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SSA market steels itself for choppy times ahead

Stormy cloudy day. Dramatic sky and huge waves at the Lighthouse

The SSA market has enjoyed a remarkably smooth run in 2021, but volatility is returning and tougher times are ahead, according to the results of a survey of public sector origination and syndicate bankers, undertaken by Lewis McLellan

The debate over fees in the sovereign, supranational and agency bond market was reignited in 2021 by the announcement that the European Union would use a different grid from the standard SSA fees model. Other issuers swiftly rallied round and said they also felt that the fees they pay are higher than they should be, particularly in light of the excellent market conditions enjoyed in the past few years.

However, most respondents to a widespread survey of SSA bankers, which GlobalCapital undertook in late October and early November, think that fees will remain unchanged next year. Nevertheless, a significant minority (some 37%) think fees will fall, rather than rise.

Bankers are swift to defend the fees they charge, pointing out that the range of services they offer goes far beyond the fee earning syndications. Indeed, with many expecting conditions to worsen in 2022, perhaps as a result of the Omicron variant, issuers may well be inclined to feel that bankers are working harder than usual to earn their keep.

Banks have, in the past few years, very rarely had to keep large residual positions on their books after execution, but with many in the market predicting a more challenging 2022, banks may well be called upon to use their underwriting capacity more frequently.

Almost three quarters of respondents to the survey say they expect the average spread SSAs pay versus Bunds, Treasuries or Gilts to rise in 2022, reflecting the fact that uncertainty is growing in the market.

The spreads achieved in 2021 have pushed through levels previously thought impossible, particularly in the US market, where several deals were able to price with a single digit spread to Treasuries.

“Spreads to Treasuries have been terrible this year,” says one head of SSA DCM. “It’s hard to see these continuing. There’s simply very little room for tightening left.”

Opinions are further divided on the question of whether, with volatility in the offing, issuers would prefer to frontload their borrowing to get ahead of their run-rate while conditions are good.

Around 37% say they feel issuers will do so more than usual. Some 21% say they will not frontload as much as usual, while the rest say that the usual amount of frontloading is most likely.

“The shorter, scarcer windows mean that there will certainly be competition among issuers, particularly at the start of the year, when borrowers want to get ahead of their run-rate,” says Ben Adubi, head of SSA syndicate at Morgan Stanley.

Refinancing risk

It is not just spreads that are set to rise, but as inflation returns, it seems likely that we will see absolute rates climb as well. If yields climb uncomfortably quickly — outstripping the recovery in economic growth — it is possible that countries may find it difficult to stay ahead of their refinancing obligations and, if the market shuts down their access, be unable to meet them.

Only a slim majority, some 53%, say that they feel it is unlikely SSAs will face refinancing risk. Around 37% say it is a possibility, with 10% marking it as a major concern.

Moody’s has published a report highlighting that, while the economy of the euro area is recovering, the fact that European debt levels are so elevated “could become a challenge”.

The ratings agency’s overall expectations for sovereign creditworthiness are stable, relative to 2021, underpinned by the assumption that the ECB is likely to “retain its accommodative stance despite growing inflationary pressures”. Sarah Carlson, senior VP at Moody’s, says that this will “contain any increases in borrowing costs and allow some to refinance maturing debt at lower rates”.

It’s possible, however, that the substantial minority in the survey that are concerned about refinancing risk are thinking about those sovereigns with the most elevated debt levels.

“The ECB is likely to start reducing purchases,” says one euro rates strategist. “But borrowing is coming down too, so overall, the situation is likely to remain similar — the ECB will absorb the vast majority if not all of net new supply.”

Around 58% of the survey participants say they think SSA supply will fall by up to 20% in 2022 relative to 2021. Another 11% say they think it will fall by more than 20%. The rest mostly feel issuance will stay roughly the same, with just one respondent predicting a rise.

Dollar return

The euro market has outstripped the dollar market as a source of capital for SSAs for the past few years. Jamie Stirling, head of public sector DCM at BNP Paribas, says that he expects the dollar market to catch up somewhat in 2022.

“It was very much suppressed in 2020, with euros making up over 65% of the supply and dollars under 30% in the SSA sector,” he says. “In 2022, we should see some more activity there.”

Opinion in the survey is divided on the topic. Some 37% say euros will be the better source of funds for SSAs, while another 37% say both currencies will be equivalent. Around 26% feel that dollars will be the better source of funding.

There is certainly room for the dollar market to improve even if it does not overtake the euro market.

The cross-currency basis swap is a key factor and the relative scarcity of dollar supply from European issuers has helped it normalise. If the rise in volatility triggers a rush of people swapping for dollar exposure, then the swap could move in favour of European issuers looking to swap dollar proceeds into their home currency. “If that’s the case, we could see a lot of dollar issuance come in 2022,” says a head of SSA syndicate.

Even with rates climbing, it’s fair to say that from a historical perspective, the long end still looks extremely cheap for issuers to access.

Accordingly, it is no surprise that bankers say that issuers are still keen to print at the long end. Generally speaking, euros has provided much better value for long dated funding than the dollar market, but bankers say that issuers are keen to look at the long end in dollars, even though it has proven historically difficult.

“We’ve seen almost no supply beyond 10 years in the public SSA market for many years,” says the SSA syndicate banker. “But issuers are keen to do it if it can be made to work.”

Going native

After years of only gradual, incremental improvements in the technology underpinning capital markets, several factors have come together to create the conditions for sudden leaps forward in the technology bankers and issuers rely on day to day.

The issuance of the first digitally native bonds, paid in test versions of central bank digital currencies, took place in 2021. Although the systems are nowhere near being rolled out for universal use at this stage, the survey indicates that market participants universally expect that they will be.

When asked if digitally native bonds will become common place in the SSA market, 32% say that they will within five years.

Furthermore, some 37% say they will within 10 years, while the remainder say that they will, but it will take longer than 10 years. No participants say that they will never become commonplace.

Order book inflation

Order books, particularly in euros, are frequently accused of suffering from inflation. Investors, particularly in the hedge fund community, know that they will receive only a small percentage of their order, if anything. Their response is to put in larger and larger orders in the hope of convincing those making the allocation decisions to put some more bonds their way.

Around 58% of survey respondents say that this practice is becoming a problem in the SSA market. A further 37% acknowledge that it has happened, but say that it is not a problem.

The concern is that the huge volumes of orders can obscure the real level of demand for an asset, making pricing more challenging and raising the possibility of damaging volatility in the secondary market after execution.

European safe asset

Perhaps the single most important development of the last two years has been the arrival of the EU as the largest non-sovereign issuer in the SSA market. Early on, EU commissioner Johannes Hahn said that he hoped the bonds would come to be seen as a European safe asset.

There’s certainly a need. The scarcity of Bunds can be a limiting factor for those wishing to build a portfolio in euros. The scale and liquidity of the EU’s supply gives it some hope of fulfilling this role.

A slim majority (some 53%) of survey respondents say they feel the EU is filling that role already, with another 16% saying that it will in the future — perhaps when it has a few more bonds outstanding.

Still, a sizeable minority feel that the EU’s bonds will never become the EU’s safe asset. This might reflect the fact that the EU’s borrowing programme is scheduled to come to an end in 2026.

It is difficult for an issuer of this temporary nature to take on the role of providing a safe asset — a fundamental piece of capital markets architecture. GC

Additional data from the survey

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Lewis McLellan
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