There is no such thing as a typical crisis. There are some commonalities, though, and it would be fair to say that when a crisis hits, debt markets usually slow down, or even grind to a halt. As a result, problems that start as social, health or environmental ones can morph and mutate into debt crises as refinancing debt becomes a problem.
But despite the economic turbulence, conditions were superb and borrowing in the SSA market ballooned to almost $2tr in 2020 from just $1.2tr the year before, according to Dealogic. At present, 2021, at around $1.57tr, looks set to come somewhere in between, and 2022 supply is likely to be closer to 2019’s level.
As crucial as the sovereign, supranational and agency primary bond market is to financing the effort to protecting the world from coronavirus, it is at least equally crucial to leading banks in the capital markets. Its prestige makes it important to the overall business models beyond the fees earned.
But as volumes return to more typical levels, overall fees will also fall, and as market conditions worsen, banks will find their commitment to the market tested.
Primary dealerships, in particular, are an expensive business for banks, and in times of cost-cutting there is constant scrutiny on whether the status they confer truly provides the value it claims to.
The flurry of borrowing that characterised the past 18 months meant a flurry of fee-earning business, particularly at the sovereign level, where the increased needs were sharpest, although some of this was offset by the additional work the banks had to do at sovereign auctions in order to be in with a chance of winning the lucrative syndication mandates.
But as 2022 nears, that fee wallet is shrinking back to normal size once more. Accordingly, banks are beginning to review their participation in the business again. NatWest Markets dropped five of its remaining European dealerships in early November, leaving itself with six.
“There has been significant supply of sovereign syndications over the past year or two,” says Ben Adubi, head of SSA syndicate at Morgan Stanley. “There have been more auctions as well, so costs have been up, but overall, being part of primary dealerships has made sense lately. With supply dwindling, the coming years will perhaps look less rosy from a revenue perspective. Overall, I’m not surprised to see banks dropping out at this point. It won’t be the end for those that do.”
He points out, though, that just because the business isn’t attractive for one bank doesn’t mean that will be the case for every house. “Banks across the Street will be analysing their participation to ensure it’s worthwhile, but just because it doesn’t make sense for some doesn’t mean that’s the case for everyone. Everyone has different aims for presence across Europe.”
Banks that wish to expand their operations in a particular country may see benefits beyond the possibility of syndication fees from participating in the auctions, for example.
“If you have clients with real needs for sovereign paper, it’s still good to meet those — and if you have a big footprint in the country, then it makes sense,” says Patrick Seifert, head of primary markets at LBBW. “For example, we have established business in Austria, including FIG and corporate issuance. The synergies we can extract from that primary dealership are very different from banks that don’t have that. When banks streamline their business, it’s no surprise to see them cutting some primary dealerships.”
For banks whose regional focus overlaps with the biggest and low-paying primary dealerships, pushing their way to the top of those league tables can be a painful experience.
It has not all been one-way traffic leaving the PD game, though. Deutsche Bank has returned to prominence in the SSA and sovereign market. It’s important to take a long view on the question of the value of primary dealerships, according to Neal Ganatra, Deutsche Bank’s head of DCM SSA syndicate. “We want to be a sustainable partner for sovereigns,” he says. “There’s no point dipping our toe one year, exiting and then coming back the next year. That doesn’t help the bank or the sovereign. We try to act in a way that is sustainable for the bank and adds value for our clients.”
That might mean suffering through a year where the costs banks shoulder at auctions outweigh the fees they earn at syndications in the cause of a broader commitment to the market.
Only the EU, with its huge borrowing requirement and fat fees wallet, is capable of commanding 39 primary dealers. Germany, with its status as the provider of the euro’s safest asset, has 36 — in spite of the fact that the prospect of further syndications has dwindled, meaning banks will find it even harder to make money directly from the Finanzagentur — but nobody else has more than 20 and the figures keep shrinking.
And, although auctions might not be well subscribed, most see little prospect of this changing for anything short of a series of failed auctions that materially cheapen the curve and push up issuers’ cost of funds.
Tricky conditions beginning to return
With the exception of the first few months of the pandemic, the past two years or so have been remarkably smooth sailing for SSA borrowers, thanks in no small part to confidence that central banks would do everything in their power to preserve what ECB president Christine Lagarde terms “favourable financing conditions”.
But as inflation begins to bite, calls for action are starting to sound and monetary policy around the world is diverging. The Fed is promising an aggressive tightening cycle, while the ECB warns that raising rates now would do more harm than good.
As an indicator of a recovering economy, interest rate increases are not necessarily a bad thing, but the fact is that the consequence will be volatility in the rates market of the sort that the fourth quarter is giving us a taste of.
“Overall, that should benefit the SSA market,” says Seifert. “Particularly the most liquid names, because that’s where people want to be in times of uncertainty.”
But while the sector as a whole will not want for demand, the lack of conviction around the direction of rates will introduce difficulties.
“There’s a higher likelihood of macro risk,” says Jamie Stirling, global head of public sector DCM at BNP Paribas. “We have seen evidence of that in October and November, with trickier or delayed deals across other sectors and some softer results in the SSA market.”
Seifert agrees, adding that issuers would be “well advised to be more flexible in terms of size, maturity or currency”.
Adubi at Morgan Stanley points out that another consequence of the less consistently constructive tone in markets is shorter execution windows.
That means that issuers will have to cram more deals into the windows when investors are feeling receptive. The result, says Adubi, is that deals will skew larger, meaning that borrowers can come to the market less frequently to raise the same amount.
“Windows won’t be as clear and open as they have been and borrowing won’t be so easy,” says Stirling. “Markets will be more volatile and that could mean windows become saturated by issuers rushing into market.”
For issuers, that could mean higher premiums as they fight for attention. Adubi believes this move will probably be fairly slight, as the dynamics of net supply are likely to remain favourable, especially in euros, as central banks continue to hoover up paper.
But for banks, conditions will become more challenging. “Pricing will be less transparent, as volatility returns to the market,” according to one head of SSA DCM who prefers not to be named. “As risk returns, that will mean issuers are focused on execution and underwriting.”
Difficult market conditions will probably mean issuers differentiate more between banks. As Seifert puts it, “hard work is an opportunity to demonstrate we add value”, adding that “franchises that don’t have dedicated resources to compete could struggle”.
Larger banks suggest that this will mean issuers lean more on those with big franchises, with the global reach to distribute in difficult times and the balance sheet muscle to take on residual positions, if necessary.
Seifert feels differently. “Not everyone has to be a global bank. What issuers need are syndicates that cover all bases: big global houses and players with more specific distribution expertise.”
He adds that competing for deals in a more challenging market backdrop would require technological investment. “When the market gets tough,” he says, “it will be vital to have good, recent data on why investors are or aren’t buying, so that we can advise issuers on how to manage a less receptive market.”
The rock-bottom rates have given issuers a golden opportunity to issue long-dated debt. With inflation returning, investors may be less keen to look at the long end of the curve. “If they can hit yield targets without going to 30 years, many investors who don’t have structural needs at that maturity, will return to the shorter end,” says one SSA syndicate banker.
For issuers, the fact that yields are still historically low will mean that they are keen to do whatever they can at the long end. However, Seifert acknowledges that the long end could become tricky if investors lack conviction about the direction of rates, suggesting that issuers could end up doing smaller sizes there. However, he adds: “Generally we believe QE is here to stay, and the deals we are seeing in November indicate that investors support that idea.” GC
