Those involved in raising capital for sovereigns are entering 2010 in much better spirits than they were going into 2009. And for good reason: the world’s economy is recovering from a deep recession, the panic and fear that characterised the first few months of 2009 are gone and sovereign issuers and their banks have largely achieved what they set out to do, not least of which was raising an unprecedented $5tr of funding. But this does not mean 2010 will be easy. Far from it. Quantitative easing is on its way out, inflation — possibly — is on its way back in, competing supply is rising fast and macroeconomic shocks — like the kind Dubai gave us in late November — are more likely than ever before as a result of the dangerously high levels of debt held at state level. In this overview of EuroWeek’s inaugural special report on the financing challenges facing sovereign borrowers, Toby Fildes looks at what they have achieved in 2009 and what they need to look out for in 2010 and beyond.
As 2009 draws to a close, all those involved in the raising of sovereign debt might well be tempted to give themselves a small, discreet congratulatory pat on the back in recognition of what they have achieved this year.
By the end of December total gross issuance via syndicated bonds and auctions by sovereigns across the world will have hit a staggering $5tr, a startling 66% increase on 2008, driven by spiralling deficits.
This vast sum is all the more impressive considering the period in which it was raised — a time of great uncertainty when the world’s leading developed economies were in deep recession — and the fact that, by and large, it was executed without any big hitches or disasters.
Granted, there were a few hiccups — most notably when the UK and Germany reported uncovered auctions and a few badly informed commentators presumed that this equated to full-on government bond buyers’ strike — but the many fears that most market participants had going into 2009 never materialised.
That is not to say those fears were unjustified. Entering 2009, borrowers, investors and bankers were faced with the great unknown: sovereigns could not accurately predict just how much issuance they would need to do to match escalating deficits and no one knew how investors would behave in the face of so much economic uncertainty and enormous issuance. Meanwhile, confidence in the banking sector, already creaking under the weight of enormous losses and bruised and beaten by public wrath, was at an all-time low.
On top of the immense issuance levels and bleak conditions, sovereigns also faced competition in the market, not only in the form of other public sector issuers such as European supranationals and agencies (who themselves had seen their borrowing requirements double as a result of their role in the support programmes to boost economic growth) but also government guaranteed bank bonds — a new asset class born in the days and weeks following the collapse of Lehman Brothers and a key pillar of many governments’ financial sector rescue plans.
Many sovereigns also spent the year under constant threat from rating agencies that quite rightly regularly voiced concerns about ballooning deficits and the lack of coherent strategies to deal with them. Some, such as Greece, Ireland and Spain, ended the year at least one notch lower than they started it while others, such as the UK, have been given final warnings.
Lucky cards
Despite the odds stacked against them at the beginning of the year, sovereigns did have a few, important aces up their sleeves. The flight to quality was one such card as was the flight to liquidity. Many investors had, following the Lehman collapse, quit riskier products for the safe haven of treasury bonds while others partly reallocated away from money market funds in search for more attractive yield levels which were to be found — in the first few months of the year at least — in sovereign debt.
"The sovereign sector has been fortunate in a sense that at the end of Q1 this whole crisis hit the bottom and that was when every sovereign’s spread was at the widest level," says Kentaro Kiso, head of MTN syndicate and head of public sector group, EMEA at Barclays Capital in London. "This made them very attractive to many real money investors who were either looking for safe places or alternatives to cash and money market funds."
By the end March, however, the threat of imminent global economic Armageddon had receded. Sovereign spreads, having spent three months at historic wides began to close in and those investors who had remained on the sidelines realised they had to get back in the game. "Many investors missed the early rally when spreads started to contract in March, and continued to do so through the second half of the year," says Sean Taor, head of SSA syndicate at Barclays Capital in London. "A lot of the money was stuck on deposit and in money market funds, which clearly weren’t earning enough interest to justify the fees that clients were paying those funds."
As to whether the sovereign market has ended up with more investors than it started with at the beginning of the year is open to debate. For Spencer Lake, global head of debt capital markets and acquisition finance at HSBC in London, the investor base metamorphosed several times but that by the end of the year it had, essentially, returned to its traditional shape.
"The investor base for sovereigns changed throughout the year," he says. "At first we saw a lot of credit-type investors move into rates product, looking for quality and liquidity. They also found yield because, in the first quarter at least, spreads were at historic highs for many sovereigns. We saw central banks pull back from the product, at least in the short term, while they evaluated the implications of government guaranteed bank debt on governments’ balance sheets." At one stage central bank participation in new issues dropped from the usual 40% area to the 10% area, but returned by the end of the year. "We had pretty much gone full circle in terms of sovereign investor base breakdown," he notes.
Paul Tregidgo, vice chairman of debt capital markets at Credit Suisse in New York, also noticed a change in investor behaviour but makes the point that the market has ended up much stronger than when it started the year. "One of the significant effects of the crisis was the change in the sovereign investor base in the early days of risk appetite recovery," he says, "If you put a deal up on the screen or began to market a deal, your universe of investors was somehow broader than it was before, both by type and geography."
"The relative value and risk/return analysis was recalibrated after the upheaval of the crisis. Very simply, investors in debt and equity were looking at asset classes in which they had traditionally not played. In the early stages of recovery, you had equity market investors looking at fixed income instruments. It was quite a turnaround from just a few months earlier when sovereign debt was seen to be a shrinking asset class. Volumes were declining and depending on what part of the globe you were in, it was looking pretty expensive. But now, whether it is because of volume, benchmark liquidity or in terms of relative risk assessment, the crisis has shone a light on sovereign debt."
He notes that sovereigns tick many boxes for investors. "Sovereigns issue in size and provide liquidity. Markets are readily made. You have plenty of benchmarks. You have local and international benchmarks, but perhaps above all the key has been the focus on the fundamentals of the asset class."
One answer to the heavily increased borrowing requirements — and related interest costs — that sovereigns faced was to look at increased issuance in foreign currencies. A beneficial euro/dollar basis swap in the three to five year area prompted eurozone governments such as Austria, Germany, and Spain, as well as agencies including Société de Financement de l’Economie Française (SFEF), KfW, Caisse d’Amortissement de la Dette Sociale (Cades) and Rentenbank to issue in US dollars and swap the proceeds back into euros. Conditions are likely to remain favourable for further dollar issuance by European sovereigns. Deutsche Finanzagentur, Germany’s debt finance agency, for example, has already said it might issue another foreign currency bond if arbitrage opportunities continue.
"The US investor base for sovereigns in dollars grew in 2009," says Scott Graham, joint global head of the borrowers group at Royal Bank of Scotland in London. "That market really came alive as US investors liked the combination of diverse but high quality names and the spread that issuers were offering."
"For issuers, dollars complemented what they were trying to achieve with funding programmes as it was another important source of liquidity and fitted in well with their increasing realisation of the importance of having a global investor base. They began to think as truly global issuers,"says Myles Clarke, joint global head of the borrowers group at Royal Bank of Scotland in London
Sisyphus syndrome
But while all those involved in sovereign debt will no doubt be feeling quietly relieved after getting through an exceptionally tough year in which they have dealt with nearly every obstacle with impressive skill, their relief will be tempered by the looming prospect of having to do it all over again next year.
In fact, forecasts across the investment banking community point to another record year of government bond issuance — up to $5.15tr — as many countries will continue to register massive budget deficits despite economic recoveries gathering momentum.
They will, of course, be encouraged by their achievements in 2009 — as Lake at HSBC says, "market participants have clearly gained valuable experience having gone through a tough and eventful 2009 and have proved to themselves and everyone else just what is do-able."
Participants will also benefit from greater clarity — something they had very little of going into 2009 when they were entering a world of confusion, panic, fear and the unknown. "We are going into 2010 with more confidence," says Clarke at RBS. "This is in stark contrast to 2009 when we just didn’t know how bad things were going to get and how much, therefore, sovereigns would have to issue to finance bail-outs, deficits and stimuli. But we’ve hopefully realised the worst, we have been able cope with it and as a result we can be more confident in our approach to 2010."
But despite this optimism, next year will provide a set of new challenges that will test issuers, investors and intermediaries alike.
One such challenge will be the return of competing supply from the financial institutions market which spent much of the first half of this year on the margins. With markets back open — including the subordinated sector — banks and insurance companies will be regular visitors to the debt markets as they look to refinance, restructure and recapitalise. Covered bonds will also be more a feature in 2010 than they were in 2009, with around €410bn of redemptions due next year compared with around €370bn-€380bn in 2009.
Regulatory support
Another challenge will be the expected withdrawal of government liquidity support programmes. Asset purchases related to quantitative easing policies have been a dominant factor in absorbing heavy supply this year in some countries. In the UK, this has especially been the case with the Bank of England’s Gilt purchases accounting for around 90% (£197bn) of full year 2009/10 issuance, and to a lesser degree the US Treasury buy-back programme ($300bn) by the Fed accounting for nearly 16% of full year 2009 US government supply.
However, the UK’s Financial Services Authority and the Basel Committee on Banking Supervision are implementing a ready replacement for QE in the shape of liquidity buffer rules for banks.
The proposed phasing in of such measures would equate to an additional £110bn purchases by UK banks of eligible assets in the first year alone, according to HSBC research. "If this was largely targeted at Gilts, which is a distinct possibility given the narrow definition of permissible assets, it would account for around 60% of prospective Gilt issuance in the next fiscal year. Over the subsequent two or three years the shortfall in liquid asset buffers could nearly double, to £210bn, and at the extreme reach £620bn," says HSBC.
Meanwhile, the Basel Committee on Banking Supervision is set to propose what it calls a "new minimum global liquidity standard" for consultation at its quarterly meeting in December. If the liquid asset buffer (LAB) ratio — high quality liquid assets as a percentage of aggregate balance sheets — for eurozone banks increased by, say 0.5%, from a current estimated level of 6%, it would equate to potentially up to €160bn additional purchases of government debt. Under the assumption that a LAB ratio of 7.5% may be required in the eurozone, which could eventually be the case in the UK, this would imply around €485bn of progressive bank demand for government bonds.
"As far as sovereigns are concerned, the new regulatory requirements regarding banks’ liquidity are a very positive development," says Amir Hoveyda, head of EMEA debt capital markets at Bank of America Merrill Lynch in London. "As a consequence, banks can be expected to become a more meaningful source of demand in this asset than has historically been the case. While the new framework is going to be implemented over several years, starting in the fourth quarter of this year, we’re already seeing tangible evidence of a ramp-up in bank treasury interest for sovereign new issues."
Dubai shocker
Aside from the reversal of liquidity measures, the market will no doubt have to contend with the occasional macroeconomic shock, like the one Dubai inflicted on the rest of the world in late November. Its flagship government-owned holding company, Dubai World, without warning, requested a standstill agreement on its $59bn of debts triggering concerns over potential defaults on bonds and loans that could exceed $80bn in the emirate.
It is too early to tell whether this Dubai drama will develop into a global crisis but it is unlikely to throw the top tier sovereign bond market off balance. In fact, triple-A government bonds were much in demand in the days following the debt standstill request, with the yield on the benchmark 10 year US Treasury falling 7bp to 3.2%. Japanese government bonds also rallied, with the yield on the 10 year JGB falling 4bp to 1.25%.
"There will, of course, be macroeconomic flashes and shocks but the fact that the sovereign bond market has coped so well in 2009 bodes well for 2010," says Clarke. "The market mechanism of complementing auctions with syndications where necessary worked extremely well and for that reason 2010 is less intimidating than 2009 was."
Coupled with the threat of another Dubai shock is the prospect of a W-shaped recession next year. Exactly how appetite for government bonds will be affected by such a development remains to be seen of course, although as was seen after the Dubai shock, top-rated sovereign bonds will no doubt benefit from any flight to liquidity and quality.
But the fear of another recession will, though, affect the timing of issuance by many sovereigns. Many will want to get as much out of the way as possible in the early part of the year before conditions worsen. However, this could mean an even busier first few weeks or months of the new year than usual which could create its own problems such as higher costs for sovereigns.
In 2009, €544bn, or 62% of the anticipated final eurozone sovereign total of €884bn, was issued in the first half of the year. HSBC analysts expect around €600bn to be issued in the first six months of 2010, and a slight bias towards the first quarter with €310bn, out of an expected total of €1tr.
"I think the market is deep enough to take down funding but there are clearly concerns about crowding out early next year, the price that issuers will have to pay, and also that we’re moving to a market where interest rates can’t stay low forever," says Taor. "As result, there may be periods where the market isn’t so easy. So I’d say issuers are concerned but I wouldn’t say they’re overly worried."
Market participants will also have the challenge of terming out bonds in 2010 and issuance is expected to shift towards longer maturities. HSBC analysts point out that 2009 was characterised by sudden demands placed on governments implementing stimulus packages of which the eventual size was unclear. So while short-term funding was the preferred option, 2010 will see a focus on spreading the repayments of the associated debt into the future. The pattern has already begun to materialise towards the end of this year with the US Treasury announcing plans to shift around $400bn of borrowing from bills to longer term fixed rate notes and bonds, new 30 year bonds from Spain and Italy, taps of existing bonds from Germany, France, Portugal and Austria and new 15 year benchmarks from Finland and Ireland showing that smaller borrowers are keen to extend the life of their debt. Meanwhile, China, commemorating 60 years of communism, showed just what was possible for emerging market borrowers when it issued a 50 year bond to domestic investors towards the end of November.
Inflation in the distance
Along with a W-shaped recession and macro shocks, the other worry on the minds of all those involved in the raising of sovereign debt is the return of inflation.
While it is unlikely to be next year’s problem — the long term curves are not showing much evidence although this year has seen a surge in commodity prices — it will undoubtedly be a concern at the back of investors’ minds. Their concern is logical: the amount of money that has been injected into the market via liquidity support mechanisms around the world can only result (eventually) in one thing — inflationary pressure — even if those mechanisms are systematically and carefully reduced.
"While the volume of issuance for next year appears eminently manageable, it would be wrong to become complacent and there is always the risk of unexpected exogenous events — inflation being the obvious one," says Hoveyda. "Our call is for general pressure on rates as a result of this increased issuance. If you are an investor looking at this asset class, you would need to ask yourself why would you jump in early? I think it’s going to be a very interesting space to navigate in and where issuers and lead managers will have to be more tactical in terms of going about their business in the next couple of years."
Myles Clarke at RBS agrees. "The threat of inflation is one of the big blots on the landscape for next year. It will certainly be troubling the minds of investors as they will start to worry about it for future years. How the bond market reacts to this will be very interesting. But as we saw this year, the rates market has shown that it can cope with challenges."
The growing concern about inflation is expected to be matched by a sustained supply of linker bonds in 2010. Momentum is already building — compared with the second half of 2008, the first half of 2009 has already seen inflation-linked issuance increase by more than 50% for the UK, France and Italy. Not only will linkers give issuers another useful avenue of financing, it will also help them achieve their desire to extend maturities — ultra-long tenors are a feature of the linker market.
The UK’s Debt Management Office is understood to be considering a 50 year linker next year following its successful extension of its nominal curve to 50 years in 2009, while it is also thought possible that the German Finanzagentur will issue a new 30 year Bund linked to eurozone inflation.
Creative creatures
As Clarke at RBS implies, sovereign debt managers and their bankers are a resourceful lot. Not only are issuers likely to step up foreign currency issuance, use more syndications and inflation-linked markets as well as FRNs, but other alternative funding methods are also likely to be a feature next year. These include commercial paper, as well as other private placement markets such as medium term notes and schuldschein, which, EuroWeek understands, Spain, Ireland and Poland have all looked at this year.
Some have been more creative. Ireland established the National Asset Management Agency to facilitate a €54bn programme (around 30% of GDP) to buy bad property debts from its banks, funded through the direct issuance of government bonds. According to a preliminary Eurostat ruling, that will not — somewhat counter-intutively — count towards national debt figures.
Meanwhile, French President, Nicolas Sarkozy, has proposed a "grand loan" which could be up to €100bn, although the exact size and term still remains uncertain. The proceeds may be used to meet energy, infrastructure needs and industrial development.
"One of the natural responses to sovereigns’ vast increase in issuance is diversification of the investor base and of markets," says Tregidgo at Credit Suisse. "This will be an even bigger theme in 2010. Obviously the domestic market is incredibly important; the manner in which they’re approached is key in many countries. But in looking at the international markets, diversification beyond the core investor base, being opportunistic in the best sense of the word, cross-currency, cross-maturities, cross-investor-bases is what they’re going to be thinking about a lot more. It’s going to be a fascinating time to be involved in this business."