR buffers,” he says.
“Fine tuning is important because they first invested in government bonds and are now switching into safe and liquid eligible products that offer some pick-up like SSAs.”
Finlayson agrees that within that context the most important regulatory limit is on bank liquidity which will make some tailored and structured products less appealing for certain investors.
“By their very nature tailored products are not going to be the most liquid products so that will have some impact on where it sits within your capital structure,” he says.
“In that sense from an investor’s point of view if you are getting a nice return on it that lack of liquidity may be offset but generally speaking I don’t see the same volume of structured notes going through that we have seen.”
Laurent shares that lukewarm outlook saying she has seen very few complex trades. The core investors that are underpinning the SSA market, which tend to be highly conservative and seeking to increase their high quality liquidity assets, are less likely to buy structured products that do not come into that category.
The implication is that if investors are concerned that there will be a rise in yields, most structured deals will not qualify as high quality assets.
However there will be some institutional investors such as life insurance companies with certain yield targets that they may not be able to reach other than by targeting emerging market currencies or structured products, and who can buy private placements.
A new normal?
After the initial knee-jerk reaction to QE tapering has come a more normal market environment with yields likely to grind higher as the US economy continues to recover. However, as the outbreak of tension in Ukraine has reminded investors, there can be bumps in the road.
While many issuers were successful in taking advantage of the wave of demand from SSA investors for paper in the first months of the year, they are aware that conditions may change as rates climb. “It’s going to be a slow process and a much steadier process,” says the EBRD’s Laurent.
She says that the low level of swap spreads does not point to a climate of rising interest rates.
“So I think the general perspective is that they are more willing to invest in the best credits,” she says. “They are not going down the credit curve to get yield pick-up.”
Investors are likely to be more cautious about sacrificing liquidity in order to lock in protection against rising yields. “People went short and they got burnt and then they got burnt a second time and now they’re not doing it any more,” says Brefin. “In fact tapering has had minimal impact.”
He says investors would have taken note of the indication that Yellen gave to the US Congress in February that the Fed would continue to gradually withdraw liquidity.
“Yellen’s first testimony to Congress confirmed that FOMC was likely to continue along the same path on monetary policy, in other words tapering in measured steps,” he says.
His colleague Kerr Finlayson says there is increasing evidence that the SSA market is returning to some sort of normality. “Even the emerging markets crisis we have been through has had minimal impact notwithstanding the volatility,” he says. “It’s getting towards a more normal market where you bring a bond and it is priced in the context of where you market it.”
However everyone has a very slightly different view of rates, which will lead to some opportunities if some investors think they will go up more quickly.
Stoll points out that the removal of QE will lead to a decline in excess levels of liquidity as well as rising yields. “If there is normalisation you probably have to consider that yields settle at much higher levels,” he says.
However, he believes that the impact will be more worrisome for corporate and other credit markets. “In my opinion SSA issuers are not really at risk because we have a traditional investor base that will still be there looking for solid credits and could be attracted by higher yield levels,” he says.
