The flight to quality enabled sovereign borrowers to supplement their treasury bills with ever cheaper commercial paper issuance. Brendan Daly investigates what part CP has to play in their funding, and whether the tight spreads can continue.
In the European commercial paper market, the banks’ loss has been the sovereigns’ gain, as risk-averse investors have piled into sovereign, supranational and agency paper during the credit crisis.
Ever since the crisis began, investors, desperate to put their cash somewhere, but unsure which, if any, bank would be safe, even in the short term, grabbed any sovereign paper they could get.
At the end of 2007, there was $76.97bn equivalent of government/sovereign ECP outstanding; 11.3% of the $679.61bn total outstanding, according to Dealogic data.
At the end of October this year, the absolute total for the sector was up to $141.06bn, while its share of the market total was up to 21.5%.
The demand for their paper has enabled sovereigns to achieve ever-tighter levels in the CP market.
"It’s cheap for them," says Ian Bedford, head of CP dealerships at Royal Bank of Scotland in London. "The sovereign sector has certainly taken advantage over the last two years in terms of the changes in risk appetite, and I think they’re sensible to do it."
The crisis meant sovereigns needed more funding as well, and were happy to oblige hungry investors. Many have increased their funding programmes and lending on to central banks has been an important aspect of this.
"Spreads have become more attractive, but the reason for us to tap the commercial paper market has been for on-lending to our central bank, the Riksbank," says Maria Norström, assistant director for domestic and foreign currency funding at the Swedish National Debt Office.
Even though banks were struggling to sell directly to investors, they could get CP funding indirectly through the governments.
"Some sovereign issuers used the proceeds to fund local banks when liquidity was limited," says Peter Eisenhardt, head of short term fixed income origination, EMEA, at Bank of America Merrill Lynch and chairman of the ICMA ECP committee.
Picking up the bill
For most sovereign borrowers, treasury bills remain the main source of short term funding. But there are many advantages that CP offers over bills.
"A bill market trades based on an auction system, with specific auction dates and maturities, and sometimes there are issues that reopen," says Eisenhardt. "A CP market trades every day and is a tailored market in terms of maturities and amounts for each and every trade. So depending on your actual cashflows, you can issue to specific dates. You can please investors by issuing to specific dates. Flexibility is what it has going for it."
Flexible maturities enable sovereigns to use the market to manage liquidity.
"Because of the flexibility around maturity dates, someone like the Netherlands can use the one week market or two week market — parts of the curve that aren’t available in the bill market," says Sheldon Mair, director and head of ECP trading at Barclays Capital in London. "Because of that, a government borrower can use the market as a cash management tool to complement the bills, which is primarily a funding tool."
Issuers appreciate the advantages of CP issuance. "Commercial paper is an extremely efficient and flexible instrument to have as an issuer," says Norström at the Swedish debt management office. "As a sovereign issuer, our investor base in the money market is dominated by central banks. Commercial paper in foreign currencies is good to have and serves as a complement to the traditional short-term instruments available in the domestic market."
Some see the ability to diversify their investor base as a particularly important advantage.
"We have treasury bills, but we found that commercial paper is a different market with different customers," says Peter Nijsse, head of cash management, issuance and trading at the Dutch State Treasury Agency in The Hague. "So the most important thing for us is that we reach short term investors who would not buy treasury bills. And for them it’s more important to have specific maturity dates. Another difference is that we issue commercial paper in foreign currencies, which we don’t do in treasury bills."
The need to manage reserves adds to the importance of this aspect.
"Commercial paper opens up a non-euro investor base, which is important when you consider that the majority of central bank reserves are still in dollars," says Mair at Barclays. "And when you look at the majority of the sov/supra market being in US dollars, you can then look at it as a straight comparison to where US bills are yielding and see that you’ll have a fairly healthy pick-up at all times to US bills."
Thus, both methods have their place in any country’s funding strategy.
"Auctions have a role, because people come to know when to come and play," says Eisenhardt. "All the participants come on the auction day and they put their bids in and get their paper. But there’s so much flexibility in CP."
However, when push comes to shove, most sovereigns only use CP opportunistically, and were spreads to be insufficiently attractive they would stick to bills.
"We have a policy that if treasury bill financing were cheaper, then we would not be eager to issue commercial paper," says Nijsse. "Because we can issue treasury bills at certain dates and amounts and place it very easily, so why have the fuss of commercial paper? But it has recently been very attractive compared with treasury bills."
Of course, recently spreads have been more than sufficiently attractive.
"The levels are very attractive compared with the bill market," says Mair. "If you look at three months, the high quality sovereign names can trade anything from 10bp-15bp below their own bill levels, so that’s obviously fairly important for those borrowers."
The fact that most sovereigns see CP simply as a liquidity management tool to be used on an opportunistic basis means there is a limit to how much they would issue as CP as opposed to treasury bills.
"We typically use CP in our liquidity management to reduce costs" says Norström. "For instance, if it’s cheaper to issue CP than treasury bills in krona we would use that or other money market instruments. Using the international markets also enables us to broaden our investor base. It’s a very flexible and efficient vehicle to use."
It is not only demand for and supply of the product that determines an issuer’s CP spreads. Many sovereign issuers have benefited from a volatile basis swap, with euro-based sovereigns selling large dollar tickets at attractive spreads.
"The prices we have on the screen are very much determined by the basis swap, but I guess that’s the case for many commercial paper issuers," says Nijsse.
Will the music stop?
It seems likely that investors will grow less risk-averse and will begin seeking out yield. This may mean a move away from sovereign paper.
"Over time money funds will get hungrier for yield," says Eisenhardt. "And when that happens, some attention will shift from sovereign paper."
Already, sovereign paper outstanding has dropped from its highest level of 28.7% at the end of April to 21.5%.
In any case, it seems that the current tight levels for the sector cannot continue for much longer.
"We’ve kind of reached a nadir on yields," says Mair. "Though the underlying bid for sovereign paper and agency paper remains solid, the biggest danger is that as the flight to quality subsides investors will demand levels closer to those in the bill market. Investors that don’t like to swap will look at where these issuers are achieving funding in the bill market and try to demand the same."
However, in the first instance, investors have achieved yield by buying longer-dated paper in the safe names, rather than buying riskier names.
"As yields were coming down, there was still a steep money market yield curve," says Eisenhardt. "And if you were going to go down the curve, what type of issuer would you want to do that with? If everything was chaos and you were very worried and six months seemed like the rest of your life, you’d buy six month paper from those kinds of names. And that’s what investors have been doing."
Some dispute whether a fall in the sector’s outstanding CP is imminent, and any decline as a result of yield appetite may be counteracted by a fall in government guaranteed bank paper.
"Even more sovereign names are coming to the market," says Bedford at RBS. "Some of them might begin to take up the slack when some of the guarantees run out. I think that over the next five years the proportion of government guaranteed paper will probably fall. But over the next year or so some of the money that’s been flowing into banks covered by ‘blanket guarantees’ such as those in Denmark and Ireland could divert into sovereigns when the Danish guarantee runs out next year. But over the longer term we are likely to see a return to more normal conditions and possibly a bit more risk appetite."
Some new issuers have indeed positioned themselves to take advantage of the pleasant conditions in CP.
For example, New Zealand increased its ECP programme to $5bn in September from $1bn. Market participants expect the issuer to be well received by investors in the ECP market, though it still has not issued ECP since June.
Many issuers anticipate stable CP borrowing in the near future.
"I think for the near future our presence will more or less stay the same," says Nijsse. "As long as we have enough short term demand, we will not increase or decrease. Our outstanding can fluctuate quite a lot, because it’s very much demand driven, and we can use CP to a certain extent to address our own fluctuations in liquidity needs."
Some issuers may have higher requirements.
"We have lost a bit of supply to the term market, but I think issuers’ requirements will remain pretty stable," says Mair. "If anything you could see it slightly increase because there’s plenty of financing governments need to do to boost the recovery."
Indeed, though many funding programmes are likely to fall next year, they will probably remain higher than in previous years, and many will continue lending on to their central banks.
"A fair assumption is that the Riksbank would want to refinance some of the maturing CP going into next year, which means that we will keep some presence there," says Norström. "I don’t see us increasing issuance, unless something spectacular happens that we have not taken into account in our forecasts. Our funding needs in foreign currencies in 2010 will be less than this year."
Mair believes that the high rate of outstandings will not be maintained, but investors’ hunger for quality paper will mean that there’s always demand for sovereign CP.
"I think that we’ll see outstandings drift lower as the flight to quality trade abates," he says. "And I think clients will look to other sectors, but we’ll maintain a historically high core of outstandings as investors understandably exercise caution. The central banks will still have reserves to invest and some clients have set up separate government funds which will require assets. So there’s not the same kind of panic flight-to-quality trade there was, we’re just drifting slightly lower."