It used to cost banks money to be primary dealers. But in the last 12 months the government auction business has swung back into profitability and worked exceptionally well, considering the vast increase in issuance volumes. Will 2010 be as sweet?
Julian Evans reports.
The government bond markets have come through one hell of a year. As Paul Spurin, head of government bond trading at Royal Bank of Scotland, and vice-chair of the European Primary Dealer Association, says: "The market has been through the biggest test imaginable. On the one hand, governments were raising record levels of debt, and on the other, the banks were facing serious crises with their balance sheets."
Government bond issuance this year has broken records all over the world. In the US, the Treasury has borrowed an almost unimaginable $1.9tr, compared with $1.2tr in 2008 and $200bn in 2007. In Japan, the government is borrowing a record ¥149tr in the fiscal year ending March 2010, and its debt to GDP ratio is approaching 200%.
In the eurozone, governments raised almost €1tr, up 45% on 2008. In the UK, the Treasury will have raised a record £220bn by the fiscal year ending March 2010. The number of auctions the UK’s Debt Management Office (DMO) holds has ballooned from four in 1998, to 58 this financial year.
Meanwhile, the primary dealer banks that governments rely on to sell their debt have been struggling with the worst banking crisis since the Great Depression. Guy Reid, managing director for frequent borrowers at UBS, says: "What made things difficult was that, at a time of record issuance, the markets were extremely volatile and banks faced balance sheet constraints."
Stanislas De Caumont, managing director and head of European government bond trading at Credit Suisse, agrees: "In the first half of the year, a few of the banks who were active in the primary dealer market dropped off the radar. Some banks merged, some disappeared altogether, and most reduced their balance sheets dedicated to government bonds. So there was a reduction in the bidding appetite at some auctions."
The number of primary dealers in the US, for example, fell from a high of 46 in 1998, to a mere 16 at the beginning of this year.
This led to real concerns in the first quarter of 2009 that governments might struggle to meet their borrowing requirements, which would have sent a disastrous signal to the markets. Sean Taor, managing director and head of SSA syndicate at Barclays Capital, says: "If European sovereigns had struggled, the knock-on impact would have been huge. They were the borrowers of last resort. They had to lead the market, and show that it was still open."
Alarmist reports
So when governments looked to be struggling to meet their auction targets in the first quarter of 2009, it sent real anxiety through the market — anxiety that was magnified by alarmist reports about failed auctions in mainstream newspapers around the world.
For example, in March, the UK Debt Management Office failed to raise the £1.75bn it intended in an auction of 40 year bonds, raising only £1.6bn. The auction failure was seized on by newspapers, as well as by opposition politicians, including the shadow chancellor, George Osborne, who helpfully commented that: "It is too early to say, but the risk is that at some point the Government will not be able to fund its huge debts."
But Robert Stheeman, chief executive of the UK DMO, who has had plenty of practice of batting away irritating questions regarding the uncovered auction since it happened, remains calm. "Uncovered auctions always provide for headlines, but they don’t mean much in themselves. We’ve had them in the past — like in 2002, when our borrowing requirements were 10% of what they are now. When it happens, we just take the unsold debt on to our books and aim to sell it on later, as we did in April, for a lower yield."
Other DMOs had problems. Brazil cancelled an auction in August this year. Several German auctions have been uncovered. Belgium had to cancel the auction of a 10 year bond in September 2008.
Anne Leclerq, director of treasury and capital markets at the Belgian Debt Agency, explains: "The auction was on September 29, the day that Fortis collapsed. Given it was such an important bank for the Belgian primary market, it had an effect on volatility during the auction process. It particularly affected the 10 year auction, so we decided not to carry out that auction, and just opened the three year and five year benchmarks."
Volatility spikes
Volatility picked up substantially for just about every eurozone sovereign except Germany at the end of last year. Other eurozone sovereigns had traditionally traded at levels close to Germany. Suddenly, in Q4 2008 and Q1 2009, investors started to distinguish a lot more between sovereigns, with spreads on the so-called "Pigs" issuers (Portugal, Italy, Greece and Spain) widening by up to 100bp.
"At certain periods of the year, we had to pay a steep risk premium — our 10 year debt widened out to more than 100bp over Bunds, for example," says Alberto Soares, CEO of the Portuguese government debt agency.
The spread widening was partly caused by rating agencies downgrading sovereigns — Standard & Poor’s downgraded Spain, Portugal and Greece in January, and Ireland in March. Some analysts even spoke darkly of the break-up of the single currency. The outlook for the UK’s AAA rating was also switched to negative by S&P in May.
The volatility in asset prices made it riskier for banks to hold large amounts of government debt on their balance sheets.
James Rice, managing director of liquidity rates at Bank of America Merrill Lynch, says: "Investment banks are like warehouse managers. The volatility of eurozone government bond spreads made it more risky for us to carry inventory. It meant we had to adapt our strategy, because of the fairly significant risks."
The consequence of these various factors — tight balance sheets, increased price volatility and concerns over supply gluts — was that banks became less aggressive in their bidding at auctions.
And this in turn meant that liquidity dried up in the secondary market for some issuers. "The bid offer spreads grew very wide, and sometimes it was impossible to find bonds," says Leclerq of the Belgian Debt Agency.
Not all bad
While this made it a very challenging environment for primary dealers, it also made it potentially a very lucrative environment. "For once, it was a profitable business," says De Caumont of Credit Suisse.
"The market has almost gone full circle," adds Paul Spurin at RBS. "In 2006, the trend was that banks were withdrawing from primary dealerships, because it was too cost-intensive. Only the very biggest banks who offered every possible product and derivatives could afford the bill."
One managing director at a leading firm admits: "The auctions market was a loss-maker for many banks. The rates business cost them tens of millions of dollars, if not hundreds of millions, every year."
That was because banks bid aggressively, and often over the market price, during auctions, to win market share, get to the top of primary dealer league tables, and then hopefully win syndications — most DMOs say they award syndications based, partly, on league table positions. "Why be in the business?" asks one head of syndicate. "There’s the visibility aspect. Banks like to be recognised as primary dealers in a country."
But banks sometimes had trouble selling on the debt of less liquid sovereigns, for example of EU accession countries like Poland or Slovenia. In 2007, Goldman Sachs publicly walked away from NewEuroMTS, the trading platform for CEE sovereign debt, saying the costs of participating in the platform were too "onerous" for it to be worthwhile taking part.
One trader says: "2006 was probably the worst year for the business. But the last 12 months or so, it has become quite a lucrative business. The bid offer spread has returned, and there’s good money to be made."
De Caumont of Credit Suisse says: "Supply went up while demand fell, which obviously favoured the banks. Issuers had to make some concession to the market. Bonds would be issued at historically wide levels, and then tighten in a few weeks later. Banks took some advantage of this."
Rates pay again
Will Scott, director of rates trading at BofA Merrill, says: "You had European issuers trading at record highs. It was a once-in-a-decade opportunity. If investors could do this year again, I think many would put as much money as possible into eurozone government bonds."
DMOs say they also heard from primary dealers that the business had become more attractive.
Leclerq at the BDA says: "Before the crisis, it was getting more difficult for banks to be in the primary dealer business and make money. We had a lot of primary dealers telling us it wasn’t an easy business. Now, they tell us it’s become an interesting business again."
Indeed, the interest rate business was one of the main drivers behind investment banks’ record profits in the first quarter of this year. Morgan Stanley estimates that 58% of investment banks’ revenues in the first quarter came from fixed income, currencies and commodities (FICC).
At Deutsche Bank, for example, FICC was up 68% in the first quarter, while Goldman Sachs made a jaw-dropping $6.6bn profit in FICC in the first quarter, more than double what it made in Q1 2008.
Issuers turn to innovation
While fixed income desks were filling their boots, DMOs were trying to come up with ways to make sure they hit their borrowing targets. Most of them had stepped up their discourse with their primary dealers.
"During the crisis, all DMOs were definitely more in touch with dealers than they were in the past," says PJ Bye, head of public sector syndication at HSBC. "It was very valuable for them to know when we saw good demand from one or other particular investor."
There were also instances where investors became more involved in auctions, attending with a primary dealer and submitting a bid — Axa, Generali and Bank of International Settlements (BIS) are some of the investors that have bought government bonds at auction during 2009. For the primary dealers, it was a good way to make sure their balance sheets did not stay burdened for long, while for investors, it meant they could secure large blocks of bonds.
DMOs also tried to introduce greater flexibility into their auction processes, for example, by opening off-the-run, or non-benchmark, bonds when bankers or investors told them demand was there.
"Big issuers like France, Germany or Italy have not changed their auction calendar, but they have maximised demand by tapping off-the-run bonds," says Bye at HSBC.
"France, for example, at a recent auction, didn’t only tap the 10 year, 15 year and 30 year benchmarks, but also seven year, eight year, 12 year and 20 years, according to where the Agence Trésor heard demand was strong."
Belgium’s Leclerq agrees: "We took to issuing more off-the-run bonds. It allows the agency to look at what traders are really demanding. For example, we held an auction in September for 2028 bonds, which was off-the-run, and we attracted €1.8bn of bids for a €1.2bn offer."
Belgium also took to holding auctions bi-monthly rather than monthly. Other DMOs have also upped the number of auctions they’ve held — the most significant example being the UK DMO, which has taken to holding mini-auctions, in between its scheduled auctions.
Stheeman of the UK DMO explains: "We’ve tried to make it easier for primary dealers and investors. For example, we introduced mini-tenders in the third quarter of the last financial year (in October 2008). Our auction calendar provides a lot of predictability, but it can be a bit inflexible. Mini-tenders are smaller-sized operations, which allow for a smaller amount of debt to be with less pre-commitment. We announce the identity of the Gilt to be sold a week or so in advance, and it lets us be more responsive when we see, say, strong demand for individual bonds. We’re planning to issue around £12bn through mini-tenders this year, of a Gilt sales total of £220bn."
The UK DMO has introduced other innovations. Stheeman says: "In April, we also introduced the post-auction option facility, which allows primary dealers to purchase an extra 10% of the nominal amount they successfully bid for at auction in a fixed timeframe (to 2pm) following the auction. We judge that participants will value this option during auction, and it provides an incentive for dealers to bid more aggressively at auctions."
Dealers have responded well to these innovations. Andrew Graham, head of sterling rates trading at BofA Merrill, says that the UK DMO’s innovations have been well received by the market: "The mini-tenders have been a very useful tool for the DMO to auction the bonds that the market has the most need for."
More syndications
For many DMOs, the unpleasant experience of watching their bonds cheapen sharply during auction and even of having auctions uncovered combined with their ever-rising borrowing requirements persuaded them that they needed to rely more on the syndication market.
The UK DMO, for example, made an unusual return to the syndication market in June, issuing a £7bn 50 year bond, which was the largest ever sovereign bond of that maturity.
Stheeman says: "It’s quite new for us to use syndications, though we did it in 2005, to launch the first ever 50 year inflation-linked bond. This year, the motive for introducing the syndication programme was we wanted to align our supply of longs and linkers with market demand. We felt that in the context of our high financing demands and difficult market conditions, it would facilitate higher levels of issuance."
De Caumont of Credit Suisse says: "There were a lot more syndications than usual among eurozone sovereigns as well — probably 10% of total issuance was via syndications. It was useful for smaller or lower-rated issuers. Greece, for example, only used auctions for T-bills. When there was a lot of volatility in spreads and bonds could cheapen suddenly during auctions, syndications meant governments had a better idea where their bonds would price. Issuers could also place a larger size than they would have done via auction, and add some supply without disrupting their auction calendar."
Syndications also meant banks didn’t have to provide so much of their balance sheet to warehouse debt. "There were certainly more syndications this year than in previous years," says Reid at UBS.
"A number of issuers preferred the certainty of execution and the larger volumes that can be achieved via this distribution method, compared to auctions. The greater level of syndications was positive for banks considering the league table and fees these transactions generate."
Stheeman says auctions aren’t necessarily cheaper than syndications: "It is a fallacy to think that auctions are cost-free. Often, the market builds in concessions ahead of the auction, with yields going up in the run-up to the auction. The difference is that with syndications, you pay explicit fees."
Aggression returns
As 2009 progressed, it became clear that, for the time being at least, the government bond market was working well and would be able to absorb this year’s record levels of debt. "The fact all this debt was sold shows how deep and well functioning these markets are," says Brian Coulton, head of EMEA sovereigns at rating agency Fitch. "Governments have been able to raise record amounts of debt with limited impact on their borrowing costs."
One trader in US rates says: "Looking at the US market, it’s quite an achievement that the US Treasury has been able to sell over $1.5tr of debt this year, with fairly low levels of volatility. Sure, you sometimes see tails of maybe 4bp or 5bp after auctions. But considering the levels of issuance, a tail of a mere 4bp is quite impressive."
Paul Spurin at RBS is surprised at how quickly the market came back to more normal levels. "The speed with which the market has recovered has amazed me," he says. "Up to the summer, volatility was still very high. Then, over the summer months, spreads suddenly came down again, and banks started being much more aggressive once more in bidding at auctions."
Guy Reid at UBS agrees: "The markets have returned to normality, and banks want to position themselves for the business. Competition has probably never been so intense in the sovereign business."
De Caumont at Credit Suisse has also seen competition return. "It’s become very aggressive again in the last two months," he notes. "Banks are once again aggressively bidding over the market price at auctions in order to win market share. For example, in early November, Spain held an auction for five year bonds that was priced 14 cents above market price, and in mid-November its 15 year bond was priced 25 cents above secondary market price."
Why the sudden increase in bidding aggression? One reason is the number of bidders in the market. While at the end of last year, the number of bidders fell because of mergers and bankruptcies, now new players are looking to establish themselves in the primary dealer business. Santander, for example, is making a push into the market, and joined the list of France’s primary dealers in June.
US investment bank Jefferies has also joined the list of primary dealers in the US, where Nomura has also re-joined the list, having pulled out in November 2007. RBC Securities, the Canadian bank, also joined the US primary dealer group, and bankers say RBC and Scotiabank are also looking at moving into the European primary dealer market, as are Daiwa Capital Markets and MF Global.
Even hedge funds are considering applying for primary dealer status. Citadel Investment Group, the Chicago-based hedge fund, is considering a move into the European primary markets, according to wire reports. Citadel had expressed a desire to join EuroMTS, the electronic primary dealer platform for European govvies, although MTS refused after banks threatened to walk away from the platform.
Obvious appeal
The lure of the business is obvious, says Reid of UBS: "There’s a huge amount of sovereign business to do, whether its syndications, securitisations, asset disposals, or secondary trading. If you’re going to commit your balance sheet anywhere, it’s a good market to be in."
But some established players think the new arrivals may have missed the boat. "Some people got into the market at the beginning of the year, thinking market conditions would stay that generous," says Spurin at RBS. "But bid offer spreads are very tight once more. We’ll see if the new players have the economies of scale to stay competitive. I think we’ll return to a situation where there is more concentration in a few big banks."
Morgan Stanley predicted, in a report on the future of banking published earlier this year, that the banking market would indeed become dominated by a handful of a few large "flow monsters", who had the balance sheet to bully smaller banks out of the market in balance-sheet-intensive businesses like government bonds.
If that happens, then DMOs will have to be careful that the concentration of market players doesn’t lead to the emergence of cabals or price-fixing. There have been instances of market manipulation in government and municipal auctions in recent years — indeed, executives from CDR Financial, a California municipals broker, were indicted in October by the US Justice Department for rigging auctions.
However, the sanctions for banks if they are caught manipulating the market are severe. One only has to look at the example of Citigroup, which manipulated the European government bond market in 2004 by selling €11bn of bonds in two minutes on the MTS platform, then buying back €4bn a few minutes later when prices had collapsed. The Citi traders, who were later indicted, called the trade "Dr Evil" in emails, in a reference to the villain of the Austin Powers films.
Citi itself was fined £14m by the UK government for the trade, but more serious was the ground Citigroup lost in the government syndication business. "No one would give them any business for a couple of years", says the head of one DMO.
The challenges for 2010
Next year, governments may issue even more debt. "2010 will set a new record for gross issuance by sovereigns in the eurozone," says De Caumont at Credit Suisse. "We think issuance will break through the €1tr mark."
Issuance might be slightly lower in the US, with the Treasury raising a mere $1.5tr. But the UK is likely to raise a similar amount to this year, while emerging markets will probably see higher levels of issuance, with names like Russia returning to the syndications market.
"It’s going to be another challenging year," says Sean Taor at Barclays Capital. "There is likely to be a lot of congestion in the market, with a lot of activity in the first quarter."
Scott of BofA Merrill says: "The challenge for 2010 for sovereigns will be pushing out their maturity profile."
Reid at UBS agrees. "At the beginning of the crisis, governments dramatically increased their one month to 12 month debt," he says.
"Rates were very low at the short end, and investor demand was very high. Sovereigns who required additional financing to stabilise financial markets were reluctant to add to their long-term borrowing requirements. Now, they have huge outstanding short-term liabilities, and the market has improved. So there’s a need to term out some of the shorter-term debt."
The Netherlands has the highest proportion of its debt in T-bills, at 22.9% as of August, down from a high of 30% in January. Most of the T-bill debt was raised to finance to bank bail-outs. Spain and France both have 18% of their debt in T-bills, which for France is the highest level for 12 years.
Germany only has 4% of its debt in T-bills, but demand seems to be tapering off at the short-end of the curve, and the sovereign only found €5.8bn in bids for a €6bn Bubill auction in October.
UBS’s fixed income research team said in a recent note: "We view short end rates as being at increased risk of a correction as excess liquidity drains from the Eurosystem and bank demand for short-dated debt tapers off."
At the longer end of the curve, however, investors and bank are faced with the threat of inflation. "There’s a risk that the ECB might err on the side of caution, and leave rates low for too long," says Spurin at RBS. Then, if inflation picks up, that would impact the demand for longer maturities. It’s a question of the credibility of the ECB."
One way round this is for sovereigns to issue long linkers or floating rate notes, as indeed many have been doing this year. Some of the longer term debt may have to be initially raised by syndication. Spain, for example, sold a three year FRN in July through syndication, with the deal pricing at Euribor less 5bp. It tapped the issue through auction in November.
In the US, the Treasury Borrowing Advisory Committee, which is made up of US primary dealers and large investors like Pimco, took advantage of its meeting with Treasury officials in November to recommend an increase in the issuance of Treasury Inflation-Protected Securities (Tips).
The minutes of the meeting say: "The committee generally recommended that the overall issuance of Tips be increased over the next couple of years. For FY2010, Tips issuance should be increased from the current run rate of $58bn per year to an overall issuance amount of between $70bn and $80bn per year across securities. In FY2011, overall Tips issuance should be further increased to between $100bn and $125bn."
Of course, the real question for 2010 is whether the markets can absorb an equal amount of debt as this year, without the benefit of central banks providing trillions of dollars in bank liquidity and quantitative easing bond purchases.
The Bank of England, for example, bought £175bn in the secondary market, while the UK Treasury has so far issued £153bn this financial year. The Federal Reserve has been similarly aggressive, while the ECB has injected over €1tr into the European banking system via short-term liquidity auctions.
Most bankers expect QE to end sometime in 2010. "We expect QE to end next year," says Taor at Barclays. "It’s hard to know the magnitude of the impact, but clearly it’s going to be a challenging act, both exiting QE and raising record amounts of debt."
Andrew Graham at BofA Merrill says: "There is no question that QE has helped in keeping yields lower than they otherwise would have been. When QE stops then Gilt yields will probably have to rise to enable Gilt supply to go as smoothly as they have this year."
Careful exit
All Robert Stheeman at the UK DMO can do is hope the QE exit is handled carefully, although he is quite optimistic about next year. "Any big buyer distorts the market," he says, "but as the Bank slows down its QE programme, and yields may move up, presumably our debt will be more attractive to other investors. My main concern is that any market adjustment happens in as smooth, orderly and frictionless way as possible."
Anne Leclerq at the BDA makes the valid point that, while QE is ending and government debt issuance is hitting record levels, other sources of high grade issuance have dried up completely, such as the $3.6tr-a-year securitisation market. New issuance in the multi-trillion dollar government-guaranteed debt market is also likely to dry up next year as the schemes are retired.
Bankers are confident that the government bond market will rise to the challenge of 2010 as successfully as it has risen to the challenge this year. Scott at BofA Merrill says: "As we finish the year, there’s a confidence that these markets will continue to work. It’s just a question of finding the right price. That’s what’s changed this year. At the beginning of the year, people were asking ‘can governments raise all this debt?’ And now the question is ‘what price?’"