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All eyes on the long end in euro SSA bond market

02 Dec 2005

Agence France Trésor's 50 year OAT and the European Investment Bank's 30 year Earn have taken euro benchmarks into previously uncharted waters this year. And behind these flagships have come a flotilla of other issuers seeking to ride the wave of liability-driven investment.

One story has dominated the headlines when it comes to benchmark euro transactions this year, and it has been a long one. Since the beginning of the year the move along the yield curve by issuers and investors alike has been impossible to ignore.

The trend was evident as early as the second week of the year when the Kingdom of Spain put down a new marker for the euro market — a Eu6bn 32 year Bono, led by Barclays Capital, Banco Bilbao Vizcaya Argentaria, Calyon, Deutsche Bank, Dresdner Kleinwort Wasserstein and Santander Central Hispano.

Investors placed some Eu17bn of orders for what was then the longest government bond in euros, enabling the Kingdom of Spain to achieve record tight pricing.

José María Fernández, head of the public debt department at the Spanish Treasury in Madrid, told EuroWeek: "If you adjust for the difference in maturity between our issue and the 2034 Bund, the spread of 4bp over the Bund equates to 3bp over the curve, which is the best level we have been able to achieve for a syndicated deal."

Just in case anyone remained unconvinced about the blossoming of the long end after the 30 year successes of Spain and several of its peers, Agence France Trésor undeniably took the euro market into new territory with the first ever 50 year government bond in the currency.

Launched in late February by Barclays, BNP Paribas, Deutsche and HSBC, the 2055 OAT attracted a Eu19bn order book comprising 200 accounts from 22 countries, allowing France to create a Eu6bn benchmark.

Not bad for an exercise that the Trésor  had only begun to discuss with investors in a concrete manner a few weeks earlier.

"What was most surprising about the deal was the speed at which it could be executed," said Benoit Coeuré, deputy chief executive officer of the Trésor. "We had envisaged various options regarding the timing and the reality was the quickest of any that we could have imagined."

Much expected of investors

France's banner transaction set the tone for much of the activity this year. "It was such a huge success in terms of the approach and the execution," says one frequent issuer syndicate manager. "It performed well and got investors involved in the French curve who hadn't participated before — it even got some accounts who didn't normally buy fixed income to have a look.

"The convexity angle was probably the main conversation for the first three to six months of the year."

Investors are increasingly preoccupied, not just with how to make simple curve plays or pick up some extra yield, but how to match the structure of their assets and liabilities.

Emanuele Ravano, Pimco's head of portfolio management in London, explained in the run-up to the French 50 year deal that there was a basic obstacle to doing this. "If you look at the Dutch pension fund system, some pension plans have a duration for their liabilities that extends out to 20 years, whereas the longest duration asset available in terms of coupon bonds is about 18 years," he said. "The ability to buy longer duration assets would clearly be a plus for such institutions."

However, he added that more important was the convexity of the instrument. "The main problem for pension funds is not duration, but matching the convexity of their liabilities and their assets," said Ravano. "The longest bond they can hold at the moment is a 30 year, but when interest rates fall their liabilities rise at a more exponential rate.

"A 50 year bond would allow them to better capture the convexity they need and allow them to better neutralise the risk."

One banker said that while the duration of the 50 year bond would only be 24% greater than a 30 year's, its convexity would be 75% more.

Such considerations are rising to a new prominence with the growth of liability- driven investment. Pension reforms in the Netherlands, for instance, were cited as a prime example of how investors would increasingly be compelled to match their assets and liabilities.

However, what one banker called "old-fashioned" reasons for buying out along the curve also played a big role in driving demand for what were the highest yielding euro zone government bonds available.

Some classes of investors, such as hedge funds, also bought in the anticipation of curve flattening driven by the trend towards liability-driven investment.

Supply ebbs and flows

Since the first quarter of the year, long bond issuance has slowed gradually, but that does not mean the early burst of activity was mere hype.

"People just wanted to get funded early in the year, and government new issues are often concentrated in the first quarter," says one DCM official in London. "And once you see such a trend and investors buying in a certain part of the curve, you want to be out early, not late, because you don't want to be the last issuer in a sector as the depth of demand might not be what it was.

"Demand has been very robust," he adds. "There is a very strong institutional investor base behind these issues that very clearly wants to extend, that is concerned about asset-liability matching. And that demand is not going to go away."

Indeed, some bankers say the trend will gain support as time goes on.

"The Dutch pension reforms that had been expected to come into force on January 1, 2006 are now scheduled for implementation on January 1, 2007," says Hans den Hoedt, head of public sector origination at ABN Amro in London. "But Dutch pension funds see no reason why they should wait until then and have already started to work on the necessary changes."

Many are locking in longer dated assets when 30 year yields approach 4% or slightly higher. "For a lot of them that is something of a threshold," says den Hoedt. "And a lot of them are still active on the swap side as well as bonds."

Demand has ebbed and flowed during the year as the shape of the curve has evolved. In the early months the spread between the 10 and 30 year parts of the curve was close to 70bp. This fell to around 40bp in April, before backing up again to about 60bp.

The spread between 10 and 30 year government bonds is now around 30bp, with about 36bp between 10 and 30 year swaps. These gaps are expected to narrow further.

"At the start of this year we forecast that the curve could flatten to anywhere between 10bp and 20bp if January 1, 2006 was achieved for the Dutch reforms," says den Hoedt, "and we now believe that such a level is going to happen next year."

The EIB does its duty

As is often the case, developments in the government bond market cascaded into the supranational and agency sector.

Not surprisingly, it was the institution that has done most to align itself with the sovereign sector that produced the most impressive long dated non-government bond.

The European Investment Bank showed the potential for non-sovereigns to issue long dated paper with a Eu5bn 30 year Euro Area Reference Note (Earn) in May, led by Barclays Capital, BNP Paribas, HSBC and Morgan Stanley.

It was only in 2004 that the EIB had pushed benchmark issuance from supranationals and agencies as far out as 15 years; now it went twice as long with a 2037 bond paying a 4% coupon.

"The books opened on Monday morning London time and closed 36 hours later," Barbara Bargagli-Petrucci, head of the EIB's funding department in Luxembourg, told EuroWeek. "After reaching close to Eu8bn on day one, the total order book closed on Tuesday afternoon at over Eu11bn, more than twice oversubscribed relative to the final deal size. This is the largest order book ever for an EIB Earn."

Just as pleasing for the EIB as the size of demand was the quality of accounts. "The real gain for the EIB has been a further likening of their investor base to sovereigns," says Rob Whichello, co-head of European syndicate at BNP Paribas in London. "It has in the past been quite frustrating for agencies and supranationals that their curves were much steeper than sovereigns' and that they did not really benefit from quite the same interest in 10 years and beyond.

"That has really started to change. The levels that the EIB, for example, can attain in 10 years and beyond have improved and that is because they have opened up these new maturities and got investors involved in their deals who previously only bought sovereign benchmarks."

The EIB was also able to price its new 30 year at the same spread over mid-swaps — plus 2bp — as it obtained with its 15 year in 2004. That was just 2bp over where its 10 year Earn was trading.

"The Libor curve for sovereign issuers from 10 years to 30 years is incredibly flat and in some cases inverted," says Allegra Berman, head of frequent borrower origination at UBS in London. "So on a Libor basis for a supranational or top quality agency issuer, the cost of extending along the curve has been marginal, to the tune of a couple of basis points."

A rising tide lifts all ships?

No other non-government, triple-A rated borrower has yet launched a 30 year benchmark, but further issuance beyond 10 years has confirmed investors' appetite for duration in highly rated credits.

Caisse d'Amortissement de la Dette Sociale (Cades) launched a Eu4bn 15 year trade the week after the EIB's 30 year, led by Barclays, Credit Suisse First Boston, DrKW and SG CIB.

It proved one of the most successful issues to date for the agency, which funds the French social security deficit and has recently had its funding requirement increased.

"Fifteen years is an interesting maturity for us, given that it is the longest maturity that we can use at the moment on the basis of the debt that we have taken over so far," Patrice Ract Madoux, Cades's chairman in Paris, told EuroWeek. "When we take on the remainder of the debt then we may try to issue longer dated bonds.

"For investors, it is clear from the fact that we were able to build a book of Eu8bn that there is still unsatisfied demand for long dated paper, as has already been demonstrated by the successful 30 year trades that we have seen."

Long dated agency issuance since then has been thin, but the deals that have emerged have typically been well received.

OBB Infrastruktur Bau, which is responsible for financing the Austrian railway network and has taken over Schig's funding role in the capital markets, chose the 15 year maturity for its inaugural euro benchmark, a Eu1bn October 2020 transaction led by CSFB and Deutsche in October. The triple-A rated and zero risk weighted issuer is guaranteed by the Republic of Austria.

"The longer maturity played well into investor demand for long end product," said one syndicate member. "There was a strong order book of over Eu2bn, and the deal tightened by 0.5bp. What more could you want for a debut?"

However, while some issuers might have long dated assets that are suitably funded by long dated bond issues, this part of the curve is not to everyone's taste.

"Some issuers simply don't need 30 year money or don't want to take that view on the market," says one debt capital markets (DCM) official. "Take KfW, for example. It makes no sense for them, given their investment portfolio and their loan portfolio, to be issuing 30 years. So for them paying 3bp more than where they trade in 10 years seems like a huge amount."

Liquidity deepens

But some bankers are optimistic about the prospects of supply from other quarters. "There should be more long dated issuance to come," says Armin Peter, a public sector syndicate official at HSBC in London. "The EIB's 30 year opened the door for the agency market and OBB, for example, hinted at what can be done.

"Other markets that can offer high and stable ratings as well as the promise of liquidity are also entering this maturity range. I am pretty sure that at some point we are going to see a 30 year covered bond, for instance."

After the success of this year's long dated cédulas issuance, the odds are shortening that Peter will be right.

In January, Caja Madrid launched the longest dated benchmark in the covered bond market — a Eu2bn 20 year deal led by Barclays, Caja Madrid, HSBC and Ixis CIB — and a steady stream of its peers have followed it out along the curve.

Indeed, Carlos Stilianopoulos, head of capital markets at Caja Madrid, recently told EuroWeek that there was already interest in a 30 year cédulas issue.

"A couple of banks have been trying to bring us to the 30 year maturity over the course of the year," he said. "However, we did not have the need to raise funds at those times and that is why we have not issued so far. But we could go longer than 20 years.

"We would just have to make sure that investors understood that the longer you go, the less liquid the issue is going to be, because most of the investors will be buy-and-hold accounts. And in any case, we would not be able to launch a very large issue, of Eu2bn-Eu3bn, because we don't have enough assets on our book of that maturity, although we could comfortably do Eu500m-Eu1bn."

A growing number of bankers say this is not a large concern. "If you had done a 15 or 20 year covered bond transaction some years ago, you would have needed to provide size for liquidity reasons as there was hardly anything else in that part of the curve," says one syndicate manager. "But now the investor has a broader range of choices to trade in and out of in triple-A assets, and sizes need not be so large."

The buy-and-hold approach of many long dated investors has certainly not impeded liquidity in all of this year's deals. "The 30 year Earn, for example, trades no worse than a 1bp bid/offer spread and is quite liquid," says Nick Dent, head of the frequent borrower syndicate at CSFB in London. "Not all long dated issues are so liquid, but the Earn is Eu5bn and I've never heard anyone say that it has gone technical or that they couldn't get any bonds.

"We've seen this whole play down the curve and it is trading like a government surrogate, there is no question about that." 

 KfW and the EIB — the tortoise and the hare?
While euro benchmarks have extended along the yield curve, they have in some cases got smaller.

In December 2004, KfW, the German development bank, announced that it was cutting the minimum sizes of its benchmarks. In euros that meant a reduction from Eu5bn to Eu3bn in maturities of five years and shorter.

This followed a similar reduction in size for maturities beyond five years and was accompanied by another reining in of KfW's ambitions: it would no longer commit to issuing five and 10 year benchmarks.

The aspirations of Depfa — the Irish registered public finance bank — also shrank, when it cut the minimum sizes for its benchmark covered bonds this year to Eu3bn in maturities up to and including five years, and Eu2bn in six to 10 years.

These moves reflected the sentiments of many market participants.

"A couple of years ago big was beautiful," says Armin Peter, public sector syndicate official at HSBC in London. "But now it is all about being as big as investors' demand."

And this, in turn, means balancing two needs. "Which do you care about most as an investor — liquidity or performance?" asks Julia Hoggett, global head of capital markets at Depfa Bank in Dublin. "There is an inflection point between these two factors. If you size a deal too small, it will perform brilliantly, but when you ask for a bid for Eu100m of the bonds you bought in primary you won't get one because nobody is making a liquid enough market for you to make the profit you think you've made from the screens. If it is too large, you can trade it at the price you see on screen, but it may not give you outperformance."

The precise location of this inflection point has varied through this year and is likely to remain a matter of debate as the euro interest rate environment turns bearish.

The flexibility that Depfa and KfW have afforded themselves has therefore proved useful in 2005.

"Our main focus has been to fulfil the demand that we have seen and — with the flexibility that we announced at the beginning of the year, to be prepared to increase deals to Eu4bn or Eu5bn when appropriate — that is exactly what we have done," says Horst Seissinger, head of capital markets at KfW in Frankfurt. "This flexible approach was really appreciated by the market.

"Investors have felt that our bonds were priced according to market conditions and that the volume reflects the actual demand, so they have a high degree of confidence that the transaction will be executed properly, with all the bonds sold by pricing. This gives them confidence that there will be outperformance."

Indeed, KfW did not launch any benchmarks of Eu3bn in 2005. It started the year with a Eu4bn 10 year in January, followed this with a Eu4bn five year in June, and rounded off its euro programme in September with a Eu5bn three year.

The European Investment Bank, however, has continued to issue the Eu5bn size that is most directly comparable with benchmark euro zone government bonds, even in 10 years and with its groundbreaking 30 year Earn. Some bankers say the EIB is rewarded for its greater ambition.

"I do believe that the EIB and KfW should be very aware of the fact that real liquidity in their transactions is only seen at the Eu5bn size," says one head of frequent issuer origination in London. "The EIB has strongly stated that it will continue to do Eu5bn deals and they have been rewarded for that in the investor base that they have been able to tap into." 

02 Dec 2005