The secondary supranational and agency market has had everything thrown at it in the past 18 months. In addition to the issues that hit the entire fixed income sector lack of liquidity, widening spreads, the withdrawal of leveraged money it had to cope with a wave of government-guaranteed issuance and then with the crisis surrounding many of the sectors European sovereign backers. Yet market participants are remarkably chipper their market has shrugged off the threats and the indicators for the coming year are overwhelmingly positive.
Of course, the sector hasnt come through unscathed. During the crisis and in the immediate aftermath it followed a similar trajectory to the rest of the rates universe. After the boom years of the mid-Noughties, when the sector was awash with leveraged money, liquidity dried up in late 2008, not so much as a result of credit concerns but because of a lack of balance sheet availability for the product.
"Pre-crisis we had a flush of cash in the system. There were a lot of different players in the market and all those guys were bringing in their interests, so the market was extremely liquid," says Sebastien Rosset, managing director of fixed income trading at UBS in London. "We are talking about having an EIB or KfW bid-offer spread under one basis point."
When the crisis hit, those spreads widened to as much as 10bp-15bp. Liquidity began to trickle back at the end of Q109 and was given a boost in the second half of the year by a lack of primary issuance in euros, following a spate of prefunding in the spring. By the beginning of 2010, secondary market conditions had normalised, with the dozen or so most active names including EIB, KfW, Cades, SFEF and, since its return to the market last year, EBRD trading at bid-offer spreads close to pre-crisis levels.
Whether there is any more tightening to come, however, is another matter most dealers agree that a return to early 2008 levels of liquidity is unlikely. "The market has changed, I dont think well repeat the excess that weve seen before," says Rosset. "But what was before a 0.5bp bid-offer spread has now turned into a 1.5bp bid-offer spread, so its still pretty good."
Liquidity levels have dropped for two main reasons. Firstly, there has been a withdrawal of leveraged money from the sector the hedge funds left the market during the crisis and are only now starting to return. "At the end of 2008 and beginning of 2009, more or less all the leveraged accounts had disappeared, and we were back to a market where it was real money account buying interest," says Christophe Rivoire, global head of euro rates trading at HSBC. "That being said, in the past few months the leveraged accounts are back in the market, probably more on the govvie space than on SSA but they are back in the market."
Shift away from platforms
Linked to this is the shift away from electronic platforms such as MTS and Eurex a move welcomed by many dealers, who blame the systems for distorting the market pre-crisis. In those heady days, MTS imposed quoting obligations on around 25 banks, but most removed their support during the crisis and havent gone back, preferring to focus on their client business. "This [market making on MTS] is very difficult to enforce in the supras and sovereigns world now," says Rosset at UBS. "Banks have not gone back to the platform basically because its not something that we want to do."
As a result, dealers say, bid-offer spreads today are a much better indication of actual liquidity than they were in early 2008. "Before the crisis you had artificial liquidity which was created by electronic systems and on large trades you could have rapid moves and rapid shifts of spreads," says Sebastien Gianfermi, head of SAS and covered bond trading at BNP Paribas. "We are pretty close to where we were on the likes of EIB and KfW, or maybe slightly wider, but the liquidity provided today is a better reflection of the liquidity available to dealers."
Indeed, HSBCs Rivoire argues that, from the client perspective, liquidity levels are now equal to or even better than those seen pre-crisis, given the current higher levels of volatility. "If you look at the liquidity volatility-adjusted, it has never been so good," he says.
Of course, there can be a big difference between names, a distinction that has been highlighted by the Piigs crisis and heightened concerns about sovereign credit risk.
"Sub-sovereign paper trades with a high correlation with the underlying guarantor," says Rosset. "When you see a Portuguese agency or a Spanish agency, you cannot expect those bonds to be more liquid than the underlying government. So when the Spanish government trades in 15-20 cents, then Spanish agency or government-guaranteed bonds are going to trade at least 15-20 cents."
Indeed, the correlation between agencies and their sovereign guarantors has become even more marked as investors focus has shifted to credit quality. Rosset adds: "Pre-crisis, when wed never conceived of a European country defaulting, everything was priced off swaps and the correlation was a lot greater with swaps than it was with the underlying government. With the crisis, the correlation with swaps has gone poorer and poorer, and the correlation with the underlying government has gone higher and higher."
Similarly, he dismisses suggestions that core country agencies could see their debt underperform relative to govvies in the event that they were involved in a sovereign bailout. "Bottom line, KfW is Germany, so if KfW were to buy Greek bonds it wouldnt impact KfWs creditworthiness, it would impact Germanys creditworthiness," he says. "The only thing that would change is potentially the amount of supply. The link between those agencies and the respective governments has never been questioned and its even less questioned now, because if that were to happen the market wouldnt take it very well."
This confidence isnt shared by all market participants Clement Perrette, managing director, head of euro rates trading at Barclays Capital, cites headline risk around any SSA participation in euro area support as one of the key trends for 2010. But most agree that the new focus on credit and high volatility in the peripherals has so far worked to the SSA sectors advantage, offering relative value opportunities that are enticing leveraged money back into the market.
"Now that the market is once again rates and credit, a lot of people are trading more and more one asset class against another, or one asset against another asset," says Rivoire at HSBC. "You have a lot of agencies which are in between other sovereigns, so people are in a position to trade one explicit guarantee from a country against the sovereign risk in another country."
Barclays has also seen a marked pick-up in relative value trading since the end of 2009, according to Perrette. "US investors specifically, and money managers, are much more relative-value aware," he says, "both intra-SSA sector and versus government-guaranteed bonds, covered bonds etc. The only barrier to this is the fact that bid-offer charges have increased over the past 18 months."
GGBs bring in new names
Another factor that proved unexpectedly positive for the sector was the wave of government guaranteed issuance from late 2008 onwards. Initial fears that the new sector would eat into the SSA investor base were quickly allayed, as much of the paper was bought by banks logging the carry on low-cost ECB loans. Furthermore, the arrival of the GGB sector introduced a whole new class of investors to the concept of government guarantees.
"We had the credit funds coming in, we had the traditional supras and sovereigns coming in, we had the central banks, everybody bought the GGBs," says UBSs Rosset. "Thats opened some investors eyes to the product. We never thought we were going to get credit funds buying KfW, but because those guys have bought GG, it could be that when those government guarantees redeem they put the money back into the asset class."
GGB redemptions will start this year, first in the US market and then, by the end of Q4, in euros as well. In the US alone, $250bn of debt will come due over the next two years and SSA dealers are licking their lips at the prospect of a proportion of the proceeds being reallocated to their sector.
HSBCs Rivoire even suggests that demand for supra and agency paper could outstrip supply. "The banks are going to be relatively keen to issue some senior, or lets say unsecured debt, but on the other side people who are long GGBs are probably going to be keen to buy some sovereign sector or agencies. Thats maybe where we are going to see a small mismatch between the issuers and the investors."
Indeed, the arrival of US money in a market that has traditionally been dominated by Europe and Asia has been one of the big themes of the past two years. US investors have become increasingly active in SSAs as their domestic agency and mortgage markets have shrunk, and GIC buyers have also looked to the sector as a substitute. "The GIC market is not dying but we see a lot less issuance than we used to, and SSAs offer a very viable alternative," says Rosset. "There has been some supply from the US GGs in the short end of the curve but there hasnt been anything in the long end, so if you want to buy long end you have to buy supras and sovereigns."
Both banks and borrowers have been quick to pick up on this trend. The leading SSAs have stepped up their dollar issuance, adding a new degree of depth and breadth to the secondary market, while many banks have integrated their London and New York SSA secondary desks to ensure 24-hour trading.
Another factor driving US investors towards SSAs has been the desire for diversification away from the domestic market without taking on currency exposure a benefit of the sector that UK investors have long appreciated. For others, however, SSAs appeal precisely because of the opportunity to take on FX exposure without sacrificing credit quality.
Norwegian kroner debt has been growing in popularity for this reason, as it offers exposure to the currency to investors who are unable to trade FX and are reluctant to chase after the limited amount of government paper on the market. Dealers also report enhanced interest in the other Scandinavian currencies, but are tipping Australian dollar bonds to be the big success story of the next 12 months.
"Aussie dollar is the big one, because the currency swap works for issuers, so its cost-efficient for them to issue in that currency," says Rosset. "Most of our investors want to diversify and the Aussie dollar is a prime candidate. It works for everybody."
In the core currencies, market participants identify increasing interest in the longer end of the curve as a key trend, as issuers look to term out duration and buyers join the hunt for yield. While the traditional central bank investor base has continued to focus on the forward part of the curve mainly out to five years and bank treasuries looking for carry have concentrated on the zero to three year area, Rivoire says HSBC has seen heavy demand from insurance companies for longer dated paper since the end of 2009.
UBSs Rosset agrees: "Weve seen some very strong interest in seven-year plus from accounts like insurance companies and pension funds who need some yield. They can find yield on peripherals but if they do not want to get involved in those markets supras and sovereigns offer a fantastic alternative, because youve got the quality of the credit and the extra pick-up."
Unsurprisingly, chasing all this investor money is becoming a priority for the banks. Many had scaled back their secondary SSA operations during the crisis, leaving the market to a handful of players, but an increasing number have been looking to re-establish themselves in the sector in recent months.
"A year ago the market was dislocated and a lot of our competitors were not in a position to keep their market share, or it was not their first focus to stay within the loop, which means the market was definitely less competitive from the dealers point of view than it is now, when a lot of banks are back," says Rivoire.
Tough to get back in
Yet Perrette at Barclays argues that it may not prove as easy as some banks hope to regain share in a market that they abandoned during the dark days. "We provided liquidity and worked closely with our customers during the bad times and in the process have formed deep and loyal partnerships, so much of the euro SSA business really never hits the street," he says. "This will make it difficult and expensive for new bank entrants to get a foothold and not interesting for new brokers."
For smaller players, the barriers to entry have undoubtedly been raised since the crisis with the decline of MTS and Eurex liquidity, which enabled them to play the market even when they didnt have the client distribution. Given the potential rewards, however, few bigger banks are likely to be put off by the prospect of competition not only is the secondary SSA market attractive in itself, offering access to high profile clients and high volume turnover, it is also becoming an essential stepping-stone to accessing the lucrative primary market.
The biggest issuers, including EIB and KfW, are increasingly looking at banks secondary market trading activity when determining the award of mandates. "If we decide to award a benchmark, either in dollars or in euros, we look first of all at the distribution capacity of the lead manager," says Horst Seissinger, head of capital markets at KfW. "Secondly we look at the overall business we do together, and third we look at their activities in the secondary market."
Since mid-2009, KfW has been asking banks to supply monthly updates on their secondary volumes and dealers report that some issuers are drilling down even further, insisting on breakdowns by ticket size and client type to ensure suitable coverage levels. "Its important for issuers, because when you underwrite such a deal you need to be able to distribute it," says one market participant. "Its not enough to be able to say I like the bond, Ill buy the bond and keep it on my balance sheet. And the best way to show distribution is how much of those bonds you trade in the secondary market."
Seissinger reports that new entrants to the market have already taken note of this change in emphasis. "We do see that banks who become more interested in this sector start their activities in trading to get experience in the market segment. If someone wants to be benchmark-eligible they know they have to demonstrate this capability, and therefore its natural to start with more activities on trading desks."
But as more and more banks pile into SSAs, including new entrants from Spain and non-core European countries, some dealers are warning that changes to capital requirements could yet put a dampener on the sectors growth. Under Basel II most government-guaranteed debt is zero risk-weighted but regulators in the UK and Europe are considering removing that advantage, which could have serious implications for parts of the investor base, including bank treasuries.Rosset at UBS admits that clients are looking closely at the proposed changes, but is sanguine about the potential effects on the sector. "It [Basel III] could have an impact for some investors, but the investor base for supras and sovereigns is pretty wide," he says. "Banks are becoming more and more important because they have used supras and sovereigns as part of their liquidity buffers, but you also have central banks which are big buyers of the product, and they dont have those issues about risk weighting, and pension funds and insurance companies dont have those kind of issues either. So it could affect the market, but I think its a very long shot and we are not there yet."