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Braced for shocks and bumps: supras face turbulent markets

By Toby Fildes
19 Jun 2018

The withdrawal of quantitative easing and ultra-generous monetary policy in both the US and Europe has yet to produce any grave market upset. But it is still in its early stages, especially in Europe.

Absent disasters, the bond market event of this year will be the European Central Bank filling in the blanks in its plan to throttle back QE – and probably, actually cutting its purchases. 

Normalising rates markets could be good for supranational borrowers, for several reasons – notably that yield curves will move into positive territory again, making low-spread product attractive to more investors who want a smidgeon of yield with their safety.

However, all expect bond markets in the coming months and years to be choppier than the placid seas of recent years, and to be hit from time to time by storms. And these purely financial squalls may be nothing compared with the upheavals to come from politics, as the cycle swings – possibly for a long time – towards populist and nationalist feelings.

To discuss the funding challenges and opportunities for supranational bodies at this time of change for markets, GlobalCapital gathered representatives of leading borrowers and banks in New York in early June. As well as the macro market outlook, they debated other topics, including the growing demand for SSA paper from new investor types, especially in the US, the slow improvement in liquidity that is bringing, and the pros and cons of green bonds.

SSA 2018

SSA group

Participants in the roundtable were:

Ben Adubi, SSA syndicate, Morgan Stanley

Marcin Bill, senior financial officer, International Finance Corp

Ricardo Carvalheira, principal treasury officer, African Development Bank

Amélie Darrort, executive director, JP Morgan

Andrea Dore, head of funding, World Bank

Spencer Dove, managing director of public sector debt capital markets, Nomura

Sandeep Dhawan, head of funding in the Americas, Asia and Pacific capital markets, European Investment Bank

Søren Elbech, treasurer, Asian Infrastructure Investment Bank

Laura Fan, head of funding, Inter-American Development Bank

Toby Fildes (moderator), GlobalCapital

GlobalCapital: How is the normalisation of monetary policy, above all by the Federal Reserve and European Central Bank, affecting supranationals?

Sandeep Dhawan, European Investment Bank: Normalisation in dollars has been under way for a while and pretty much everyone knows what the state of play there is. But in euros you can start by saying that if there’s a regime shift of this magnitude, clearly that’s going to have an impact on markets. 

It’s unclear whether that impact is going to be symmetric — and by that I mean what happened to European asset prices and spreads going into QE should not, or may not, be the mirror image of when QE is withdrawn. 

The pre-QE world was very different from the post-QE one. The ECB is going to choreograph the exit very, very carefully. Our view is that the gradual withdrawal of QE is not going to have exactly the same, opposite, mirror effect that introducing QE had. But that’s a long term issue. In the immediate term it is probably more accurate to say that this is the beginning of the end of QE, rather than the end of QE.

The ECB is still growing its balance sheet. We expect the balance sheet to grow at least to the end of September; the betting is perhaps beyond that. In addition to that, they’ve got close to €2tr worth of SSA assets with an average maturity of 10 years, so roughly speaking €200bn per annum of redemptions on average, which are going to be ploughed back to the market. So that’s supportive of spreads in the short term.

You’ve had the euro curve become positive, at least in SSA space, all the way down to two years if not lower; that’s getting back investors who couldn’t buy negative-yielding bonds. You could issue negative-yielding bonds, but certainly not copious quantities of them. So you’ve got many investors that come into play, and that’s supportive of spreads.

Then there are the FX-hedged investors that have stayed away from the market. As US rates are inexorably going up, many of them are finding euros a lot more attractive than dollars. That too is supportive of spreads.

Finally, SSA net supply is reducing and that too is helpful for spreads. So just focusing on QE and not talking about all the other shenanigans in Europe which work the other way, in the short term we feel spreads are supported by all these things.

Towards the end of last year, when people were starting to focus on the end of QE, SSA spreads gapped out somewhat. Ever since then they’ve come back in, until the latest episodes of the past two or three weeks.

As far as volumes are concerned, all of us who’ve been raising money in euros for several years have been doing that in the absence of QE. In any case, the ECB doesn’t buy in the primary market, so we don’t expect that to be a problem in any case. 

At the EIB, we were borrowing much larger quantities pre-QE than we expect to be borrowing in the future or are borrowing today, so I don’t think raising volume is an issue because of the largest secondary market buyer disappearing over a period of time. And as I say, they’re not disappearing for several years yet.

GlobalCapital: The World Bank obviously funds a lot in dollars and the US is where we’re seeing the biggest shifts in this normalisation process. How is it affecting you?

Andrea Dore, World Bank: The normalisation process in the US has been on the way for a while now, and since it has been a relatively orderly process, with no big surprises, our funding has not been negatively impacted. Additionally, volatility levels have been relatively low.

In the case of euros, the normalisation process has been fairly muted for us because we are not a big euro funder and we are not part of the Public Sector Purchase Programme. Over time, however, we expect the differential spreads between PSPP and non-PSPP-eligible issuers to compress and return to normal, making it more attractive for non-PSPP issuers to fund in the euro market.

With the rising rates in the US we are seeing increased investor demand for US dollar products, away from some of the higher yielding but high risk products.

Many investors, however, are taking a more defensive approach in the current rising yield environment and are investing in shorter maturities, given the relatively flat yield curve. 

GlobalCapital: Laura — must we expect more bumps in the road?

SSA IADBLaura Fan, Inter-American Development Bank: Yes. There are many different moving pieces so it’s hard to ascertain for example the direction of spreads, but in theory it’s technically when rates rise, credit spreads widen. 

However, there are other factors in play. We’ve had a tax overhaul in the US. If companies repatriate more profits from abroad that could mean less corporate issuance, which means tighter spreads overall. That benefits us.

On the other hand, many corporate treasuries are holding SSA paper, so liquidation of those positions could lead to a widening of spreads.

However, the potential rolling back of the Volcker Rule, suggested at the end of May, might well be a net positive for liquidity in the sector and lead to narrower bid/offer spreads. It basically prevented firms which take deposits and make loans from engaging in proprietary trading activities. If those rules are loosened it would bring back more liquidity in the market, allowing banks to take positions which they might otherwise not, to facilitate market trading.

Some of the bumps stem from effects of the policies that have been implemented. While the policies have been great for those who own stocks and bonds, you’ve seen stagnation of wages and growth in inequality, especially in the developed countries. This has led to the Trump presidency, Brexit and the rise of many conservative parties in Europe. Hence, if a financial crisis were to materialise, it may be politically difficult to implement policies similar to ones in the past.

Marcin Bill, International Finance Corp: In general, I have a sense that there has been less supply in the market from the supra space. It probably will be supportive of spreads if this continues to be the trend. 

Some investors who were unable to express their views on interest rates via floating rate notes — and some of them can’t — are more interested in the front end of the curve, so there has been increased demand for fixed rate paper up to three years. Some of us have benefited from that by accessing the market in the three year space, in particular.

There have also been moves by some of the investors as a result of the rising yield curve in the US out of longer dated US assets into Australian and New Zealand assets in the long end. That’s clearly a shift of substantial money that is afraid of rising rates in the US.

And we’ve seen some indications of increased demand from the US retail space, where we’re quite active. These aren’t volume-bringing transactions but they’re responsive to the higher level of interest rates.

SSA AfDBRicardo Carvalheira, African Development Bank: Dollar rates have been rising for the last two, three years, and I don’t think that that has had a significant impact on the dollar fixed rate market. Deals are still being done in the three and five year maturities; those are the main maturities in that market and that has not changed for quite a while.

Discussing with the investors, we feel they are not confident that normalisation is finished, so they’re not comfortable taking a lot of duration risk. 

There have been a few deals in the 10 year space, but they’ve been really well timed. If interest rates stabilise and investors think they’re not going to get hit on positions with high duration, then there will be scope for long end issuance in the dollar market, which is not there right now.

On the euro market, I’d support what Andrea said: as it normalises the difference between PSPP-eligible and non-PSPP-eligible names has been compressing, which is favourable for the World Bank, as it has been for us.

In this market, a lot of investors have been pushed out to the seven and 10 year space, which for some is not their natural habitat, but because of negative rates and that yields have been so low for so long now, they’ve had to move out along the curve. If and when euro rates normalise, the average maturity on deals may come down a little bit, more towards the five to sevens, because right now the market is really stretched in terms of the maturity of the deals being done.

Søren Elbech, Asian Infrastructure Investment Bank: What we all know is that this is a gradual approach. In terms of normalisation there’s no guaranteed outcome. We have seen already that some of the things that have happened are intended, but there are also unintended consequences. We’ve seen geopolitical risk certainly coming with a vengeance back to what we’re doing; we’ve seen a flattening of the yield curve that we haven’t seen for quite a while; and if there’s a potential for an inverted yield curve I’m pretty sure that the Fed will think twice on rate rises and asset sales.

When we talk about rising rates, it’s important not to forget where rates are, historically speaking. So normalisation — what does it really mean, where will we end up? As Laura said, many moving parts are in this equation. The market is reacting on a weekly basis to these risks — rates expectations are changing all the time — and I think we all have to ascertain how they impact. 

There will be bumps on the road, but as long as we’re ready for those bumps and know how we’ll tackle them, I think we’ll do well as a sector.

Ben Adubi, Morgan Stanley: The market’s certainly become a lot more sensitive to each individual data print, particularly in the US. I was in Asia recently and the shape of the US yield curve was something that came up repeatedly because everyone was talking about the return to normal rates.

Then suddenly someone brings back into the equation that the US recovery has been going on for a very, very long time now and is beyond its natural cycle. People are trying to work out exactly where the Trump stimulus is being felt and where the natural growth path has ended. That’s putting a greater focus on every single data print in terms of windows that are available, and causing some pretty big moves in markets and yields on a weekly basis.

What you, Laura, were touching on is market complacency. For me, in terms of the reversal of quantitative easing, yes, we’re well on the way to normalisation in the US, but in terms of exiting a purchase programme of the magnitude that’s been going on in the US, it’s something we haven’t seen before.

Japan have tried to exit their quantitative easing programmes numerous times, but if you compare their balance sheet to 10 years ago they’re actually larger now. So even though we’re moving at a glacial speed out of this towards normalisation, it’s definitely of a magnitude which we haven’t seen before and which could produce bumps later on in the year.

Sandeep, to your point with respect to euros, the wobble in January, I’d agree that we won’t be seeing a one-to-one move back into rates and supra product, versus those who have moved out during the PSPP programme. 

Investors, broadly speaking, moved further out along the maturity spectrum and further down the credit spectrum to reach their yield and spread targets. In the January wobble, when spreads moved adversely for us, we didn’t see demand return. So there are a couple of factors at play but the wobble and how we move out of euros is probably the largest concern at the moment.

To your point, Søren, interest rates are significantly lower than five, six, 10 years ago, so that’s definitely a concern, given it’s unlikely we’ll move back there, with the volume of central bank balance sheets, in the next three to five years.

Spencer Dove, Nomura: The one advantage for the ECB is that their portfolio is a lot longer duration than the Fed’s, so they’ve got more time to try and smooth the process. Looking ahead we would worry more about the ECB managing to normalise rates, simply because the ECB is at the beginning of a process that has been under way in the US for a number of years already. The market is particularly sensitive to messaging and with growth and inflation, while improving in Europe, still fairly benign by historical standards there is a real danger of increased volatility. 

GlobalCapital: Do you think what’s happened in Italy recently and the reaction in the markets has pushed back any hope of normalisation in Europe?

Dhawan, EIB: The concern is focused on Europe and the fragile state of the economies, and if the ECB starts exiting faster than anticipated or somehow making a mistake on the exit. Then the impact could be far greater than for the Fed. The only thing in the US was a taper tantrum in 2013 and ever since then the exit policy is basically non-news, it just doesn’t matter.

However, on the other hand, the ECB has learned lessons from seeing what the Fed has done and it has therefore acted in a very well-choreographed manner so far.

There are event risks like [ECB president Mario] Draghi leaving at the end of 2019 and that will get addressed when we come to it. But between now and then, which is the best part of 18 months, the concern, purely about QE, is probably far too amplified, because QE’s far from finished. As we’ve seen over the last few weeks the gyrations are coming from the normal course of events that we’ve seen in 2011 and 2012, which is always that if there’s a political issue in one European country the general impression is: this is the end of the eurozone, Europe’s going to go back to the Stone Ages by tomorrow, and so on.

From where we sit, the reflexive reaction has not been too much of a surprise. It’s Italy, which is seven times the size of Greece, so clearly the reaction had to be quick and severe. But people had not learned the lessons of 2011-12 — both the way politicians behave in a particular country and how markets react to that. 

No one’s really interested in fundamentals in this kind of situation. It’s like throwing your toys out of the pram as soon as possible, because unless you do that someone else will. Every time we talk to someone the issue is not fundamentals. Everyone claims to understand fundamentals. What they don’t claim to understand is what the next guy will do. If asset prices are going to be driven by momentum because the next guy’s going to sell, then you’d better sell before the next guy sells. That feeds into itself. It’s ludicrous that 10 year Treasuries had to rally 35bp, 40bp because of what happened in Italy. It just doesn’t make any sense.

GlobalCapital: Do you not think that what’s happening in Italy is a very serious event?

Dhawan, EIB: My point is this: do you see what’s happening in Italy as an idiosyncratic risk or a systemic risk? If you think this is the end of the eurozone, sure, we’ve got wider problems; forget about SSAs, we’ve got much wider problems. You’ve got a global recession; you’ve got all sorts of things happening.

But it’s a big leap to go from Italian idiosyncratic risk and a little bit of contagion across the eurozone to global systemic fallout, and that jump was made far too quickly. It still needs to be assessed where all this is headed. I could sit and talk for the next 20 minutes about Italian politics and economics but the fact is that this is a G7 country. It’s not Greece, it’s a reasonably rich country with a high rate of domestic savings, a current account surplus, a fiscal deficit that has been less than 3% for five years. 

Yes, it’s got a large sovereign debt issue and that needs to be managed and you get a couple of political parties from two extreme ends of the spectrum come together to try and formulate a fiscal expansionary policy that might lead to a 6.5% deficit compared to GDP. 

Sure, people get concerned, but do they really expect that these guys will be able to implement it? You’ve seen the story where politicians have come in from extreme ends of the political spectrum in a particular European country, made all sorts of promises to get there and then once the responsibilities of government fall upon their shoulders, quickly backtrack. We already have seen some of that in this particular case also.

Adubi, Morgan Stanley: When I say our concern is around euros rather than dollars and the unwinding, it’s not a concern around Europe, it’s around European volatility and rates rising too quickly or a mis-step by the ECB. There are going to be political wobbles all along the way but our concerns are not the break-up of the eurozone or European Union. Our concerns are very much on the shape of the euro yield curve. Actually, we think higher yields in euros are much more constructive for the market, as long as it’s managed in a step-by-step process.

SSA AIIBElbech, AIIB: I think the lesson learned is that we had — and there’s no conspiracy here — a democratic election in a country in the eurozone that turned into massive global turmoil. This shouldn’t really be a surprise — we’ve seen populist tendencies in a lot of countries in the last several years. People seem to forget that, only last year, Marine Le Pen actually got 34% of the vote in France’s run-off presidential election.

We’ve had many years, many decades of centrist policies; now we are going through maybe decades of populism and we have to put up with that because the political landscape is neither something that we will be able to change nor something that will disappear fast.

So rather than airing my particular views on this or that I would say that the lesson learned is: volatility is something there will be lots of. We will have to see what happens with interest rates and yield curves but we have to be ready for more frequent shocks, even if they’re based in something as noble as a democratic election.

Dove, Nomura: But there is also more volatility because there’s a lot more fast money in the markets now. And banks haven’t got the same balance sheets to stand behind the market as they would have in the past. Also a lot more is traded in non-cash instruments, so the market tends to be more volatile on that basis as well.

Amélie Darrort, JP Morgan: We shouldn’t forget that we have been operating in markets which, thanks to QE, have been incredibly liquid, in which deals have been consistently fully sold and often largely oversubscribed. It has not been a normal environment. We need to remember that we’re heading back to more normal conditions where you can have some volatility, where you might need to postpone a trade — which we have experienced very recently, thanks to the Italy-inspired volatility.

Issuers will therefore have to be a bit more strategic in their choice of window and perhaps do a bit more front-loading — as a lot of the issuers have in fact been doing.

Adubi, Morgan Stanley: The market has shown a propensity time and time again to overshoot. We saw that this week in Italy where yields in the two year blew up to 2.75% and all of a sudden, two days later, without any fundamental change we’re back at 1.3%, 1.4%.

The market did the same during the taper tantrum.

Liquidity for accounts now is slightly better than it has been, though clearly fell off a cliff during the recent episode regarding Italy, with liquidity providers either taking a step back or being suspended.

Darrort, JP Morgan: Although, in a stressed market, it is not always clear who is there to make a bid. It’s great in benign markets and bullish conditions but it disappears pretty quickly at times of stress.

GlobalCapital: As Laura said, maybe with the toning down of the Volcker Rule banks might take on some more inventory.

Carvalheira, AfDB: Part of the reason why the reaction to Italy was so strong is that basically investors know that central banks have pretty much played all their cards. There’s less scope to move interest rates and to do something significant in terms of balance sheet, buying programmes and so on. There are fewer tools available so they cannot step in as they did during the financial crisis. Central bank balance sheets are so much larger than they used to be and rates are close to zero so there’s less scope for central banks to soften the blow of an unexpected political event.

Fan, IADB: You don’t have the shock and awe effect any more, so if something does go drastically wrong there is very little room to manoeuvre. There is also potentially going to be less political appetite to go along with those processes. In the US you were looking at a crisis of such magnitude that you hadn’t seen before that it required huge government intervention.

But one can argue, who has it benefited? Recently, banks have had record earnings, stocks and bond prices are higher, but the common man’s wages have stagnated. So there may be less political appetite for these large programmes going forward, which begs the question of how will future crises then be dealt with? 

GlobalCapital: How is the dollar market evolving for SSAs?

Fan, IADB: Since the global financial crisis we have seen new investors in US dollars. One set of them was a direct result of the global financial crisis, which was increased regulation forcing bank treasuries to hold more high grade, Level 1 HQLA [high quality liquid assets]-eligible assets. The supranational sector has benefited from those regulations, seeing an uptick in bank treasury participation.

It started off with the European bank treasuries and large global banks — that was in the first wave.

Now what you are seeing, in the second wave, is regional bank treasuries, mainly in the US and Asia, optimising their HQLA portfolios. They may have been holding US Treasuries but now they are looking at what other assets they can hold that still qualify as HQLA but perhaps earn a slightly higher return. Many SSAs should be direct beneficiaries of that optimisation. 

Another factor, out of the US, is the decline in government-sponsored entity issuance, especially in global benchmark format. We have seen strong domestic US interest — I’m predominantly talking about US state treasuries, cities, municipalities and localities — looking for alternatives. Because they’re very conservative they’re looking for high grade paper. Clearly the supranationals fit that category. We offer a spread above GSEs while offering a credit uplift as well, because we’re rated triple-A, whereas GSEs are not. Before the global financial crisis that relationship was reversed so many US investors at that point preferred the GSEs relative to supranationals, which were trading very tightly relative to GSEs.

GlobalCapital: The World Bank, especially George Richardson, deserves a lot of credit for developing this investor base.

Dore, World Bank: Yes. George certainly deserves a lot of credit for developing that investor base, not just for the World Bank but also for other SSA issuers. I call him the father of the US market!

It was a concerted effort that took many years and is still ongoing. Our first success was with the state of California, where through legislative changes it added the World Bank and other US-based SSA issuers to their list of eligible investment assets. This paved the way for the counties, municipalities and cities to follow. We were also able to replicate that success in several other states.

The US market, given its depth of liquidity, is a very important market for us but we discovered that many investors knew very little about the supranational asset class. Therefore, our extensive investor outreach into the US was our attempt to educate the domestic investors and to present the supranational class as a complementary asset class to the GSEs. Also, the inclusion of our paper as HQLA assets for regulatory purposes gave added impetus to that effort.

Bill, IFC: The question that always comes up in the discussions with investors in the US is liquidity. We’ve all been issuing more but often the question is: ‘is there enough paper out there in the market for us to be able to source it in the secondary market?’

The argument we bring up is the availability of bid as the best proof of liquidity and whether you are going to be able to offload the paper in times of distress. We have worked really hard across the supra asset class on increasing investors’ awareness of us and making sure there are investment guidelines that put us in eligible categories.

This of course involves the definition of liquidity — is it a function of available free float or of available bid? We certainly argued the latter, in particular in our discussions in the US.

Fan, IADB: It’s a chicken-and-egg question. Once certain states approved various supranational names you saw more interest, especially in the US afternoon. In the past, the US in the afternoon was really quiet. However, with the additional interest from these state funds, localities and cities, you now have trading desks in New York which are much more active than they were, trading the secondary market.

Because of this increased interest, investors can call and get prices, so the SSA liquidity is perceived as better, especially in the New York afternoon.

GlobalCapital: It’s a success story but it’s involved a lot of shoe leather, a lot of negotiation with these states. It’s great having California switched on because on its own it’s the fifth largest economy in the world. But it hasn’t been easy, has it?

Dore, World Bank: No. It took many years and a lot of resources and lots of trips, some to places off the beaten track, but it has really paid off. This has been evident by the results we see in our order books. For example, four, five years ago we’d on average place less than 10% into the US. That number has increased tremendously to over 20%. So there has been a very strong correlation between our US outreach effort and our placement statistics into the US market.

GlobalCapital: How are you getting on selling debt into the US market, Sandeep?

Dhawan, EIB: The pace of change in the US is frustratingly slow for a market that’s seen the decline of GSE scale and the creation of HQLA assets for a long time now. We haven’t seen the uptake reflect these changes at any particular pace.

It’s true that certain states, counties and municipalities are now opening up but it requires legislative changes at most of these places and those aren’t easy to get through. So here’s the largest dollar liquidity pool in the world, but still mostly inaccessible to SSAs.

The question is: is it just a matter of continuing with efforts or is something else needed? HQLA is a good example. The Fed early on named almost all the supras that qualified as HQLA Level 1 but then they put in a twist, which is that every time a bank puts on an HQLA asset, every quarter it has to go in front of the Fed and justify why that asset is on its books and qualify it as an HQLA Level 1.

In Europe it’s much simpler — you present the ISINs and there are no arguments. It’s a different approach here, so the moment you go beyond the larger banks down to regional institutions it gets harder. Their confidence in being able to stand in front of the Fed and argue why they have this whole alphabet soup of supras in their HQLA Level 1 portfolios diminishes.

Liquidity, I think, is a made-up story. GSEs used to distribute tons of debt outside the US. None of those investors complained of liquidity being only available in US time. Liquidity, unfortunately, almost by definition is where the risk takers are based.

So our asset class is always going to suffer from the perception of being illiquid. Most people need liquidity at a time of crisis — in the last week, 10 days I imagine a whole bunch of dealers got calls from investors wanting to at least check the liquidity in SSAs. 

Or you have these index buyers who need to adjust their duration each month, and as a consequence at 4pm when the fixings are done locally they want London traders to be available to make the prices, to buy or sell whatever they need to in small quantities to adjust their index duration.

But I haven’t come across very many people complaining about liquidity in the US. Sure, everyone would like to have a trader here in the US, and not just someone shepherding the trader’s book out of London, but actually making an active and aggressive market here. That’s not the case yet, although, as Laura says, as GSE traders have found less and less to do, it’s natural they ought to be trading supras more and more. 

But the primary risk trader is based in London so they’re still shepherding that book and I haven’t come across very many banks where there are multiple owners of risk. There are one or two people in a particular location on SSA risk and everyone else is basically looking after their book.

So it’s a red herring. I won’t call it a factor that detracts from our ability to access the US domestic market. There are other issues. Part of it is parochialism — it’s a very domestically focused investor base.

Fan, IADB: In the past most of the SSA trading was dominated by London-based investment banks. But because of the additional interest now, especially in the US, you also see trading by smaller US regional dealers, and thus, if there are more firms trading, that can help liquidity.

Most of the institutions are strictly just in the US. So you’re seeing more local players trading the names that the state treasuries, municipalities and localities are enquiring about because they’re doing less GSE trading. So the traders say: ‘Hey, my investor just expressed an interest in IADB, World Bank, IFC. Maybe I should start trading those instruments.’

SSA Morgan StanleyAdubi, Morgan Stanley: The perceived liquidity they would need is a lot smaller than the London-based liquidity. We’re talking about $10m, $15m, $25m clips as opposed to $100m, $200m, so from that perspective not having the key risk-taker in the US probably isn’t a problem. You can have the guys who are managing the GSE books look after that.

Carvalheira, AfDB: What has also helped liquidity is the fact that multilateral development banks in general and as a group have increased their balance sheets and borrowing requirements quite a lot over the last five or 10 years. A consequence of this is that benchmarks have become quite a lot bigger and that’s also a sign of liquidity — when investors see a $4bn line or a $2.5bn line, a common size for MDB dollar benchmarks these days, they feel a lot more comfortable regarding liquidity, as bigger lines are typically more liquid. Right now our trades are comparable to what a GSE would have issued in the past.

Dove, Nomura: Do you think there’s an element of bid-offer spread as well that affects domestic accounts? When they’re looking in small size and can trade Treasuries on a quarter of a basis point spread or whatever it is, and you see a six-month-old SSA bond that can trade with anywhere between a 2bp and 5bp bid-offer, I wonder if that’s one of the factors that would be an issue for small domestic accounts.

Fan, IADB: You may have had a limited number of investors looking for paper in the New York afternoon but because you have more regional broker-dealers who want to get into that space, you may see more institutions bidding, which increases competition, which hopefully will then tighten in that bid-offer spread.

Bill, IFC: And it’s the offer that moves higher as opposed to the bid edging lower. That’s the situation we’re dealing with here.

GlobalCapital: Has the success you’ve had in the US domestic market, at the state level especially, had anything to do with selling green bonds? 

Dore, World Bank: I wouldn’t say green was the driving factor. Rather, it’s the reasons already discussed — liquidity, the pick-up we offer as a triple-A credit over Treasuries and being able to include those bonds as HQLA for regulatory purposes. There have been investors, though, that are also attracted to the sustainable nature of our bonds. For instance, our first US dollar green bonds were placed with the state of California in 2009.

Adubi, Morgan Stanley: The regional banks obviously feel a lot of pressure to increase returns. If you look at SSAs, and supras in particular, versus Treasuries, for me it’s quite a clear and easy move, to get increased returns, relative to what your portfolio already holds.

Fan, IADB: Yes, we made that quite obvious when we were in the market with our $4bn three year, which we offered at Treasuries plus 22.1bp. At the exact same time, Fannie Mae was in the market. They ended up doing a $2bn three year trade and were offering Treasuries plus 9bp. There was a clear differentiation in real time.

Domestic US investors who participated in our deal may have come in for larger size than anticipated, due to the price differentiation compared to the GSEs.

Carvalheira, AfDB: There are also implications beyond the investor constituency we’re talking about (US states, counties and municipal investors). Insurance companies and other players active in structured finance are required to buy very safe assets for structuring purposes and for hedging liabilities. Their interest in bonds issued by MDBs has been growing, as far as we can tell. 

We’ve seen some activity coming from this type of specialist investor when they’re structuring products or executing liability management deals, because of the pick-up MDB bonds offer versus US Treasuries. They’re now considering MDB paper for their hedging purposes.

GlobalCapital: What can we expect from this sector in terms of green or SRI bond development?

SSA World BankDore, World Bank: While green bonds will continue to be a very important tool to raise awareness for climate risk and projects they support, the market is also transitioning to a broader sustainability approach. Investors are focusing on integrating not just the E (environmental) in ESG into their investment decision processes but also the social and governance factors. 

In the case of the World Bank, we are promoting our entire balance sheet, and highlighting the sustainable development work we are doing not just in green but also in areas such as agriculture, education, health, etc. Green bonds, however, will continue to play a key role and are an important catalyst towards building sustainable capital markets.

GlobalCapital: So you think in 10 years’ time we won’t be talking about green bonds, we’ll be talking about sustainable bonds?

Dore, World Bank: Maybe not in 10 years, but some time in the future, the focus will be more on sustainability overall, hence “sustainable development bonds”. We will still have huge environmental problems to deal with in 10 years’ time, so climate risk will remain an integral part of the investment decision process. Future generations will analyse ESG and impact as part of their regular assessment.

GlobalCapital: Søren, when you issue your first deal is it likely to be a green or sustainable benchmark? I know your love affair with green bonds is well-documented…

Elbech, AIIB: AIIB is a new bank so we have an opportunity to do things differently and with a blank slate. We have no legacy assets, we have a whole new borrowing platform to build. We have been spending the last six months meeting most investors in supranationals, and green is one of the things we have talked about — how could we embrace it and still lower the cost of funding. That is ultimately the starting point — I will not do anything that increases the cost of funding. That has always been my argument with the green bonds. Because of additional reports and independent verifiers, etc — all of which comes with a cost — I just don’t think green bonds are cost-efficient for a supranational borrower with ample access to a multitude of funding sources.

Having said that, because AIIB has been mandated by our member countries to only finance sustainable infrastructure projects, we have put together an ESG framework in collaboration with best-in-class approaches like those from the World Bank, and now every project we do is compliant with that framework. 

We contemplate using a net proceeds approach and say that every bond we issue will exclusively finance projects that qualify with our ESG framework. That allows us to not have to issue labelled green bonds or labelled sustainable bonds, but to argue that investors can determine it for themselves. Through buying our bonds they will get access to a loan book that is exclusively sustainable. So we have the privilege and opportunity to do it somewhat differently from some of our peers.

Investors also come in all shapes and sizes. Some have very specific mandates and we might not be able to cater to them. We will continue to listen to investors, but this path is what’s best for AIIB as we prepare to become a new borrower.

Darrort, JP Morgan: The investor base is quite different on the social and green side for both benchmarks and private placements. In Japan for instance, some investors are constantly looking for new theme bonds, and don’t mind investing on a best efforts basis. Such formats wouldn’t really work on the benchmark side. Given their scope of action, this type of private placement fits better with the supra issuer community rather than the agencies. 

Adubi, Morgan Stanley: The US investor base is still primarily a green investor base as opposed to a social or sustainable one. They’re a bit less advanced than Europe and Asia in terms of their liberality around bonds they’ll buy. There is a very large variety of investors which have primarily green portfolios. They may have some sustainable and/or social portfolios, but they feel social and sustainable are more subjective than green bonds.

We obviously have had the Green Bond Principles; we now have the UN SDGs, but the SDGs arguably don’t dive deep enough, compared to the Green Bond Principles, and at the moment the US investor base by and large — and there are obviously pockets of demand which are counter to this — is more focused on green rather than social and sustainable.

GlobalCapital: Have you noticed any change in attitude after President Trump’s decision to take the US out of the Paris Agreement?

Adubi, Morgan Stanley: It’s gone too far already. The momentum’s there and it’s going to be hard for the person at the top of the chain to stop that. You have all these independent private organisations managing funds which have embedded into their mandates that they’re going to be more sustainable and are trying to change things from a green angle. So I think on the margin maybe, but in terms of the outright momentum, it’s too hard to stop that.

Bill, IFC: If anything it instigated some contrarian behaviours and encouraged more people to take a stand.

SSA NomuraDove, Nomura: The biggest problem we’ve got is there are not enough assets. We could do with more supply. If we’re talking about the future of green bonds and supranationals, your work in that field and in developing emerging markets for green product is hugely important in the years ahead.

GlobalCapital: Doesn’t the fact that there are not enough green bonds mean they should perform better than they are and should price and trade inside conventional curves?

Bill, IFC: For the most part you see the outperformance of thematic bonds versus vanilla lines in the secondary markets. Obviously there are attempts by some issuers to address this extra performance in the primary market. But it’s then a function of how the primary market operates. Some of them are different, such as in Australia, where the price where it’s launched is where it is usually priced. You have to take a leap of faith and decide if you think the bond will outperform, and if the investors will be supportive. But in markets like dollars, euros, Canadian dollars, it’s a bookbuild process that determines the ultimate primary market pricing, where there is incremental demand to your normal demand. So simply, the price will get driven tighter. 

Carvalheira, AfDB: Given the natural imbalance in the green bond market, research clearly shows green bond portfolios have outperformed conventional ones. There’s also research that shows a halo effect. When you start issuing green bonds it can affect the rest of your curve.

From our own experience issuing green bonds into Scandinavia, we managed to get pricing that we wouldn’t have achieved if it hadn’t been labelled green. Even recently when we did a 10 year social bond, it priced well inside our initial expectations, inside fair value for our secondaries. Interestingly, at that time there were two other deals in the market which were neither green nor social and they didn’t do so well. 

Meanwhile, our deal went really well. We were hoping to print €1bn and we had to bring €1.25bn, simply because the book was too strong, even though we had tightened by 2bp from initial guidance.

So at least from our own experience in terms of primary pricing, in terms of opening new markets and even as a marketing tool, it’s been really strong. We are really happy to be green bond and social bond issuers.

Dhawan, EIB: From our perspective — and I think this is true for the entire asset class — the green bond is not just another product for funding purposes, it’s not something you want to put out there like you put out a variety of structured products and so on. SSA EIB

The idea of doing green bonds was to address the biggest threat our generation faces, which is climate change. The idea for SSAs was to set up a model that could be scalable by others, to get private sector capital involved in the fight against climate change. So our idea is not to try and see how tight pricing can get on green bonds.

If you look at the history of them over the last 10 years, for the first five years nothing really happened. A couple of us issued a green bond here and there and nothing happened. But of course there was a lot of work in the background. A whole bunch of supranationals got together and started harmonising the metrics around what do you mean by a green bond, what is the use of proceeds, how do you segregate the use of proceeds in complex organisations, how do you start evaluating what impact these things have, what measurements do you do to harmonise impact reporting? 

Then the Green Bond Principles came out in 2013, 2014 and that’s when the market took off and now it’s $250bn. It’s a pittance compared with the fixed income markets as a whole but the fact that we’re talking about it — and we have these same conversations when we meet investors, even those who don’t buy the product — suggests that at least some of the purpose of supras doing green bonds has been met, which is to create noise around the subject and set up a model for others to follow.

China is one example. We’ve done a lot of work with the Chinese government to harmonise the way they look at green bond standards with the way Europe looks at it, and introduced a white paper last year with the PBOC on that. 

We are just here to set up the model, the paradigm for others to scale and operate. We do €4bn or €5bn of green bonds a year out of a €60bn funding programme, which is not meaningless, but it’s not meaningful either. So it’s not a funding tool for us, but like the others, we also want to look at something beyond green and we’ve announced we’re going to start looking at a sustainable development bond later this year.

Carvalheira, AfDB: It has reached the political level and it’s now systemic, it is systemic top-down guidance, making the capital markets more sustainable. So even though as a proportion of fixed income capital markets, green bonds are still small, the push from the top will have a real catalytic effect.

Dhawan, EIB: To your question about what’s next, there is an old saying: ‘Beware of someone from the government saying: I’m here to help you.’ But the fact is that government and regulatory involvement in a formalised manner is probably the next step.

At least as far as we’re concerned, and leave aside a few pandemic bonds and catastrophe bonds, by and large all investors are doing is buying triple-A rated bonds, they’re not buying project risk. So it’s not like this has revolutionised anything.

But with a bit of regulatory fillip, a bit more formalised governance — right now it’s just dealers, issuers and investors getting together and creating something out of nothing — it can really move on to the next level.

SSA IFCBill, IFC: And it’s not only the tax incentives that perhaps Sandeep has in mind, but also the commitments from governments on limiting greenhouse gas emissions that can really make the difference. Tax incentives for green bonds can only have limited impact. But if they declare that they will try to shift their entire economies towards a certain GHG emissions goal, that can make a significant difference on climate change.

Benchmarking and creating indices for institutional investors to build portfolios that properly follow certain performance standards is a wide area for development that we, and governments, can help foster. I completely agree that supranationals are essentially catalysts, trying to incentivise corporates and other mainstream issuers to enter the space.

Fan, IADB: We do not have a green bond programme. Instead, we chose to implement a social bond programme on education, youth and employment, our EYE bonds. There was so much focus on green and the environment — and even the bank itself is very much focused on sustainable infrastructure, sustainable cities etc — that we thought the social aspect was overlooked. So we deliberately highlighted part of our social lending to bring awareness to investors that this is also an important component of the IADB lending.

What we hope — and we haven’t got there yet — is to see investors becoming involved with the social sector lending, not just via our triple-A rated bonds, but to have them motivated to directly invest in projects themselves or provide technical, non-reimbursable financing.

GlobalCapital: Søren, you left the IADB in 2014 and resumed your SSA career in early 2017 at the AIIB in Beijing. How has life changed for a supranational borrower in that time?

Elbech, AIIB: The supranational asset class is of course incredibly well known and the recurring frequent issuance is very helpful to a newcomer like us. There is a lot of experience in the sector — some have been issuing for 70 years — and that has been helpful to me when putting a team together. Because of that experience, some things are the same as they were. 

But some things are new, particularly in the investor base. When setting out on launching our supranational bond programme there were some investors I never thought I would be going to see.

Of course the fact that banks have a very different approach to risk is a completely different set-up. Compliance is a much, much bigger factor. And there’s much more competition between the brand names we have to deal with, which is both good and bad. The sector’s priced pretty tightly, so I think that is good — we can piggyback on that.

But deal sizes and issuance volumes have increased. We are very well capitalised so we don’t have to borrow that much. Meanwhile, we’re seeing, for instance, Laura doing a $4bn deal for IADB, and that’s already more than I have authorisation to borrow in 2018. Peers are doing these much bigger deals on a regular basis and while we will get there, it will take some years. We have to persuade investors that they can also get liquidity in smaller deals. Five or 10 years ago we could argue that $2bn was a massive deal, so things are changing. 

Having spent the last six months on the road, we have probably seen 175-plus investors. I think we’re ready. The feedback has been tremendously positive and that is, in part, thanks to all the borrowers in the room — we are a very well understood and worked-in asset class. Investors respond positively to the opportunity to be buying a new name, AIIB, and that we’re triple-A.

I should of course use the opportunity to mention, with my peers being here, that we’re putting together what we perceive to be a very market-friendly two-way ISDA CSA [credit support annex].

It’s been a fascinating journey and we’ve been helped a lot by all those who’ve gone before us down this path. We know we’re standing on the shoulders of tremendous organisations and people.

GlobalCapital: Is the MTN market as effective as it once was and what can we expect from it over the next six to 12 months?

Darrort, JP Morgan: Yes, we’ve seen a lot of change over the years and I’m sure everyone in this room has seen the shift. We used to sell lots of callables into Asia, for Taiwan and Korea, but that has declined as a result of regulation and the fear of how those instruments will be treated in future. 

Then we started doing long-dated Norwegian krone, euro or Swedish krona vanilla trades for Korean investors, something we wouldn’t have imagined doing three years ago. And with the strengthening of the dollar, we’ve seen declining demand from Japan for EM currencies, especially with all the political troubles in certain countries.

At the same time, there is increased appetite for private placements of green and social bonds. I think the private placement market will always be able to adapt and remain an important source of funding for SSAs, especially supranational issuers. 

Dove, Nomura: They’re much more bespoke and much more competitive than they ever used to be. It’s not as if there’s a vanilla product that goes through the market regularly. There are much less of them. You mentioned the green bonds and theme bonds into Japan. They’re very, very competitive and they’ve got to be different from anything else that’s been done. It’s a lot of work and effort to get one of those trades to fruition.

Darrort, JP Morgan: Yes, it is very competitive, both in terms of what an investor wants — in Japan they want to be the first one to come with a new theme — and among the banks, because supranational issuers, and SSAs in general, put a high level of importance on private placements.

Fan, IADB: Hopefully with the return of volatility to the market we will see the return of structured notes with longer lockouts. We have largely been out of the structured note market because the volatility was so low that it only made sense for structureds to have very short call periods. The way our liquidity policy is structured made it very difficult for us to issue bonds with lockout periods of one year or less.

Dove, Nomura: It’s also more expensive for banks to put structured swaps on their books, given the regulatory changes, and with the low yield environment this can rapidly remove any coupon upside for investors.

SSA JP MorganDarrort, JP Morgan: Due to the increased volatility, we are seeing new opportunities for supras as well in Europe, such as German or French investors looking at long-dated structures from supranationals that we did not see two or three years ago.

Bill, IFC: One other trend that’s worth mentioning is emerging market currency MTNs. Historically they offered an issuer cost enhancement but not necessarily term. This is changing. We have seen more and more demand for term issuance in EM currencies, for not only duration but also tight funding cost.

GlobalCapital: How will technology, in particular artificial intelligence and blockchain, affect this sector?

Darrort, JP Morgan: Technology can help, especially when you are a smaller team. There are so many issuers — I think we have now as many as 80 issuer clients on the SSA side. That’s a lot of information to manage for those issuing private placements and posting funding grids, for instance.

Bill, IFC: We started working with the Origin platform and trying to pave the way in that context. Maybe there is a future there for supra product, although full standardisation will be challenging.

Carvalheira, AfDB: In addition to the Origin platform, to which we’re also signed up and which hopefully will take off in terms of trades, blockchain can have an impact in the way transactions are processed through settlement and the back and middle offices. There was a deal by Marex that settled in a minute, versus the two days typical settlement for an MTN.

I think it’s likely that in five years or even shorter you will see that this kind of technology makes a big change in how MTN transactions are executed and it will reduce a lot of risk, or at least the number of middle and back office people that are required to process trades.   

By Toby Fildes
19 Jun 2018