Copying and distributing are prohibited without permission of the publisher.


Consolidating triple-A credentials

28 Oct 2004

Spain has in 2004 been able to build on its achievements of recent years and maintain its membership of the top tier of the euro government bond market, despite the dual dramas of the Madrid bombings and change of government. Government guaranteed ICO has shared in the kingdom's success, while venturing far and wide in search of new opportunities.

The bombings in Madrid in March that killed almost 200 people and injured hundreds more provoked a tumultuous few days in Spain's history. The perceived mishandling of the immediate response to the attacks by prime minister Jose Maria Aznar's Popular Party government compounded public opposition to his stance on Iraq. The result was a surprise general election victory for the Socialist Jose Luis Rodriguez Zapatero days later.

But in the months that have followed, the country has not allowed the events of that week to overshadow its future, and any fears that the bombings could have a lasting economic or financial impact have thankfully dissipated.

This was clearly demonstrated in June, when the Kingdom of Spain made its most public outing into the capital markets since the bombings, and the first under the new administration. Rated Aaa/AA+/AAA, the sovereign was able to more than equal the spreads of its triple-A peers by launching a Eu5bn 10 year government bond through France, flat to Finland and just 8bp over Germany.

With investors impressed by the government's continued commitment to fiscal discipline and Spain's 2.8% economic growth rate ? still well above average for the euro-zone ? lead managers Banco Bilbao Vizcaya Argentaria, Calyon, Credit Suisse First Boston, Deutsche Bank, Dresdner Kleinwort Wasserstein and Santander Central Hispano were able to amass a book of Eu14.2bn.

At the Spanish treasury in Madrid, José María Fernández, head of the public debt department, says that in the economic field 2004 has been business as usual.

?We continue to outgrow our European peers while, at the same time, the Ministry of Economy, geared by Mr Solbes, has committed to a close to balance position in the coming years.?

Making the grade
Indeed Spanish debt continues to trade at the tight end of what might be expected for that of a country of such a size and rating.

?Investors already price Spain as a triple-A sovereign,? says Fernández. ?We are already triple-A by Moody's and Fitch, and we are now double-A plus by Standard & Poor's. Our economic dynamism and fiscal discipline allow us to enjoy gradually decreasing debt to GDP ratios and to hope that in the future the positive outlook signalled by S&P will turn into the final upgrade to triple-A.?

And Fernández is optimistic that the sound position of the Spanish economy can be maintained or even improved, ?because the fundamentals of the Spanish economy allow us to look into the future and be confident that we will continue to perform as well as we have done in the past, or even better.?

Standard & Poor's (S&P), while not yet having awarded the kingdom its top rating, suggests that it does share Fernández's view to some extent, given that its AA+ rating is on positive outlook.

?The positive outlook is a strong indication that if there is any move in the future, in the short or medium term, then it would be upwards,? says Juan de la Mota, managing director for Spain and Portugal at S&P in Madrid. ?However, we do still see some weaknesses in the Spanish economy relative to its triple-A rated peers ? in terms of per capita GDP, unemployment, labour market reforms, and others ? even if these are only relative weaknesses and nothing dramatic.?

And de la Mota is looking forward to meeting with the new government soon as part of S&P's regular updates on the kingdom's rating. ?It is a very interesting time, with this new government in place,? he says, ?as they have come in with plenty of ideas and plans, and we have to factor in any impact these might have.?

Fitch's confidence in the Spanish economy was demonstrated last December when it joined Moody's in awarding the country a triple-A rating, saying that prudent fiscal policy was at the heart of its decision to upgrade the kingdom. The rating agency acknowledged that much needed to be done in the areas cited by S&P's de la Mota, but Fitch said that many important advances had been made and expressed confidence that strong real convergence with core euro area countries would continue.

The rating agency also declared itself pleased with the country's debt management. ?Prudent and competent debt management has extended the maturity structure of the government debt stock and reduced funding costs,? said the report. ?At the same time, the stock of short term debt has fallen, and the redemption profile of medium and long term debt has been smoothed. Consequently, liquidity and rollover risk have fallen sharply over the past few years, and short term residual debt is now in line with the average for the euro area.

?Liquidity risk is further limited through a combination of bank credit lines available to the Spanish treasury, and a large stock of government deposits held at the central bank. Together these items are equivalent to roughly 30% of the forecast debt servicing (plus short term rollover) for 2004.?

Across the curve
The fall in short term debt mentioned by Fitch had in fact been so great that it prompted Spain to rethink its letras del tesoro (treasury bills) market in 2001 and 2002, when it added three and six month maturities to its auctions, increased the average size of its bills fourfold and included the product on electronic trading platforms Senaf and MTS Spain.

?In the mid-1990s, we were issuing Eu80bn of treasury bills,? says Fernández. ?Now we only issue Eu40bn in bills, so the question was how, with these lower funding requirements, we could ensure the liquidity of our market. The answer was to reform our market in such a way that would ensure its efficiency and provide a liquid alternative for investors active in the treasury bills segment.?

This has clearly been achieved, with secondary market volumes rising and the number of international participants increasing. ?We have more international investors on board,? says Fernández. ?Nowadays more than 10% of outstanding bills are in the hands of foreign investors, whereas it used to be only 3%, and the figure is still growing.?

At the other end of the yield curve, the Kingdom of Spain had, in its issuance strategy for 2004, said that it might launch a 15 year deal if market demand and financing requirements warrant such an issue. However, developments this year mean that no such issue has emerged.

?We have been issuing in the 15 year maturity for quite a few years as we believe that this part of the curve enjoys very attractive demand,? says Fernández. ?We therefore said that we could launch a new bond in the maturity this year. But given the developments in the budget and our forecasts for our cash management, we realised that we did not need to issue this new bond yet.

?We will therefore wait until the first months of 2005 to consider this new transaction. This does not represent any strategic change on our view of longer dated bonds, but rather the outcome of the positive performance of the economy and the developments on the fiscal side.?

A flexible framework
This year the treasury has been operating under the revised general budget law, which came into force in January. The new text greatly increases the flexibility of the public debt department, but some of its aspects merely reflect developments over the previous 15 years.

?The previous budget law dated from 1988, so it was quite an old law and many things have changed in the market and in the way that the treasury has operated since then,? says Fernández. ?We therefore needed this new framework.

?Under the new law we can manage debt more flexibly. What we mean by this is that some options, such as pre-hedging, for example, were simply not considered under the old framework but are now allowed.?

However, the option of using derivatives does not mean that the treasury will suddenly become active in that market. ?We have analysed the activities of other treasuries in this regard and we have analysed the evolution of our average debt and duration,? says Fernández, ?and the results of these analyses show that our current issuance strategy allows us to generate a portfolio that enjoys the cost-to-risk balance that we are seeking and to comply with the objectives that we have set for the coming years.?

Fernández acknowledges that this position could one day change and points out that the budget law has been written in such a way as to take in as many potential developments as possible over the coming years.

A disinterested observer
Spain has so far remained shy of the burgeoning inflation-linked euro zone government bond market and according to Fernández this is set to continue, as the sovereign focuses on its core products.

?We have a strong commitment to the liquidity of our markets,? he says. ?Our gross funding figure has been around Eu80bn in the recent past and it will remain around that level. With Eu80bn being raised and about Eu40bn of that in treasury bills and Eu40bn in bonds, it would be difficult for us to incorporate new products into our offering without affecting the liquidity of our current lines.

?We would therefore rather continue to ensure the liquidity of our market, which we believe is a key characteristic demanded by investors.?

However the treasury is watching developments in the inflation-linked market with interest. ?Demand for index-linked bonds is growing in Europe and other sovereign issuers have been successful in their activities in this market,? says Fernández. ?We are therefore analysing the market and could perhaps at some future time issue this type of product, even if we will not be doing so for the time being.?

Another move to have caught Fernández's eye has been the creation of the Dutch direct auction system by the Dutch State Treasury Agency. The technique is a hybrid of the auction and syndication methods used by most sovereigns.

?The Dutch direct auction is a very innovative initiative put forward by the Dutch treasury and we are looking with interest at this alternative approach to attracting investors to your market,? says Fernández. ?In the European Union and within the euro-zone in particular competition for investors among issuers has become a key issue and the Dutch treasury has done a great job in this regard through its innovative approach.?

A rare foreign currency outing
In late October, the kingdom launched its first foreign currency bond since May 2001, a $1.5bn five year RegS/144a deal via ABN Amro, Barclays Capital and Credit Suisse First Boston. The issue was priced at 18bp over the five year Treasury, or some 23bp through Libor.

Part of the explanation for Spain's absence in non-euro markets had been that only in October did the sovereign sign its updated MTN programme to include the collective action clauses (CAC) recommended by G10 countries. The push for developed countries to include the clauses in their documentation is aimed at encouraging emerging market sovereigns to do likewise.

?Prior to launching the transaction we needed to update our MTN programme,? says Fernández. ?We modernised it, incorporating the collective action clauses, the 144a mechanism, and the most recent legal and registrar practices. Once we were ready from the legal point of view, we took advantage of a nice window of opportunity.?

The kingdom had several goals in mind when approaching the market. ?These were to further internationalise our debt,? says Fernández, ?to comply with the commitment of the Spanish government to incorporate the CACs in its international debt issues, to allow holders of our foreign currency bonds maturing this year to benefit from the exposure to our credit and, finally, to take advantage of an attractive opportunity to issue below our funding levels in the euro market.?

Fernández says that the sovereign was pleased with the results. ?With the valuable help of the lead managers, we have been able to achieve a highly diversified distribution,? he says. ?The oversubscribed book incorporated high quality orders from over 60 investors, with real money accounts and central banks representing over 70% of the book and close to 100% of orders on a cash basis. The strength of the order book together with its lack of price sensitivity allowed us to issue at the tight end of the price range and to achieve a cost effective funding versus our domestic curve.

?Last but not least,? he adds, ?we complied with our commitment to include the CACs in the documentation of our issues.?

Next door at Instituto de Crédito Oficial (ICO), a benchmark transaction is also being considered.

?We are considering the possibility of launching a one billion transaction in either euros or dollars,? says Antonio Cordero, financial markets manager at ICO, ?but we are in no rush.?

ICO's funding target for 2004 is Eu3.5bn-Eu3.7bn and by mid-October the agency had raised some Eu2.7bn.

?We could raise further amounts either through a benchmark, through private placements, or by re-opening some outstanding issues,? says Cordero. ?In fact if we were to raise Eu1bn or $1bn through a single transaction, it would partly be pre-funding for next year. We are in a very comfortable position.?

One factor that could work against a new benchmark, says Cordero, are the limited windows of opportunity before the year end. ?With the US elections, holidays in Asia and important economic indicators due out, there are not many weeks left in which we could launch a benchmark transaction, and we have to take that into account,? he says.

A sterling achievement
Many market participants had been trying to second-guess ICO's plans in early October when the agency chose neither dollars nor euros for its latest large foreign currency issue, but sterling. ICO had only tapped the sterling market once before, in 1999 with a block trade, and its first public foray into the currency proved a hit.

Lead managers Barclays Capital and HSBC had first discussed the project with ICO ahead of the summer holidays, but the agency chose not to proceed at that time because it was dealing with some internal changes resulting from the arrival of the new government and also because it had ample liquidity.

But in September ICO visited London on a non-deal roadshow and talked to sterling investors about what their preferences for a sterling issue might be, in terms of size and maturity. And when ICO did launch the £300m five year transaction at 29bp over the 4% March 2009 Gilt in early October, it had clearly delivered what investors were looking for.

?This issue went down extremely well,? said one market participant. ?Investors are looking for triple-A assets and were keen buyers of a new name in the asset class.?

ICO's goal in launching the transaction was to broaden its investor base. ?We are really proud of this sterling transaction,? says Cordero. ?It has enabled us to access a new investor class as asset management accounts made up a big portion of the buyers. The main driving force for our big public transactions is usually central banks, mainly in Asia, but here we could achieve great diversification.?

The Spanish agency was even willing to give up 1bp-2bp in its quest for new investors. ?Pricing was not on this occasion the driving factor,? says Cordero. ?The idea was to broaden our investor base and although we got a decent level, it was somewhere in between what could be achieved in euros and dollars, and not as good as we could have achieved in dollars.?

At the same time, some accounts said that they would have liked to have seen a wider spread. ?We would have liked to see a bit more space between ICO and KfW ? the differential was only a couple of basis points ? to account for ICO's slightly lower rating.?

The investor did, however, acknowledge that the deal was still attractive because of the diversification play on offer, and ICO has consistently shown that, despite maintaining an often aggressive approach to pricing, it can sell at competitive levels.

?Sometimes investors complain about the spread of our transactions against the Kingdom of Spain, because it is narrower than the spread of KfW against the Bund,? says Cordero, ?but this is where our transactions trade and where they can be placed.

?We are very pleased with the spread we have against the kingdom,? he adds, ?and although the sovereign's absence from the dollar market for some time makes it hard to judge in that currency, in euros we pay no more than 3bp, 4bp, or maybe 5bp more than Spain.?

Spotting opportunities
ICO's funding strategy has taken it across many currencies and structures this year. One highlight for the issuer was a A$250m November 2006 bond in Australian dollars, ICO's second in the currency after a debut last year.

Some 60% of the bonds were sold into Australia and next year ICO could make further inroads into the Australian market. The agency has seen the success with which other top credits have accessed the Kangaroo market this year, particuarly early in the year, and is considering establishing a Kangaroo programme. However, no final decision has been made and any move will depend on market conditions next year.

ICO considered tapping the Canadian dollar market earlier this year and would have done so had arbitrage been available. However, while some of its peers have this year launched successful global Canadian dollar issues, ICO is sticking to Eurobonds. It has not updated its global programme since 2001 as it considers the Euromarket sufficently large to absorb its Eu5bn-Eu6bn average annual funding needs.

The MTN market has provided ICO with plenty of funding this year, although Cordero says that there are restrictions on its activities in that market. ?Our financial risk department has to feel comfortable with the structures that we do and with their valuation,? he says, ?and although there are a wide variety of structures available, we can only do a few. For example, one of the most popular structures has been the power reverse dual currency, but we cannot do it, although we are in discussion with the financial risk department about this.?

ICO's funding volumes depend on its asset side and the government's plans, but after a more modest year than usual this year ?resulting from high redemptions of assets ?its funding is likely to increase back to the more regular Eu5bn-Eu6bn in 2005.

Lead sponsor:

28 Oct 2004