Sovereign debt managers are faced with a dilemma: on one hand they place great importance on transparency and predictability when approaching the market; but on the other, vast borrowing requirements are tempting them to look at innovative or alternative issuance techniques. Philip Moore looks at how sovereigns are striking the balance.
Opinion is split over how much room sovereign debt managers have to apply innovation to their funding programmes.
It’s not that the top-rated sovereign borrowers have no track record of innovation. France, with initiatives such the Balladur Bond in 1993 and Tec10 in 1996, springs to mind. So too does Italy, which made highly inventive use of securitisation before initiatives like SCIP fell foul of Eurostat guidelines on what does and does not constitute government debt (see separate article on securitisation). The UK has also provided its fair share of innovative offerings, with its inflation-linked bonds ahead of their time when they were first launched in 1981.
But debt management officials aren’t paid for writing snazzy headlines about innovation, nor for reinventing the wheel. And as most debt management offices and government treasuries do not have unlimited resources, the suggestion that they should devote some of those resources to exploring exotica at the fringe of the debt market is greeted by some with laughter. "We occasionally read about some of these exotic innovations and we receive e-mails from people peddling them," says Gonzalo Garcia Andres, head of funding and debt management at the Spanish Treasury. "We like to be open to new ideas, but frankly, we have our work cut out completing our funding programme through traditional markets and a handful of complementary instruments such as dollar issues."
Others point out that innovations need to serve a legitimate purpose, although this need not always be exclusively financial. At a pinch, it can be related to promoting share ownership (as the Balladur Bond project was), or to encouraging environmental protection (as recent initiatives from borrowers like the World Bank and the European Investment Bank have been). It can even be politically-motivated (as some of the early ECU issues were).
"The techniques that are going to have to be used in order to successfully undertake this kind of issuance are going to be critical," says Amir Hoveyda, head of EMEA debt capital markets at Bank of America Merrill Lynch in London. "We’ve started to see greater usage of, let’s say, less conventional means. In particular we’re seeing, and I suspect we’re going to continue to see, increase in syndicated offerings and more cross-border foreign currency issuance. When you look at what has happened, from a rating agency perspective, there’s been massive movements in the ratings space. We are seeing, and we anticipate to continue to see, much more active, proactive management of ratings by sovereigns."
In today’s market, however, innovation is not much use to the taxpayer if it doesn’t materially reduce a borrower’s cost either directly or indirectly through, for example, opening up new investor bases or adding liquidity.
Even then, debt managers say that the size of a sovereign’s borrowing programme can militate against innovation at either end of the spectrum. For borrowers with the largest funding requirements, innovative ways of raising a billion here or a billion there fly so far below the radar that they are unable to command the attention of debt managers or their advisors.
"I would argue that when you have a funding programme of over £200bn, or £4bn a week, as the UK does, innovation is not necessarily what you need to be concentrating on," says Moyeen Islam, fixed income strategist at Barclays Capital in London.
Size matters for Stheeman
A large funding programme on the scale of the UK’s brings a natural advantage in any case in the form of liquidity. That is why a borrower like the DMO sees the use of syndication that maximises the size of its new issues as comfortably the most important recent innovation in its funding strategy.
That is not to say that the door of the UK’s DMO is closed to other innovative ideas or proposals. Far from it. Conventional syndications, for example, were not the only alternative that the UK was willing to explore when it invited proposals on alternative issuing mechanisms at the end of 2008.
As its chief executive Robert Stheeman says, the DMO has also tweaked its issuance procedure recently by adding elements such as mini-tenders and the post-auction option facility. This technique, which has been used by a number of other sovereigns for many years, gives all successful direct bidders (be they Gilt Edged Market Makers or clients) the right to purchase an additional tranche of up to 10% of the bonds they bought at the relevant auction.
Another potential innovation that the DMO examined, but rejected, as part of the consultation process that began last December was the Dutch Direct Auction (DDA) method that has been used by the Dutch State Treasury Agency (DSTA) to issue five, 10 and 30 year Dutch State Loans since June 1993.
DDAs have worked well enough for the Netherlands, allowing direct bidding and encouraging broad participation of end-investors in bond auctions while achieving more competitive pricing for the Treasury.
The UK is not the only European sovereign borrower to have looked at DDAs as an alternative way of selling government bonds. "DDAs have been relatively successful in terms of the sizes they have been able to create and the distribution they have been able to achieve," says Greg Arkus head of frequent issuers and public sector debt capital markets at Credit Suisse.
Proof of the resilience of the technique came in February, soon after Germany’s failure fully to cover its €6bn auction the previous month. The February DDA, by contrast, raked in orders of €15.7bn, allowing the DSTA to issue just over €6.5bn at 2bp inside original guidance.
"The DSTA has been successful in paying slightly lower fees than in a conventional syndication, while preventing abnormal behaviour like over-bidding and eliminating the winner’s curse, where the highest bidder overpays," says Arkus. "The drawback is that the management of the process tends to be more challenging because you have 14 primary dealers competing to sell bonds to the same accounts, whereas a syndication uses the pot system where the three or four lead managers are in control of the majority of bonds and work in tandem in the distribution and allocation process."
Not much wiggle room
Europe’s smaller sovereign borrowers, on the other hand, simply don’t have funding programmes that are large enough to allow them to experiment with innovations and therefore eat into the limited liquidity that they can offer.
Even a borrower like Belgium, with €30bn or so to borrow each year, has limited room for manoeuvre when it comes to exploring the potential of relatively mainstream products such as inflation-linked bonds. "We may issue linkers on a private placement basis through our MTN programme," says Anne Leclercq, director of treasury and capital markets at the Belgian Debt Agency. "But we believe that we don’t have enough raw material to allow us to build an inflation-linked curve. There would be no point in having issues at just one or two points on the curve."
Belgium, which has issued about €3bn from its MTN programme this year — around 10% of its total funding requirement — is a good example of a borrower which sees its MTN facility as a convenient channel for non-core or innovative issuance.
Portugal is another. "We have an MTN programme and we will naturally look at alternative funding ideas on an opportunistic basis," says Alberto Soares, head of Portugal’s debt agency. "But because we are a small borrower we don’t have much room for innovation."
For a borrower like Portugal, Soares suggests that something as apparently routine and mundane as stepping up its domestic marketing is probably more important than tinkering at the margin with new structures.
What may be routine for some issuers is clearly seen as innovative for others. Take, for example, the floating rate note (FRN) market, which in the context of the broader Euromarket can hardly said to be an innovation.
But that is precisely what it was for a borrower like Spain, which in July launched its first FRN, a €3bn three year transaction that helped the borrower simultaneously to explore a new investor base and to secure sub-Libor funding.
Another new technique that will be on Spain’s agenda for the same reason next year is inflation-linked issuance. Again, some would see very little that is innovative about inflation-linked bonds. "Inflation-linked issuance isn’t an innovation but it does tend to lag significantly behind other instruments as funding programmes develop," says Alan James, inflation-linked strategist at Barclays Capital. "Rather than an innovation, inflation is a natural terming out and deepening of the demand base, which is why the US is stressing its intention to increase issuance of Tips."
Whether inflation-linked issuance opens up a fresh investor base, or simply cannibalises an existing one, is open to question. "There will always be overlaps in the investor base, and the size of those overlaps varies from country to country," says James. "Research undertaken by the GAO in the US has found that roughly 75% of Tips were bought by investors who would not otherwise have invested in Treasuries. I would assume that in most other markets the number is lower.
"One element that you don’t see in the US which is relatively common in the UK and Europe is that there is demand from investors buying on an asset-swap basis."
Liquid linkers
Sean Taor, Barclays Capital’s head of SSA syndicate at Barclays Capital, adds that there is also an important reservoir of demand among index investors in the linker market. "The inflation index market equates to about 40% of the total inflation market which is about twice as much as in the nominal market," he says. "Those pools will grow as more end-investors start to see inflation as a growing threat next year."
Aside from allowing issuers to tap into a more diversified investor base, strategists say that there are clear cost advantages associated with the linker market. "In the UK you can prove ex-ante that there has been a huge cost saving for the DMO in its linker programme," says James. "The cost of servicing inflation-linked debt has fallen enormously in the last 18 months, and in terms of expected inflation I would also expect there to be a small cost saving going forward."
Within the inflation-linked market itself, James points out that there is modest room for innovation. "There has always been an argument that the UK could look at issuing limited price inflation (LPI) as well as retail price inflation (RPI) bonds," he says. "To date, the DMO has resisted that suggestion because it doesn’t want to run the risk of reducing liquidity by bifurcating the market."
The degree to which it opens up meaningful new sources of investor demand, is, say bankers, pivotal to whether or not innovation is worthwhile. "When you mention some of the more exotic instruments to the debt agencies, the questions that often come back are: who is going to buy these structures and will it take pressure off borrowers’ principal programmes?" says Christopher Marks, head of debt capital markets at BNP Paribas. "When you start thinking in those terms it is sadly inevitable that some of the more innovative funding tools will reveal themselves not to be efficient enough. For debt offices where volume imperatives are clear, historically familiar instruments that also suit current market concerns — floaters of different stripes, expanded inflation-linked programmes — will be foundation tools. There aren’t that many ways to skin the cat, which is why I don’t think we’ll look back in 12 months and reflect on a period of clever experimentation in the European sovereign debt market."
Sukuk stagnation
One of the more exotic funding options that commanded considerable press attention when they were first mooted as a possible funding source for European governments are Shariah-compliant bonds (sukuk). Theoretically, the Islamic market is perhaps an ideal source of additional funding because it provides access to a diverse base of investors, some (although by no means all) of which are motivated by a force other than price.
While Islamic bonds have been used by a number of governments in Muslim-majority countries, with Indonesia, Bahrain and Dubai recent issuers, they have not yet been used by sovereign borrowers with sizeable (but minority) Muslim populations.
The UK was expected to have broken the ice among in the sukuk market for sovereigns outside the Middle East and southeast Asia. But that innovative idea appears to have been a casualty, for the time being at least, of the traumas suffered by the global financial system post-Lehman.
A sukuk transaction, say bankers, is still on the UK’s radar screen, although the events of the last year or so have inevitably pushed a Shariah-compliant bond issue further down the Treasury’s to-do list. "I believe the sukuk project will be resurrected at some stage because it ties in with the UK’s aim of maintaining London’s status as the centre of international finance," says Islam at Barclays Capital.
Retail potential
Another pocket of potential demand that would provide sovereign borrowers with an alternative source of funding is the retail investor base. To an extent, it already does, especially at the very short of the curve. "Bear in mind that the whole treasury bill sector, which became such an important source of funding for sovereigns, is quite retail-oriented," says Cesare Roselli, head of SSA coverage at Morgan Stanley.
During the recent crisis small savers clearly warmed to the perceived quality of sovereign paper. The UK, for example, sold about £12bn of national savings certificates to private investors last year — which is not far short of the total annual funding requirement of a smaller European sovereign borrower like Portugal.
In continental Europe, meanwhile, the legendary Belgian dentist was also attracted by the solidity of sovereign paper during the crisis.
"After the Lehman collapse we saw a sharp rise in demand from the retail sector for our retail-targeted bonds," says Leclercq. "In September 2008 we issued €47m of retail bonds; in December of the same year we issued €483m. The fear factor led to a 10-fold increase. But that fear factor has receded this year. In March we issued €376m and in September we were back to €90m."
The jury is out, however, on how much more could be done by sovereign borrowers to divert retail savings away from other instruments. "One of the most interesting phenomena in the European market in recent years has been the anchoring of retail demand in fixed income," says Marks at BNP Paribas. "The challenge for bankers will be to find ways of drawing that retail demand into government programmes as well as into credit."
That may be easier said than done in an environment in which there is precious little return offered by government securities. "The problem with selling bullet bonds in normal maturities to retail investors has always been one of cost," says Roselli. "Sovereign borrowers find it very difficult to offer yields that can be attractive in comparison with corporates that are national champions."
Zeina Bignier, head of SSA origination at Société Générale Corporate & Investment Banking, agrees. "Selling retail-targeted bonds is not a very attractive option to sovereigns, because it is expensive," she says. "They would have to pay 20bp or 30bp more than current levels to appeal to retail investors."
Marks says that governments "will need to design instruments that offer sufficient return to ensure that retail investors aren’t tempted to look for racier products instead."
The problem is that this suggests a degree of structuring, or financial engineering (neither of which are very palatable expressions today) that are at odds with the sort of securities that governments are supposed to provide.
"Structured deals aren’t suitable for highly rated government borrowers," says Chris Tuffey, managing director and co-head of credit capital markets at Credit Suisse. "There is no way you can have an instrument issued by a triple-A government that may not return an investor’s principal."
With asset sales another source of funding that European governments may explore in the future, exchangeable bonds are another option that some bankers believe may come on to the agenda of sovereigns such as the UK, which are now large holders of bank shares.
More agencies on their way?
Decentralisation of funding is another variation on the innovation theme that some bankers believe may gather momentum if governments are faced with prolonged deficits and therefore saddled with hefty funding requirements.
Again, this is not a theme that is necessarily new. Witness Italy’s experiments with securitisation and, more recently, the solutions explored by a number of European governments to address the challenge of bank restructuring and recapitalisation by creating specialist vehicles such as FROB in Spain.
Nevertheless, Spencer Lake, head of debt capital markets and acquisition finance at HSBC sees no reason why the models developed to tackle the crisis in some of Europe’s banking sectors need not be applied to relieve governments’ funding burdens in other ways. "SFEF was a classic example of a government finding an efficient way of raising €85bn off balance sheet and others are looking to do something similar," he says. "But there is no reason why the same mechanism should not also be used with municipals."
Lake says that he believes municipal markets have the potential to expand in Europe just as they did in the US. "To date the European municipal market has developed in fits and starts, and was not helped by the aggressive structures that some of the Italian local authorities put in place," says Lake. "But as sovereigns become more leveraged, more financial responsibility will be devolved to sub-sovereign borrowers."
If and when that process does gather momentum, Lake says that subordinated debt could become another funding option for sub-sovereign and possibly sovereign borrowers, just as it has in California. "This is probably not an option for western European sovereigns, but we have done some work on the idea of subordinated paper for government issuers," he says. "There are a number of questions that need to be addressed, such as whether a ratings agency would give sovereigns any credit for having a deferrable feature. But this is potentially a very interesting space for governments in danger of dipping, say, below triple-B."