After a depressing end to 2007 when investors shut up shop early, turning down even the highest quality borrowers, the turn of the year proved as worrying for issuers and intermediaries as last August. Even government bond markets had become partially paralysed in the wake of the US subprime-induced illiquidity in financial markets, and it was not clear when liquidity would return.
At the end of August it was a $3bn three year global bond for the European Investment Bank that had given sovereign, supranational and agency (SSA) borrowers waiting to advance into the markets a flashing yellow, if not green light to proceed.
Indeed, that issue, the EIBs fifth dollar benchmark of 2007, offered the supranational tighter funding than its earlier dollar globals.
"As in any crisis time, the SSA sector leads the return of liquidity to the market," says one frequent issuer syndicate official in London.
But while the dollar market and then increasingly the euro gave a series of such issuers attractive funding, the return of liquidity was temporary. By the year-end, doubts were growing about just how 2008 would open.
"Central banks are indeed sitting on large cash reserves, which is good when they are willing to invest this cash," said one head of SSA syndicate in December. "However, recent swap spread volatility and the big rally in Treasuries has dampened their appetite until they feel more comfortable with yield levels and spreads again. If things stay as they are, we might see a difficult start in 2008."
In the event, January was by no means as difficult for SSA issuers as many had feared.
In the first full week of the year European supranationals and agencies sold some $12bn of three year dollar paper, including a $5bn deal by KfW, the largest ever dollar issue from the sector. All this in spite of continued sharp movements in the Treasury and swap markets, and lower rated sections of the bond market remaining as good as shut.
Quality flies on flight to quality
Perhaps the issuers and lead managers need not have worried. The flight to quality bid was playing through, just as it had at the close of last summer.
Again, the European Investment Bank was the frontrunner, mandating a three year global on Friday January 4 and executing it the following Tuesday. The $4bn size was short of what KfW would soon achieve, but most importantly, EIBs pricing remained as tight as when it had reopened the market in the autumn.
From the experience of other SSAs, investors drive for top quality assets has persisted.
"The flight to names of outstanding credit quality has been evident since the eruption of the credit crisis last summer," says Monika Seitelberger, director of international finance at Oesterreichische Kontrollbank in Vienna. "The revaluation of different asset classes has become evident and government-guaranteed agencies and supras have been the beneficiaries of these volatile markets.
"It has been possible for top quality names, such as OKB, to price deals at extremely attractive sub-Libor levels."
The Austrian government-guaranteed agency was yet another issuer that sold a three year global in January, a $2bn deal at 26bp through mid-swaps. In April it executed a $1bn five year at 25bp through. These were both priced inside what OKB had achieved with its first crisis-era global, a $1.75bn five year global at 20bp through mid-swaps in October.
"The funding levels have clearly improved over time and investors are still willing to buy top quality names in large ticket sizes," adds Seitelberger.
That demand meant supranational and agency issuance in all currencies in January almost matched that of January 2007, at Eu46.8bn versus Eu47.2bn, according to Royal Bank of Scotland-ABN Amro.
February issuance was actually ahead of the equivalent period a year earlier, and while March was relatively quiet, Aprils Eu35bn supply was far ahead of that in April 2007, meaning that total supranational and agency issuance in the first four months of 2008 has been higher than in 2007, at Eu116.5bn versus Eu108.9bn.
Weak? Not the dollar market
The biggest contributor to the resilience of SSA issuance has been the dollar market, even though its value in euro terms has declined over the past year.
Some market participants had expected the US currencys weakness to lead to a slackening of demand for dollars.
However, an SSA market weary of scare stories about dramatic shifts in foreign exchange reserves from dollars into euros has been sceptical about such tales especially with the price of oil heading in the opposite direction.
Indeed since the crisis began SSAs have seen stronger central bank demand than ever. The Nordic Investment Bank, for example, followed the EIB into the market in early September and sold 92% of its largest dollar benchmark, a $1.5bn three year global, to central banks.
"The flight to quality bid was evident on our 2010 benchmark when we sold out in 45 minutes," says Kari Kukka, head of funding and investor relations at NIB in Helsinki. "We achieved our biggest ever level of central bank distribution on that."
Add in the windfall from a favourable currency swap, and the dollar market has been a no-brainer for many euro-based SSAs.
"The basis swap from dollars into euros has worked in borrowers favour, with a pick-up of over 10bp possible in three years for example," says Alexandra Basirov, head of BNP Paribass sovereign, agency and supranational business in London. "This, coupled with a general flight to quality bid in the front end and the fact that the curve was going one way as rate cuts were on the cards, explains why nearly 50% of dollar issuance this year has been in the three year bucket.
"More recently as the curve has sold off and flattened youve started to see issuers tap into the five year bucket."
As well as OKBs deal in April, issuers including the European Bank for Reconstruction & Development, the Inter-American Development Bank, Export Development Canada, International Finance Corp, KfW and Instituto de Crédito Oficial issued in five years.
The Kingdom of Spain chose that part of the curve for its first dollar benchmark since 2005. The $2bn five year Eurobond was priced in May at 28bp through mid-swaps, the tightest spread achieved by a true sovereign issuer since Germany tapped the market in May 2005 at 31.5bp through Libor although the Bank of Englands $2bn three year bond in March came at 30bp through.
"The obvious reason for the transaction was the cost," says Enrique Ezquerra Martín, deputy director of the Spanish treasury in Madrid. "The basis swap was especially favourable for us at the time. The other reason, related to this, is that our euro debt has not been trading that well."
However, Ezquerra Martín also highlighted the role of central banks in driving the transaction.
"Finally, through our contacts with investors in Asia and the Middle East we found that there is huge demand for US dollars," he said. "In previous years we had been seeing more appetite for euros, but right now the dollar/euro exchange rate seems to be keeping some of these investors away from euros.
"A dollar benchmark therefore fulfilled the aim of investor diversification. Some 80% of the bonds were placed with central banks, equivalent to over Eu1bn, and it is not easy to achieve such quality distribution through auctions."
Euro put back in its place
The euro market for SSA bonds had gathered momentum in the past few years as arbitrage in the currency improved, but it has suffered a severe setback in 2008. Issuance in the first four months of the year was down almost 30% on the start of 2007, partly because of a reversal in the euros cost-competitiveness.
"The dollar market has been much easier to access this year and has provided more attractive funding costs, especially in comparison to issuing in the euro market," says Seitelberger at OKB. "In addition to that, the basis swap from dollars into euros has been extremely favourable.
"In such a situation it is difficult to justify entering the euro market, where all-in funding levels are 10bp-20bp worse in comparison to issuing in dollars. Alternatives have been issuance in sterling, Aussie dollars, OKB´s traditional Swiss franc market, as well as private placements and structured MTNs."
While many issuers that have avoided the euro market, like OKB, will be looking for opportunities to come back later in the year, the situation in euros has disappointed many market participants hopes.
"The outlook for the public sector market in euros for 2008 is very strong," said one head of SSA syndicate in December. "The currency is improving, the outlook for rates is more positive than in the US, and the euro market has a larger investor base."
Each of these three factors has proven less supportive of euro issuance than had been hoped. Firstly, some central banks as highlighted by Spains Ezquerra Martín above are said to have been deterred from investing rather than attracted by the euros strength. Presumably they believe the dollar is close to bottoming out.
Secondly, the outlook for rates in the first quarter was not as positive for euros as had been hoped, but remained supportive for dollars.
"There has been a more definitive direction of rate cuts coming from the Fed," says one debt capital markets official in London. "That meant the front end has been exceptionally well bid in dollars. That hasnt been the case in euros. The general direction has been the same, but not to the same extent because the ECB has still had a hawkish bias on the whole."
Thirdly, the investor base has not proven as strong a foundation for deals as had been hoped. It is not that the absolute number of investors active in euros has fallen; rather, real money investors apart from central banks have been much less active, while the leveraged money that resulted in heavy oversubscription of many triple-A euro issues in recent years has dried up.
Gathering together enough demand for a euro benchmark issue has therefore been a challenge.
However, some borrowers have been more active in euros than dollars of late. L-Bank, the state bank of Baden-Württemberg, for example, sold a Eu1.5bn five year issue in April at 4bp through mid-swaps.
"As always, we talk to our investors on a non-deal-related basis and then get a kind of a feeling for what is doable," says Sven Lautenschläger, international funding officer at L-Bank in Karlsruhe. "In this case we got the feedback that the five year part of the curve could be of interest for investors and we were able to put together domestic and international demand as the basis for a new issue.
"Distribution was a bit less than 50% in Germany and a bit more than 50% went international all in all, a very nice result."
When triple-A is not enough
While on the road, Lautenschläger witnessed a trend that many SSAs have noticed since last summer.
"Investors ask much more about the support mechanisms that we benefit from," he says. "We are in the lucky position of having an explicit and unconditional guarantee, and thats very easy to understand.
"Were a very straightforward, very boring credit, as I always say, and thats why investors still have a particularly good opinion of L-Bank, and the same is true for other German issuers with such explicit guarantees, such as KfW and NRW.Bank."
Those with less clear or direct links to their sovereign governments have faced even more scrutiny.
The clearest example of this is Eksportfinans, which is owned 15% by the Norwegian government directly, 40% by DnB Nor in which the state has a large stake and the rest by Norwegian commercial banks.
Other export credit agencies and similar institutions have had to explain their credits in more detail, but the onus has been strongest on Eksportfinans because in November it revealed a Nkr64m ($11.4m) loss as the result of investments in asset backed securities, which led Moodys to put its rating on negative outlook.
The issuer pulled a planned Eu1bn two year deal shortly after that, and finally made its comeback in April with a Eu1.25bn three year benchmark.
"Eksportfinans did a three year transaction last September that they priced at minus 3bp and then this year they ultimately priced a transaction at plus 13bp," said one SSA specialist. "A lot of real money investors have had their fingers burnt and they are very conscious of what they are now buying.
"Someone like an Eksportfinans has had to pay the price for dipping their toes into something that caused them serious losses, and investors are now scrutinising the asset side of issuers balance sheets a lot more closely. This is especially true of agencies, where investors really want to make sure that they are fulfilling the businesses set out in their mandates and not getting involved in anything risky."
Keeping out of the headlines
However, other market participants believe that Eksportfinans is a unique case, and that as long as SSAs can avoid direct hits from subprime-related exposures they can continue to trade in a fairly narrow band.
"It is not like the European sovereigns, where we have seen much greater differentiation," says one frequent issuer syndicate official in London. "Eksportfinans got hit by some concerns about what they had on their balance sheet, but government agencies, whether guaranteed or not, still trade pretty close to each other. You havent seen that much divergence or tiering."
Market participants disagree on whether or not KfW has been hit by its relationship with IKB Deutsche Industriebank, the half-public, half-private German bank that has had to be bailed out because of subprime losses.
One SSA banker points out that while KfW used to price its dollar benchmarks within 1bp-2bp of the EIB, it now comes at least 5bp wider, even if the gap in euros is little changed.
KfW sold a five year global in April at 18bp through after EIB had priced a similar issue at 25bp through in mid-March, while in January EIB had issued a three year at minus 26bp and KfW another at minus 23bp.
"KfW has got a Eu70bn funding programme this year, the largest in the supranational/agency space, and investors are recognising that theyve got a lot of paper to come this year," says the SSA banker. "Thats very much on the back of the higher volume, but I think also to a certain extent because they have had noise around their name.
"Its quite wrong to have any doubts because of the explicit guarantee [from the German government], but the IKB story resulted in some nasty headlines."
Fortunately such headlines have been few and far between for SSAs. Even in the wider financial markets bad news directly resulting from the US subprime crisis is dissipating and, when it does emerge, is being taken more calmly.
"Financial institutions results have been very important to us in terms of setting the tone, and although their first quarter numbers ranged from in line with to below expectations, the market post-Easter has been shrugging off most of the negative news," says Ed Mizuhara, head of frequent borrower syndicate at Credit Suisse in London. "We have also seen concerted action by governments and central banks, and all of this might result in an easing of the flight to quality bid."
Heads we win, tails we win?
This possibility has prompted at least one borrower to consider the surprising idea of trying to fund as much as possible before the crisis ends.
"The timing of issuance should partly depend on when you think investors will want to diversify out of triple-As into double-As and perhaps single-As," says the issuing official. "When does one expect the banking crisis to be over?
"My personal opinion is that I would rather frontload before the summer, and that way I am not taking any risks even if I am wrong."
But other SSAs are confident there will be enough demand for their paper, come rain or shine.
"I would contest the idea that when the crisis is over top tier triple-As will have a problem funding themselves," says Stefan Goebel, co-head of treasury at Rentenbank in Frankfurt. "We executed our programmes very well before the crisis, we have executed them during the crisis, and we are certainly also going to get our funding done after the crisis. If anything, there is a quite persistent and natural bid for triple-As.
"It took a long time for a lot of key investors to diversify away from government bonds, so to a certain degree we have also benefited from a tendency of investors to be less strict in their investment criteria."
Stefan Dreesbach, head of RBSs frequent borrowers group in London, agrees that the sector should thrive whether conditions improve or deteriorate.
"No matter what the outcome will be, the SSA market is well positioned to deal with that," he says. "There will probably be more volatility and more periods of uncertainty like those we have experienced in the past 12 months."But overall there are still big pockets of demand for triple-A paper and plenty of opportunities for SSAs to diversify their funding."