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Italy panic forces SSA market to sharpen up ahead of tapering

By Jasper Cox
19 Jun 2018

The recent swings in the sovereign, supranational and agency bond market due to political turmoil in Italy suggest issuers will have to change the way they execute deals in the coming months. Elsewhere, eyes are still trained on the European Central Bank’s tapering plans, while rising dollar yields are failing to attract SSA investors. Jasper Cox reports.

The first half of 2018 was not meant to proceed like this. At the turn of the year, market participants foresaw a steady beginning, before the European Central Bank’s tapering of asset purchases could force a readjustment in the third and fourth quarters.

It has not quite panned out that way. Fears about inflation bringing about rising rates shook up markets in the first quarter, before the result of the Italian election reminded investors of political risk in Europe, after a long period of calm on that front.

The market largely shrugged off the initial results of the election on March 4, when the two Eurosceptic parties, Five Star Movement and the Northern League, registered better than expected results.

But when in May the pair announced plans to form a government together and suggested a review of the accounting status of Italy’s sovereign bonds — which observers saw as the first step in an attempt to write off those obligations — warning lights flashed. The panic spread when President Sergio Mattarella blocked the parties’ nomination for finance minister. 

This could have triggered new elections, potentially giving the parties a more explicit Eurosceptic mandate, although eventually a new finance minister candidate was accepted, the government was formed and the market settled down.

Italy’s two year bond yields rocketed from 0.28% as the market opened on May 28, to 2.78% the following day, and finished that week at 1.01%.

“The movements in Italian government bonds, particularly in the short part of the curve, were very much what you’d statistically call a black swan event,” says Sean Taor, head of European debt capital markets and syndicate at RBC Capital Markets in London. 

What this means for the rest of Europe’s government debt remains to be seen. Some observers are relaxed. “We don’t think this is a systemic issue; rather, it’s a case of assessing what risk premia should be added to Italy, given its likely new fiscal focus,” says David Zahn, head of European fixed income at Franklin Templeton. 

But Taor thinks this brief outbreak of stress has “created an underlying tone of caution in the market”.

It has certainly opened a new phase for bond issues, forcing borrowers to think harder about when and how they bring them to market. 

“The extra volatility means that when there is a window you’ve got to do it and be quick,” says one head of syndicate for frequent borrowers in London.

However, not everyone is battening down the hatches. 

“For all intents and purposes, the SSA space is practically open 24-seven, compared to other asset classes,” says John Lee-Tin, head of SSA DCM at JP Morgan in London. “Rather than closing the market, the lever that we use to keep it continually open is the new issue premium.”

SSA Italy chartFurthermore, most issuers are fortunate enough — or have demonstrated sufficient judgement — to be ahead in funding plans, meaning there is not a large bulge of supply waiting to enter a weak market.

Volatility presents opportunities too. Sudden and temporary widening in the swap spread can give issuers a lucky break. Rentenbank’s €1.75bn five year deal on June 5, its largest ever in euros, profited from both market calmness about Italy and a wider swap spread. 

This swap spread reflected back on the previous lack of calm, when the retreat to safe havens had pushed down Germany’s yields.

But one consequence of the return of volatility for SSA deals could be in the length of time syndicate bankers use to price them.

“It might impact the idea of two day executions,” says the head of syndicate for frequent borrowers, who thinks issuers may be hindered by selling a bond over that length of time.

But Lee-Tin disagrees, saying there is often not much room to cut execution times further, particularly for dollar deals: “Currently we keep books open as little as we need to.”

“A two day execution is still appropriate for larger issuers,” says Taor, even if nimbler issuers can complete a deal within a day.

Adapting to QE winding down

Even if Italy has overtaken quantitative easing as the game changer in the SSA market this year, observers remain glued to the ECB’s statements on asset purchase tapering. 

Recent volatility and political uncertainty have sparked some speculation that the ECB may end up remaining more accommodative than it had originally planned.

“The messaging… is likely to remain dovish as political tensions simmer in the background and may resurface,” says Andrea Iannelli, fixed income investment director at Fidelity International.

Zahn at Franklin Templeton says: “With further tapering possible, we believe the purchase programme will lean even more towards private assets, such as corporate bonds, as the ECB continues down the path of reducing government bond buying.”

The credit curves of SSA issuers — both those included in the public sector purchase programme (PSPP) and those not — have been bulldozed into a flatter, tighter shape by QE, but the effects of tapering may already have started to take place. In January the ECB cut its monthly asset purchases from €60bn to €30bn.

“To some degree, QE tapering has started repricing bonds already, because if you look at asset valuations we are clearly a long way from the tights,” says the head of syndicate for frequent borrowers.

But Lee-Tin of JP Morgan does not foresee problems for issuers.

“SSA issuers have had little trouble accessing the markets during the QE phase, both PSPP names and non-PSPP names, and I think that will continue to be the case, even if we end up stretching out the QE phase a bit longer than originally forecast,” he says. “We are wary about repricing from current technical levels, but don’t think removal of QE will shut the access issuers have to investors.”

Meanwhile, with yields still low in the euro market, investors are keen on longer-dated paper to get juicier returns. 

“There’s still natural demand in the eurozone for long-dated euro deals,” says Taor. “If investors are looking for yield they have to go up the curve and that means there’s still inherently strong demand locally.”

Investors cool on dollars

It is a different story in dollars, where the Federal Reserve has already started down the road of interest rate hikes, with at least one more predicted this year. Yields on 10 year US Treasuries have hit the symbolic 3% mark and have hovered around there since, albeit tightening amid the worries over Italy.

On the face of it, this should present an opportunity for SSA issuers, allowing them to offer investors extra return at the long end. But other factors have combined to make the demand for long-dated paper in dollars underwhelming.

Fluctuations in the basis swap levels have eroded the advantage European issuers used to receive from issuing in dollars and swapping into euros. On top of this, Japanese investors, instrumental in the market for dollar bonds, have opted for euros due to better hedging costs in that currency. 

“If last year we had seen the same yield level as now… the Japanese investors would have hoovered up everything,” says the head of syndicate for frequent borrowers. But this year, despite those high yields, they haven’t, because “it doesn’t make sense”.

This has prevented SSA issuers from being able to take advantage of the higher dollar yields, and underlines how in that market, the lack of a domestic buyer base means hedging costs are preponderant.

SSA Five star movementFurthermore, the bank treasurers and central banks around the world that buy dollar SSA bonds are less interested in longer tenor dollar notes anyway.

“These are not people who naturally look to go long in their portfolios,” says Lee-Tin. With yields also rising in the short end and in the intermediate tenors, there is little need for these buyers to look for longer durations.

“I don’t expect to see a huge amount of shift in where the issuance has been,” Lee-Tin adds. “There are a lot of issuers that would like to extend the curve out, but I think a majority of demand still remains in the three and five year part of the curve.”

And US-based buyers are still put off by the spreads on offer in dollars, which are tight in relation to Libor and Treasuries.

This is despite efforts by some issuers, notably those based in Washington and those with big funding programmes, to penetrate that investor base. 

“US-based investors are generally more return-focused, compared with central banks and bank treasuries,” says Lee-Tin. “Central banks and bank treasuries are generally looking for safety and so they will pay up for that safety. Most US-based investors just find the market too rich, with very little upside in terms of yield and return.”

But, Lee-Tin adds, there has been some uptick in interest: “Lately that has changed a bit, and we’ve had better engagement with US-based investors as yields have risen.” 

Otherwise, the investor base remains stable, with the most recent entrants, bank treasuries, staying in the game.

“The newest type of investors are the bank treasuries building liquidity buffers, but they entered the market several years ago and now we’re in maintenance mode,” says Lee-Tin.

In that sense, the SSA market looks as steady as ever. But how it copes with uncertainty over Italy and the ECB’s withdrawal from the secondary market will test issuers, arrangers and investors alike over the coming months.    

By Jasper Cox
19 Jun 2018