German public sector borrowers have had a whale of a crisis. Indeed it is hard to find a point along the German sovereign’s curve at which an investor won’t have to pay, in real terms, for the privilege of funding Europe’s biggest economy. Ralph Sinclair discovers why that trend is set to continue.
If a public sector funding official’s performance is to be judged upon how cheaply he or she can borrow money on behalf of the taxpayer, then Tammo Diemer — who took over as chief executive of the German Finance Agency in early February — has an unenviable task. Bund yields are, from an investor’s point of view, depressingly low. You might be forgiven for thinking that he is on a hiding to nothing, since his borrowing costs can surely only rise.
But that neglects not just the full role of the Bund in Europe’s bond markets but also the weight of evidence that suggests the German taxpayer is not about to have to pay up to keep the state coffers full.
"I’m not worried," says Diemer. "Bunds and Bund yields are more correlated to the other benchmarks, like US Treasuries and UK Gilts. They reflect capital market expectations on central banks’ rates. From my perspective, we are in a stable environment for Bunds."
With growth generally sluggish across the world’s developed economies, it would be a desperate man that bets the ranch on rising interest rates and, therefore, lower benchmark bond prices any time soon. So big is the Bund market in its home currency, that it is as much a vehicle for expressing views on rates as it is one for expressing views on the issuer’s credit — although at the moment, under a sustained flight to quality, those two views appear to be synchronous.
"German Bunds play many important roles in various money and capital markets," says Diemer. "They serve as a surrogate for cash, they serve as high quality collateral for secured interbank business, they serve as efficient hedging instruments for interest rates and they are a high quality long term investment.
"Given the vivid secondary market and the fact that German Bunds are the underlying of the most important interest rate future contracts, portfolio managers also express opinions on interest rates using Bunds. Hence — to a large extent — Bund yields reflect capital markets’ expectations on the development of central bank rates."
But the second reason for backing Bund yields to stay low is the evidence of a strong structural bid both within Germany and overseas for highly liquid securities of the utmost credit quality. For many investors — as much as the French might like to believe otherwise — only the Bund will do.
The international drive behind this bid is twofold. The first is of course a continued flight to quality with the European sovereign crisis still far from resolved. The French OAT market may offer something approaching the liquidity of the Bund market, the Nordic and Dutch markets something approaching the same credit quality. But neither comes close to both characteristics in euros.
And in Germany’s case, it guarantees an agency borrower in KfW that has a programme large enough — at €70bn a year — to benefit from this heightened interest.
"There has been ample talk of a potential bubble in the core sovereign markets and especially, of course, in the Bund in recent months," says Thomas Cohrs, head of syndicate and DCM at NordLB. "And if you look at the yields that have been attainable over the last six months or so, sometimes we have been very close or indeed have even dipped into negative yield territory — that does not sound like a very good starting point for a lot of upside performance.
"Having said that, there is a very deep structural bid for Bund paper. It’s probably even better for KfW paper in that context, because obviously, they do pay a little bit more in yield than the German sovereign. But it remains the case that the structural bid is not going to disappear."
Regulators, since the 2008 banking crisis it turns out, are also big fans of the safety and liquidity that the Bund market has to offer. And this is helping to drive the structural bid for Bunds.
Basel III and the Liquidity Coverage Ratio require institutions to hold not just more capital, but better quality capital than ever before. Inevitably, that means higher demand for Bunds.
Banks are loading up on bonds to collateralise their inter-bank businesses and to support their derivatives portfolios as well as putting in place higher liquidity buffers.
Meanwhile, insurers are facing up to regulatory demands to hold high quality long-dated fixed or inflation-linked securities. When you add to the mix a trend for central banks increasing their euro reserves, it is hard to imagine a Bund selloff occurring any time soon.
But it is not just investors from the financial industries that are looking to snap up top-rated German debt.
"One sector that is buying is the fast money and the hedge fund accounts that, not only in times of turmoil, took advantage of the secondary liquidity in both Bund and KfW," says Matthias Redlich, HSBC’s head of public sector and FIG DCM, Germany and Austria, in Düsseldorf.
"But we’ve also seen new investors, especially from the countries whose wealth is rooted in natural resources. Whenever a central bank or sovereign wealth fund has money to invest, both KfW and the sovereign are on the buy-list. So there’s been a broadening of the investor base in both domestic and international respects."
Within Germany, conservative domestic investors such as the country’s savings banks, or Sparkassen, are also after sovereign paper. The end of 2015 will mark the final possible maturity of Landesbank paper issued under the Gewährträgerhaftung and Anstaltslast guarantee mechanisms that the European Commission forced Germany to abolish in 2001.
That leaves that group of bondholders facing a wall of redemptions and a dire need to find a safe place to reinvest the redeemed cash. Although a number of better yielding bonds may be available in the wider sovereign, supranational and agency sector, it is to the Bund that these buyers will make their first move.
"Sparkassen have put a big portion of their portfolios in Landesbank paper and there are massive redemptions ahead in 2015," says Patrick Steeg, Landesbank Baden-Württemberg’s head of syndicate and MTNs in Stuttgart. "There is a big challenge to replace it in the very near future, and many are already preparing and buying ahead of it, and they tend to buy 0% risk-rated assets."
It is the very certainty of return — no matter how low — that will drive these buyers into domestically issued paper — and not just that issued by the sovereign but also bonds from the agencies it guarantees, such as KfW.
"The alternative big new issuers that have been introduced into the market — the EFSF and ESM — have not quite convinced all domestic investors, certainly not the more conservative ones in the co-operative bank networks and in the savings bank networks, to give them the same faith in credit as they would give the Federal Republic and its agencies," says Cohrs. "It is spread volatility that is keeping a lot of the more conservative bank treasuries from buying peripheral agencies, despite the potential to make a lot of money if you believe in the future of the euro."
KfW — agency poster boy
KfW has as good a claim as any borrower to having had an absolute riot of a crisis. Cast in the role of Bund surrogate — and therefore paying a spread over the sovereign while carrying its full and explicit guarantee — it has enjoyed virtually unfettered access across maturities and currencies as investors from across the globe have flocked to buy its bonds.
"KfW worked and still works intensively to have its securities trading as closely to the Bund as possible," says Frank Czichowski, KfW’s head of financial markets. "We have closed the gap considerably but we have always paid a spread over the Federal Republic of Germany. It would be the ultimate goal to go flat to the Federal Republic, but on the other side the spread of KfW bonds to the Bund makes our bonds interesting to investors worldwide."
But it is not just the buy-side’s appetite for German public sector debt that is keeping prices sky high. As a number of previously top-rated issuers continue to drop down the credit rating ladder, alternative issuers simply are not issuing as much paper as they were, forcing investors to find alternatives.
"What is sometimes overlooked in the overall context is that on the other side of that equation, the supply of bonds in our asset class is relatively stable, if not falling," says Czichowski. "Overall issuance of euro member states has fallen as a result of austerity measures — and not by a small amount. And the same is true if you look in the agency sector. The overall supply from the agency sector is down by around 10%."
Should Germany ever have to, as many commentators and experts claim it eventually must, foot the bill for the European sovereign crisis, it appears there will be no shortage of creditors willing to lend it the money to do so.