As with their sovereign parents, regional borrowers in Europe and beyond have seen their fortunes diverge wildly in recent years.
Those fortunate enough to be part of an economy with perceived safe-haven status the German Länder and, to some extent, the Canadian provinces have profited from soaring demand for their assets, while others most notably the Spanish regions have seen markets slam shut and faced vast funding shortfalls.
Despite this disparity, however, some common themes have emerged across the sector, in particular the internationalisation of the investor base. Asian central banks for example, barely represented in the market before the global financial crisis, have in the past four years become increasingly appreciative of the yield pick-up offered by sub-sovereign names, partly thanks to the efforts of the borrowers themselves, which in turn have woken up to the value of diversified funding sources.
"Issuers want access to international markets these days because you never know whats going to happen, as we have witnessed in the past four years, when entities which had access to international markets were more successful," says Olcay Yagci, director and co-head of EMEA public sector debt capital markets at Bank of America Merrill Lynch. "People realised, for example, that US investors have excellent participation, so suddenly since 2008 weve got everyone on board for 144A documentation because they would like to have those investors readily available in case they need them."
Equally, there are predictable similarities in the funding solutions proposed for those regional borrowers struggling to gain market access, with the increasing use of national agencies frequently combined with inter-regional transfers emerging as the preferred option across much of Europe.
Länder sit pretty
Germanys 16 Länder not only dominate Europes sub-sovereign sector accounting collectively for 73% of the 102bn of public debt issued across the sector in 2010, according to Fitch but have also been the biggest beneficiaries from the crisis that has engulfed the continent over the past two years.
Indeed in some respects they have been the only winners, as Sean Taor, global head of syndicate and DCM at RBC Capital Markets, points out. "Germany was last year perceived to be as risk-free an asset as you could find within Europe, so anything with a direct or indirect link to Germany did perform very well," he says. "That was unique to Germany, it wasnt true in France or Holland even and it certainly wasnt true in non-core European countries."
The Länder have also been in the fortunate position again, unique in Europe of being able to reduce their funding programmes as the resilient German economy has delivered better than expected tax receipts and federal officials have begun working towards the zero borrowing target set for 2020. The total funding requirement across the sector has been steadily declining from 102bn in 2010 to 95bn in 2011 and just 82bn for the current year.
But while the flight to quality effect has ensured that the Länder have encountered none of the funding difficulties faced by other European regions, the sector has nonetheless seen extensive structural changes in recent years. Before 2008 the biggest bid for Länder debt came from the German mortgage banks, which hoovered up sub-sovereign and sovereign paper from across Europe as zero risk-weighted collateral for their public sector Pfandbrief cover pools.
When that bid all but disappeared as banks such as Depfa and Eurohypo imploded in the wake of the financial crisis, the Länder were forced to make wholesale changes to their funding structure. This not only involved finding a new buyer base fortunately ready to hand in the form of domestic bank treasuries, pension funds and insurance companies but also changing the type of instruments issued, from the illiquid Schuldscheine beloved of mortgage banks to more marketable public bonds.
But while abandoning the centuries-old Schuldschein may have been a wrench for funding officials, the move to a more flexible format helped attract a raft of new investors to the Länder market. "As a replacement of the mortgage banks what we saw in 2010 and 2011 was stronger demand for euro denominated benchmarks from central banks, especially from Asia," says Mike Richter, executive director at DZ Bank.
Central banks now make up around 25% of the demand for standard benchmark Länder issues, the same proportion as pension funds and insurance companies combined, with bank treasuries providing the remaining 50% (although bankers say the central bank bid will likely be lower for rare issuers such as Bavaria). "We have seen issues with almost no international demand which could be substituted by German demand, but we have seen other issues which would not have been such a success without the Asian central banks," adds Richter.
Expanding their investor base has required little effort on the part of the Länder as buyers in search of additional German exposure have, for the most part, beaten a hasty path to their doors. Certainly few funding officials from the smaller Länder have undertaken global roadshows although as Richter points out, they benefit from the marketing efforts of larger issuers such as North-Rhine Westphalia (NRW), Saxony-Anhalt and Brandenburg.
"A few Länder are very active in going on roadshows so effectively they market the whole sector of German Länder," he says. "If investors have understood the story of one state they have also more or less understood the story of the other Länder."
That is not to say, however, that funding officials are unmindful of their new-found international investors. "The German Länder could easily rely only on their domestic bid, which they are doing to a certain extent with their taps," says Yagci at BofA Merrill Lynch. "However, for their benchmarks, they are very careful to ensure they have some international participation."
Richter agrees: "Whenever the Länder have the chance to allocate to international or sizeable investors as opposed to smaller domestic investors, they prioritise the former."
There are also some natural restrictions on international demand. The central bank community, for example, is predominantly dollar-based and, while some of the more sophisticated Länder such as NRW do issue in dollars, it tends to be in MTN format rather than the liquid benchmarks favoured by central bank buyers. "This means that if foreign investors are interested in buying Länder issues they also have to decide whether they like the situation of the Eurozone at that point in time," says Richter. "Its not only a question of the quality of the issuer."
And while global investors are appreciative of the Länders safe-haven status, they are also more price sensitive than their domestic counterparts which means the outperformance of the sector, exacerbated by an influx of money from German banks following the two ECB tenders, is in itself starting to put a cap on demand.
"The swap yield is dropping and due to the strong investor demand spreads on the Länder are dropping as well," says Jörg Mueller, head of origination for German financials and public sector entities at DZ Bank. "It is getting very challenging to buy quality with an attractive spread."
Nevertheless, bankers are expecting a return of international demand when the Länder come back to the capital markets in April after a few weeks absence. "The cash transfer of the German Federal Financial Equalisation System was a few weeks ago so most of the Länder are cash-long at present and its very quiet," Richter said in early March. "However, we expect an increase in issuance by the beginning of the second quarter."
Provinces get proactive
The other big sub-sovereign success story of the past few years has been the Canadian provinces, which have reaped the rewards of the central governments conservative pre-crisis fiscal strategy in the form of a strong flight to quality bid from both US and global investors. A quarter of Manitobas $600m five year deal at the end of February, for example, went to accounts outside North America, including buyers in Europe, the Middle East and Asia.
More so than their German counterparts, however, Canadian funding officials have worked hard to develop their international buyer base. "Weve been fairly proactive at investor relation work and thats evidenced by the book of investors that we had for this last deal," says Garry Steski, Manitobas head of capital markets. "We recognised many of the names that weve visited recently and it gives you some satisfaction that that type of work pays off."
And despite international investors enthusiasm for Canadian risk, they are demanding ever more detailed information from the provincial borrowers, according to Grant Berry, managing director, government finance at RBC Dominion Securities. "The Canadian provinces have always been very professional in their investor relations but the worlds smaller now, so when people are asking about a particular topic they might want to dig a bit deeper in terms of, for example, housing or resources," he says.
International investors are not, however, only represented in the US dollar deals that make up around 20% of provinces funding programmes. They are also big buyers of domestic paper, attracted in part by the transparency and efficiency of the local market, where deals for larger provinces such as Ontario can be priced in 10 minutes and electronic platforms give investors high visibility on spreads.
"For most SSA issuers you have to pre-market deals or build a book for half a day before you price it," says Berry. "Were in and out very quickly, and I think that marketplace architecture has been critical for continuation of access since the global financial crisis. Also, the market is very transparent so investors know right down to the last tenth of a basis point where they are, which makes everyone pretty confident that liquidity is there."
While external demand has been a constant factor, however, the nature of the international investor base has changed. Pre-crisis, when Canada had an appreciating currency and offered a significant pick-up to the US, hedge funds were big buyers of provincial debt but in recent years the Asian bid has become more prominent. "Back in the 1990s only four or five central banks were active in this market on an irregular basis but these guys now are here to stay," says Berry. "Just about every week were getting a large client coming in saying I just need to learn more about Canada."
He adds that the provinces have also traditionally been responsive to international investor requirements, both in terms of deal maturities and currencies. Ontario the biggest borrower with an annual funding programme of C$35bn-C$40bn has in the past two years printed deals in sterling, euros, yen, Norwegian kroner and Australian dollars, while smaller issuers such as Quebec, British Columbia and New Brunswick have also priced transactions in non-core currencies.
However, in 2012 there are few currencies in which the basis swap is working in favour of Canadian borrowers. Manitoba may have saved around 4bp on its US dollar deal but, says Steski, that is the only external currency that now makes sense for issuers. "We are keeping our eyes on Aussie dollars, Swiss francs and sterling but none of that is looking attractive relative to where we could fund domestically," he adds.
Steski also cautions that, although Canada is still seen as a safe haven, there are signs that the shine may be starting to wear off. "Weve heard from a number of investment dealers recently that some investors are rethinking their allocation to Canada," he says. "It may have something to do with talk about a housing bubble here but it could be just that theyve filled up on Canadian names to the extent that they wanted, given that Canadian credits have been a priority for a lot of these people for the last several years."
At RBC, Berry is more optimistic. "Right now its obviously all about macro moves in terms of spread tightening or widening but Canadas never going to be worse off than anyone else," he says. "If something goes on in Europe we may see a reduction in offshore participation but we will be better positioned to weather that storm, which is quite different from back in the early 1990s when Canada stood out as being a laggard."
Regions lean on Spanish sovereign
At the other end of the scale, a country that has been at the eye of recent storms is Spain and the impact on its sub-sovereign credits has been predictably cataclysmic. Previously the second-biggest issuers in Europe (accounting for 10% of total sub-sovereign debt in 2010), the Spanish regions were just recovering from the loss of the German mortgage bank bid when they saw markets slam shut last year as the sovereign was sucked into the Eurozone crisis.
As the recession had also taken a substantial chunk out of regional revenues, particularly from property transaction taxes, the regions were forced to resort to short term bank loans to meet their funding requirements Fitch estimates such borrowing already accounted for 10% of the total at end-June 2011. As a result they are facing substantial refinancing risks, particularly as banks begin to scale back their sub-sovereign lending in the run-up to Basel III implementation.
With markets remaining closed at the start of the year, the Spanish government implemented two show-case programmes to help regions meet their funding needs. First, a new credit line from Instituto de Crédito Oficial (Ico) of 10bn (with the potential to increase to 15bn) has been made available for the financing of debt maturities only, based on the individual regions meeting certain fiscal conditions. However, as Juan Garnica, head of SSA DCM at BBVA, points out, this will likely be insufficient to cover total regional refinancing needs this year of around 23bn.
In addition, on March 2 the government approved a 35bn-40bn facility which will be structured as a syndicated loan administered by banking entities and Ico with a direct Treasury guarantee to pay suppliers for municipalities and regions. Garnica says this should bring much-needed stability to regional funding. "It will ensure the regions access to capital, will oblige regions to comply with their deficit targets and also is a signal of the government support to the regions," he says.
Bankers are also optimistic that the regions could regain benchmark market access later in the year as conditions improve. "If things continue to normalise with the speed we are currently seeing it shouldnt surprise anyone to see the Spanish regions print transactions, and actually we have seen trades already with international banks and distributions," says Yagci at BofA Merrill Lynch.
Kerr Finlayson, a director on the SSA syndicate desk at HSBC, agrees. "There hasnt really been much international interest yet in the Spanish regions but if the tone continues to improve then we could see that interest coming back. We have already seen some examples of German and French accounts looking again."
He adds that lack of supply on the agency side could also benefit the regions, particularly with domestic buyers. "A lot of Spanish investors used the LTRO money to invest in names like Ico, Fade and Frob, and as it stands right now those names are either not funding any more or are very well advanced in their funding programmes, so the next obvious step is looking at the regions."
But Marco Salvalaggio, head of SSA for EMEA at RBS, stresses that maintaining market access for the sovereign will be the key driver for the Spanish government over the coming month. "Spanish spreads are underperforming and if this type of environment were to continue throughout the year I dont see how it would be in Spains interests to prioritise issuance of regions over the issuance of the central government unless in the presence of a government guarantee," he says.
New era, new concepts
Agencies are also coming to the fore elsewhere in Europe as other sources of regional funding have dried up. Italys Cassa Depositi e Prestiti (CDP) has been pressed into service, while in France Caisse des Dépôts et Consignations (CDC) and La Poste are being lined up to fill the gap left by the downfall of key regional funder Dexia, which until recently was the biggest source of funding to French sub-sovereigns with outstanding long term lending totalling 82.6bn at end-June 2011, according to Fitch.
An equalisation scheme mandating transfers between subnational entities will also come into effect this year and could see the richest municipalities, for example, parting with more than 15% of revenue. Nevertheless, French regions may yet need bond market access as the abolition of business tax revenues begins to bite and bank lending becomes more expensive (Fitch noted in January that it was already "not uncommon" to see spreads of 130bp-180bp over Euribor compared with 80bp a year earlier).
Some bankers are also starting to suggest that France and other European countries with cash-starved sub-sovereigns should start to look at alternative concepts for regional funding. Scandinavian subnational agencies such as Kommuninvest and Kommunalbanken are frequently cited as possible models, particularly since demonstrating their resilience in the wake of the Eksportfinans debacle. "Despite quite a volatile background at the end of November, volatility around the Scandinavian agencies settled down quickly, which demonstrates the strong interest for higher quality local authority funding agencies in the region," says Yagci.
As he admits, however, to be successful such an approach requires a stringent approach to fiscal discipline that might not be replicable elsewhere. "If any country can impose the strict regulations that they have in Norway or Sweden, where there is a culture of lending to local authorities and local authorities have to abide by the agreement they have signed and are happy to bear the consequences if they dont pay back, its a fantastic way of managing your local authorities and its also extremely cheap funding for these entities."
Another possibility would be for regional or municipal borrowers to undertake joint issues, following the model of the smaller German Länder. As Finlayson at HSBC points out: "One of the reasons international investors shy away from some of these names is that they are perceived as being very small, both in terms of the region and the size of the trade, so youre really relying on an investor whos able to take the time to understand that region and thats usually a domestic investor. So if they can club together to issue it does make a lot of sense."
Last Mays 1.5bn joint benchmark saw an international participation level of 40%, something none of the six Länder involved Bremen, Hamburg, Mecklenburg-Western Pomerania, Rheinland-Pfalz, Saarland and Schleswig-Holstein would have been able to achieve individually. "The joint Länder issuance has been a success story in recent years," adds Richter at DZ Bank. "For those Länder which are not willing to issue benchmarks on their own it is a good alternative and they can reduce their funding spreads."
Others, however, caution that diversity can be a key attraction of the sub-sovereign sector. "Many investors like the fact that they can buy specific regions because the differences between the economies and the growth in the economies and the funding needs for each specific region are quite unique, so I dont think many regions will be in a hurry to issue jointly," says Taor at RBC.
Nevertheless, he agrees that whichever model sub-sovereigns opt for liquidity will likely remain a central theme for international investors over the coming year. "Sub-sovereign borrowers have in the past tended to focus on smaller, less liquid transactions, but internationally now more than ever investors want more liquid benchmark transactions," he says. "To internationalise their distribution these names need to look at larger benchmarks in the products and sectors where theres clearly more demand."
Frequency and investor work are also key to keeping international investors on board, according to Finlayson. "Its very important in the SSA space to be seen as a frequent issuer," he says. "The first few times you visit the market you obviously have to pay a bit of a premium but in general we have seen spreads to sovereigns tighten in the more frequent these names become. There are a lot of names that investors have to buy and we recommend issuers visit existing investors on an annual basis to make sure theyre still comfortable with the credit and also nurture new buyers."
Taor notes, though, that even the busiest regional borrowers are still struggling to regain international traction in the wake of the sovereign debt crisis. "Investors have become more localised thats not surprising given the dislocation within countries and regions over the last 12 months. But I think thatll take time to repair and get back to where we were three or four years ago when the market was much more internationalised."
Nonetheless, he is optimistic that the market is moving in the right direction. "Given the rebound in sentiment and the tightening in sovereign spreads to Germany, what weve seen this year is interest in agencies and sub-sovereigns growing well above expectations," he says. "Investors are less risk-averse and more thoughtful about what they buy, and are looking for yield pick-up."
For Finlayson, the biggest boost for sub-sovereign issuance across Europe and beyond this year is likely to come from a shortage of agency paper. "Investors are looking for a place just to put their money but a lot of the more common names are very well funded and its difficult to get size in either primary or secondary, so they are having to look further afield," he says.Whether or not such optimism is justified, one thing is for certain with austerity taking hold across Europe and regions facing a toxic combination of high fixed costs and reduced tax receipts, sub-sovereign funding will be a burning issue for a while yet.