It’s the (deteriorating) economy, stupid…

  • 15 Dec 2009
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Government bond supply is there for all to see, and fortunately so too is investor demand. But the reasons behind that supply are not quite so straightforward. Philip Moore investigates.

It is to be hoped that funding officials at treasuries and debt management offices throughout Europe get plenty of rest over the Christmas break. It is highly unlikely that they or their primary dealers will get very much in the new year. "Looking around Europe, most of the required financing for 2009 is now done," says Chris Tuffey, head of European syndicate at Credit Suisse in London. "But Christmas will mark the end of the quiet period."

And how. The good news is that following the sharp spike in issuance in 2009, some strategists are generally expecting gross new euro denominated bond issuance volumes from eurozone sovereigns to be flat or even slightly down in 2010.

In its outlook for 2010, for example, RBS says that a number of influences will combine to keep a lid on eurozone government bond supply, although net financing will still weigh in at a mountainous 6% of euro-area GDP next year.

RBS believes that redemptions, which will be down by €32bn in 2010, will help to cap total issuance, with massive net supply of bills (€97bn) also relieving some pressure on total bond issuance. Other factors identified by RBS that will keep total supply in check include further recourse to non-euro denominated issuance, and the volumes that have already been stripped out of 2010’s likely total through overfunding in 2009.RBS expects total gross supply in 2010 to reach €899bn, down slightly from the €918bn it is forecasting for 2009, but still up by 36% from 2008’s total of €660bn. The RBS forecast for gross supply from the euro-11 is, however, towards the lower end of banks’ estimates for next year. Of those that shared their projections made in October with EuroWeek, only Citigroup (€867bn) has a lower forecast. At the other end of the spectrum, Credit Suisse, Deutsche Bank and HSBC are all in the €1tr club, forecasting gross issuance of €1.095tr, €1.005tr, and €1tr flat. These are followed by UBS (€993bn), Société Générale CIB (just over €960bn), Morgan Stanley (€934bn), Barclays Capital (€924bn), Calyon (€919bn) and Bank of America Merrill Lynch (€914bn). Those forecasts give an average of about €955bn. Net of redemptions, the figure is considerably lower, with the range spanning from a forecast of €418bn at Citi to €575bn at Credit Suisse. Those forecasts could of course still be subject to revisions driven by a range of influences. But it is safe to conclude that total issuance from the euro-11 will be considerable. Add in a continued flood of Gilts from the UK and a trickle of issuance from sovereign borrowers outside the euro-11, and overall European issuance will be weightier still. Factor in very substantial issuance of short term Treasury bills, and it becomes even heavier.

Supply not a problem

That may sound like an awesome inventory of supply, but strategists are relaxed about the capacity of the market to absorb it, not least because of increased regulatory pressures on the banks to mop up much of the issuance. "I don’t think supply need be a problem for the bond markets because demand dynamics have changed," says Steve Major, head of fixed income research at HSBC. "Banks know that the FSA in the UK or the equivalent authority in other European countries are going to require them to build up much larger liquidity buffers. So throughout Europe, the banks still have plenty of buying to do. In total, we are talking about hundreds of billions of euros."

Other bankers also seem relaxed about capacity. "There is plenty of cash on the sidelines, and it doesn’t feel as though there is a capacity issue," says Myles Clarke, joint global head of the frequent borrowers group at RBS in London. "Look at the strength of demand for a deal like the recent 30 year inflation-linked issue from Italy. Although €3.5bn may not sound like a huge deal, it was not a trivial achievement to generate such a strong response for a linker at the long end of the curve."

Severe slowdown to blame

Believe the popular press, and you would probably conclude that the majority of this increased borrowing has been driven and will continue to be necessitated by bank bail-outs. But sovereign issuance directly related to bank recapitalisation has been relatively modest. At the start of 2009, for instance, Fitch put the year’s total gross financing requirement for the EU-15 plus Switzerland (including short term debt) at €1.988tr. Of that total, a little over 13.5% (€270bn) was accounted for by remaining bank bail-out costs; and well over half of that (€167.5bn) was contributed by the UK, Germany and Switzerland.

The bulk of increased funding requirements across Europe, however, is being driven not by headline-grabbing bank bail-outs but by anaemic economic performance, the extent of which has wrong-footed most analysts. "What we got wrong in our January forecast was how rapidly fiscal deficits would deteriorate in 2009," says Brian Coulton, co-author of the Fitch report published at the start of the year.

"2009 saw a return to basics on the issuance side with the amount of supply a very much unknown quantity, as the dramatic increase was being driven not only by the banking bail-outs but also the decline in government revenues," says Stuart McGregor, head of EMEA frequent borrower coverage at Bank of America Merrill Lynch in London. "But as we move into 2010, much of this supply uncertainty has been taken away, as highlighted before, the volumes needed are now, for the most part, being driven by the depth of the slowdown in the economy and the speed of the recovery, trends that are far more normal events in government debt markets."

Others agree. "The big drivers of supply are the sharp slowdown in economic activity which has affected tax revenues across the board, both from corporates and households," says Sean Shepley, head of foreign exchange research and head of interest rate strategy at Credit Suisse in London.

The structure and magnitude of those drivers vary from country to country. "I would divide the challenge facing eurozone economies into three different categories," says Teppo Koivisto, director of finance at the Finnish State Treasury in Helsinki. "These are the banking industry, the housing sector and economic cyclicality. In the case of Finland, our local banks are in a solid position and haven’t needed any state guarantees or liquidity injections. Nor have we had the sort of housing bubble that has impacted economies such as the UK, Ireland and Spain.

"But the size of our export sector means that Finland has probably suffered more from economic cyclicality than most other European countries. That has been the main driver for increased debt issuance in Finland."

In percentage terms, that increase has been spectacular. Koivisto says that in total, Finland will borrow around €30bn in 2010 (€17bn in bonds and the balance in treasury bills), and will have a similar requirement for the next five years. That is tiny relative to some of Europe’s larger economies, but compares with €24bn in 2009 and just €10bn in 2008. "We’ve seen a big jump because Finland had a surplus for many years, but we remain one of the smallest borrowers in the euro area," says Koivisto.

Speed of decline surprises

Some of Europe’s larger sovereign borrowers report that the drivers of their issuance are similar to Finland’s, but considerably more extensive. Spain’s budget, for example, foresees a funding need for 2010 of €76bn, the main driver for which is the country’s cyclical deficit.

In the UK, too, which has probably been hit harder by the banking crisis than any other European country, the costs arising from propping up the banks has represented a relatively small component of the Debt Management Office’s vastly enlarged Gilt issuance programme. "People assume that the deterioration in the public finances in the UK is all about expenditure, but the reality is that it has been driven mainly by falling tax receipts," says Moyeen Islam, fixed income strategist at Barclays Capital in London. The decline in those receipts, he says, has been a surprise even to analysts who forecast a severe deterioration in the UK’s public finances before the collapse of Northern Rock, as Barclays Capital had done.

The UK’s bank recapitalisation programme announced last October required the DMO to raise £37bn, of which £30bn was through Gilts and £7bn in treasury bills. More recently, the Treasury has announced that a further £13bn will need to be found to support the banks in the 2009-2010 issuance programme. That, says the DMO’s chief executive, Robert Stheeman, will be a very manageable addition to the UK’s total Gilt issuance requirement.

While some European economies may continue to be vulnerable to more shocks, which could push total debt issuance higher, a few are already reporting favourable surprises.

In its latest update, published in October, Sweden’s National Debt Office reports that its budget deficit for 2009 will be lower than the previous forecast in June. "The main reason is that Swedish banks will probably not need capital contributions from the state," it says. "Apart from that, central government finances will develop largely as expected in 2009 and 2010. The economic recovery will start having an impact on tax revenue in 2011. The stable forecasts mean that the Debt Office can continue to borrow Skr3bn per auction in nominal government bonds. Central government debt including the Debt Office’s financial assets will grow only marginally to 36% of GDP at the end of 2011."

Sweden’s National Debt Office reports that its funding requirement will fall "sharply" in 2010. In particular, it advises that non-kroner bond issuance will decline from a projected Skr123bn in 2009 to just Skr25bn next year. Issuance of inflation-linked bonds, meanwhile, will remain stable in 2010 and 2011 at Skr10bn per year.

Confidence in the numbers

Across Europe as a whole, however, the risk inevitably remains that strategists’ expectations for issuance in 2010 and beyond will undershoot, as they have in the past. "Our projections for total borrowing requirements in 2009 were about 20% below the realised volumes," says Morgan Stanley’s Cesare Roselli, head of SSA coverage. "But the feeling I have speaking to borrowers is that they are far more self-assured about their funding needs for 2010 than they were in 2009. So although there will certainly be an increase in supply in 2010, the estimates for issuance next year are more robust."

Treasury officials, unsurprisingly, echo that view, with Gonzalo Garcia Andres, head of funding and debt management at the Spanish Tesoro saying that he believes Spain’s funding requirement next year will be much closer to original estimates than in 2009. Those projections forecast a gross issuance for the year of €86.5bn, but as Calyon notes in a recent update, "this appears to have risen above €100bn as tax receipts in particular fell short of official estimates."Governments’ confidence does not, however, appear to be shared by all analysts. Thushka Maharaj of the research team at Credit Suisse says that in a number of countries, government forecasts for issuance is lower than those projected by the banks. "For example, France is projecting €175bn in gross supply for next year," she says. "Our projections are closer to €190bn based on our economist’s deficit forecast. This arises mainly from accounting differences, because France has accounted for its social security deficit separately from its total budget deficit."

Other strategists agree that forecasts of supply may remain vulnerable to capricious economic data. "We are still unusually sensitive to the economic and political backdrop as well as to the banking rescue measures," says Harvinder Sian, a strategist at RBS in London. "As we saw in the third quarter numbers from the UK, GDP numbers can be very volatile."

Perhaps. Overall, however, a consensus seems to be building that there is now more clarity about the prospects for European public finances, and therefore for debt issuance, than there has been for many months. "As we go into 2010 we have a much clearer idea of how the recession is impacting fiscal revenues," says Fitch’s Coulton. "Of course there could be further shocks, but my impression is that most governments have tried to be as realistic and conservative as they can to avoid getting caught out again next year."

To some degree, that reflects the less muddled outlook for politics in Europe, with elections now out of the way in Germany, Greece and Portugal.

It is notable, for instance, that the outcome of the German election has allowed analysts to crystallise their forecasts for issuance from Europe’s largest economy. When Morgan Stanley updated its forecasts for 2010 at the end of October, it added €30bn to the German total to reflect the new government’s tax-cutting plans. That might not sound a large addition in the grand scheme of things, but it is about the same as Morgan Stanley’s expectation for 2010’s entire gross issuance from a smaller borrower such as Belgium. Additionally, as Morgan Stanley notes, "we have assumed that all of this will be done in bond rather than bill issuance."

Even in the UK, where an election must be held before early June, analysts say that all the major parties share the same commitment to tackling the issue of the UK’s deficit, which will mean raising taxes and slashing public spending. So while the plans of the incoming government are unlikely to be greeted with rapture by the electorate, they are at least likely to be clearly articulated.

That, of course, assumes that the UK can avoid a hung parliament, which would usher in a period of uncertainty that would be regarded as disastrous for the country’s capital market. Although that is not an eventuality that is yet being suggested by the polls, Citigroup disconcertingly advises in a recent research bulletin that "a hung parliament may be more probable than widely (if unconsciously) assumed."

Duration extensions likely

A number of variables will, however, continue to have an important influence on total supply of eurozone sovereign issuance over the foreseeable future. One moving part is how much European governments will look to raise at the very short end of the curve in 2010 and beyond. A very conspicuous characteristic of European sovereigns’ funding strategies in 2009 was their sharply increased use of the bills market. "Bills were popular in 2009 because it was easier to raise large volumes very quickly in the short term market and because rates were so low," says Guy Reid, head of sovereign, supranational and agency origination at UBS. "They were also popular because they don’t impact borrowers’ long-term funding programmes, which are generally pre-announced.

"At the same time, short term issuance met with strong demand from investors who were focusing on capital preservation rather than capital return in the first half of 2009. Investors can no longer live with such low rates, and the focus has now moved to capital return, which naturally increases the refinancing risk when short-dated debt redeems next year. Consequently, we would expect a number of eurozone sovereigns to extend duration."

Strategists say that in terms of overall new supply in the next few years, any receipts that may be generated through the repayment by banks of government aid are likely to be used to pay down this mountain of short term debt. "In theory, there would be some downsizing in total issuance if there is an economic pick-up allowing European governments’ stakes in banks to be sold back to the market," says Huw Worthington, strategist at Barclays Capital. "But the main priority for governments will be to reduce their enormous loads of short term debt. For example, the €34bn of government lending to Fortis Bank Netherlands that was repaid to the Dutch government in July was earmarked for paying down increased bill issuance, so it shouldn’t make a dent on the supply of medium and longer term debt."Uncertainty about total supply explains why some borrowers have already heavily overfunded in 2009. Look at Ireland, and more specifically at the whopping €7bn syndicated 15 year issued by the National Treasury Management Agency (NTMA) in October. As RBS notes in its review of issuance to date in 2009, this deal "takes the NTMA well over any budget deficit financing requirement or any capital injection need for the banking system. "To put the size of October’s benchmark in perspective, RBS adds, "the NTMA’s estimate of 2010 issuance prior to this syndication was €20bn, so pre-funding could be worth close to one-third of issue needs."Although budgetary restrictions prevent some European economies from pre-funding, Ireland is by no means alone. "A number of sovereigns have borrowed more than they needed to in 2009, simply because the environment for funding has been so favourable," says Spencer Lake, global head of debt capital markets and acquisition finance at HSBC in London. Indeed. And the Irish deal, which generated demand of €16bn, was as good an example as any of just how favourable the market has been for EU sovereigns.

Q1 land-grab

Uncertainty about supply levels in 2010 also explains why there is likely to be something of a land-grab among sovereign borrowers in January. And in February. And probably in March, with HSBC forecasting issuance of €310bn in the first quarter of 2010. Some think that even that projection may turn out to be an underestimate. True, top-rated supply is always heavy in January, with SSA borrowers eager to be quick off the blocks. But it is likely to be especially so in 2010, in large part because financing conditions will continue to be so accommodative.

How long those very attractive funding conditions can last is anybody’s guess. The paradox is that the stabilisation and even the improvement in macroeconomic conditions may mean that inflationary pressures, broadly forgotten in 2009, may start to resurface in 2010. That in turn will lead to monetary tightening and the end of the easy liquidity that has driven so much of the recovery in global capital markets in 2009. "There will come a point in 2010, which you can tentatively put at around the middle of the year, when monetary authorities start to withdraw liquidity from the system," says Roselli at Morgan Stanley.

The savviest borrowers will make a number of preparations for the withdrawal of that liquidity as soon as they can. "2010 is clearly going to be a challenging year," says Sean Taor, head of sovereign and supranational syndicate at Barclays Capital in London. "Quantitative easing will come to an end and there will potentially be interest rate rises in the UK and Europe, on top of which supply will be higher. So as well as pre-funding I think we’ll see sovereigns looking at a range of options such as the dollar market, FRNs, inflation-linked bonds and MTNs. They are all looking at alternatives to the plain vanilla euro market which has traditionally accounted for the bulk of their funding."

Antonio Villarroya, co-ordinator of global rates research and head of EMEA rates research at BofA Merrill Lynch Global Research, agrees. "The situation for the bond market this year could have been more dramatic had it not been for the governments’ reliance on bill issuance (expected to fund over 31% of total financing needs)," he says. "But as bill issuance is likely to be much less supportive next year, the use of inflation-linked bonds and foreign currency denominated bonds appears to be the only alternative to limit the increase in fixed coupon Eurobond issuance."

That suggests that in terms of supply, the composition of the market for European sovereign debt may look conspicuously different in 2010 compared with 2009. One notable way in which this is likely to change, say strategists, is in its overall maturity profile. "The amount of bills outstanding as a percentage of GDP now looks relatively high in a number of countries," says Sian at RBS. "So from a duration management perspective, terming out will become increasingly necessary. I would therefore expect to see a lot of issuance in the 15-30 year sector in 2010."

Taor at Barclays Capital agrees. "Redemptions will be high for the next few years, probably peaking in 2012," he says. "So I think we will see a lot of longer dated issuance. The concern is that it will become increasingly challenging to generate investor appetite at the longer end of the curve."

That may be, although in continental Europe there still appears to plenty of capacity for issuers to term out the supply of debt. According to HSBC’s Major, the net stock of Eurozone sovereign debt has an average maturity of 5.9 years, compared with 9.6 in the UK. Even allowing for the very different character of the UK institutional investor base, with its skew towards pension funds with longer dated liabilities, this would suggest that there is room for investors to push further down the yield curve.

Linkers on way back

Another way in which the composition of supply is likely to change in 2010 is in the relative share of inflation-linked bonds. For very obvious reasons, supply and demand in the linker market remained subdued in 2009, with most issuers and investors more concerned about the prospects of deflation than inflation. That dynamic is likely to change in 2010. "Next year I believe inflation will be an extremely serious issue, with issuance of inflation-linked bonds rising sharply," says Barclays Capital’s Taor. "We are talking to a number of sovereign borrowers that are considering issuing inflation-linked bonds for the first time."

Villarroya at BofA Merrill also thinks inflation-linked issuance will be a bigger theme next year. "We expect more supply in inflation-linked bonds versus last year, especially in the US (also with increasingly longer duration)," he says. "We also expect more inflation-linked supply in the euro area, where some countries could start tapping this market for the first time."

It is easy enough to identify which European sovereign borrowers are the most likely candidates for issuance. It is an open secret, for example, that Spain will join the inflation-linked issuance club next year.

A third probable trend in the composition of sovereign supply from Europe in 2010, think some strategists, will be the continued search for diversified funding opportunities in a range of currencies, especially given the likely intensification of congestion in the euro market.

Analysts expect the dollar market to be an especially important source of funding for Eurozone sovereigns, especially if arbitrage conditions remain attractive.

As HSBC comments in its preview of issuance next year, "until the euro-dollar basis completely normalises, dollar issuance by European borrowers is... likely to continue to be a factor into 2010."

While arbitrage will of course be a driver of sovereign issuance in the dollar market in 2010, some bankers say it need not be the sole consideration. "It has historically been difficult for sovereigns to obtain approval to issue in foreign currencies unless there are demonstrable cost savings compared with domestic trading levels," says Reid at UBS. "For some, I can’t see that changing. But for others, the volumes that can be raised in some foreign currency markets, most obviously in dollars, may become more important if it relieves the pressure on their domestic funding programme and they may look for less of a cost saving."

At the same time, bankers say that there is likely to be continued strong demand for exposure to European sovereign borrowers in 2010. "We have seen a change in the structure of the US dollar investor base in 2009," says Clarke at RBS. "Many are looking for top quality dollar issuance to replace the decline in supply from the GSEs, so I think we will see more dollar issuance from Eurozone sovereigns."

While the dollar is likely to be the most popular source of currency diversification for European sovereign borrowers, Reid at UBS points to the Swiss franc as another. "Swiss francs offer investor diversification as well as duration, because demand tends to be in the seven to 10 year range," he says. While volumes available in Swiss francs may not be meaningful for the larger European sovereigns, Reid says that they are significant for those with more modest funding programmes.

A more marginal way in which the composition of supply or government debt in Europe is likely to change in 2010 and beyond is in its geographical provenance, as new members of the eurozone press for their credentials to be recognised by investors and strategists.

Central Europe makes mark

The funding requirements of a borrower like Slovenia, for example, do not find their way into most eurozone supply estimates for 2010. Nor will they do much to skew the total expected supply of euro denominated debt next year: Slovenia’s gross borrowing requirement in 2009, for example, was a very modest €3.3bn, and it has already pre-funded a substantial chunk of its target for 2010. Nevertheless, as a fully paid-up member of the eurozone, Slovenia is a borrower that clearly sees sovereigns such as Portugal, Austria, Belgium and Italy as the principal members of its peer group. That particular penny is clearly now dropping among investors. When Slovenia issued its maiden 15 year benchmark at the start of September, its €1.5bn deal was priced at 80bp over mid-swaps, in line with the secondary market pricing of Italy’s outstanding 2025 issue.

For the time being, issuance by the larger central and eastern European borrowers is unlikely to be a meaningful source of competition for eurozone sovereign issuers in the euro market. "Central banks that are very large players in eurozone bond issues are still broadly not critical buyers of benchmark bonds from central European borrowers because of perceived lack of liquidity, ratings hurdles and an element of currency risk," says Maryam Khosrowshahi, managing director at Citigroup in London.

In time, however, Khosrowshahi says that competition for the attention of investors for euro denominated debt among central and eastern European sovereign issuers will inevitably intensify as these countries join the EMU and the euro. It is notable, for example, that Société Générale includes roughly €40bn of issuance from CMEA (which covers the Middle East and Russia as well as central Europe) in its total estimates for euro denominated sovereign issuance in 2010.

Others agree that central European borrowers will become increasingly eager to tap into demand among core buyers of EU sovereign bonds. "I would expect most of the central and Eastern European countries to look to place Eurobonds in international markets over the coming two years," says Juraj Kotian, co-head of CEE macro and fixed income research at Erste Bank in Vienna. "Supply should be limited from Hungary, which is in good shape in terms of its deficit, but Poland has the highest fiscal deficit in the region."

One of the main determinants of supply from the wider central and eastern European region may, however, be the oil price. When Russia’s deputy prime minister and finance minister, Alexei Kudrin, visited London in early November, he indicated that Russia may look to borrow up to $17.8bn in international capital markets in 2010. That projection, however, is predicated on an oil price of $59 per barrel, which looks improbably low.

"I would expect Russia to issue no more than $10bn based on likely projections for the oil price," says one banker who attended the Kudrin roadshow. "Much of that is likely to be in dollars, given that Russia is an oil-based economy. But because of the strength of its trading links with Europe I would expect some of it to be in euros."
  • 15 Dec 2009

GlobalCapital European securitization league table

Rank Lead Manager/Arranger Total Volume $m No. of Deals Share % by Volume
1 Bank of America Merrill Lynch (BAML) 7,026 25 11.95
2 Citi 6,449 21 10.96
3 BNP Paribas 5,093 18 8.66
4 Barclays 4,040 11 6.87
5 Lloyds Bank 3,615 14 6.15

Bookrunners of Global Structured Finance

Rank Lead Manager Amount $m No of issues Share %
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1 Citi 118,624.20 342 12.90%
2 Bank of America Merrill Lynch 99,769.11 286 10.85%
3 Wells Fargo Securities 87,449.35 261 9.51%
4 JPMorgan 67,955.87 206 7.39%
5 Credit Suisse 50,788.13 152 5.52%