SSAs forced to get comfortable with negative rates
With the resumption of the ECB’s quantitative easing programme, any hopes of a normalisation of European monetary policy receded further into the distance. With “lower for longer” firmly established as the consensus call, SSA borrowers and investors will have to settle in and learn to love the world they inhabit
Despite the anaemic economic growth in the eurozone, in public sector debt markets the prospect for 2020’s borrowing is remarkably rosy. Sovereign, supranational and agency borrowers enjoyed an impressive run in the euro market in 2019, making up for the more disappointing showing by the dollar market, and bankers believe conditions will remain positive in 2020.
That seemed unlikely at the end of 2018. The Federal Reserve was hiking rates, and it seemed as though the ECB would wind up QE and eventually follow suit. The era of low yields seemed to many to be coming to an end. As a result, the euro market sold off in both yield and spread terms.
Looking at 2020, although those concerns are gone, new ones have emerged. Economic growth in the eurozone has continued to disappoint, hovering close to recession in spite of the ECB’s spectacularly accommodative monetary policy. With low growth, dovish policy looks set to continue.
The departure of ECB president Mario Draghi, and the arrival of Christine Lagarde as his successor, is unlikely to signal a sudden switch to the hawkish side.
For investors in the SSA market, that means more lending at negative yields. With $15tr of negative yielding securities clogging up portfolios, investors have to look elsewhere to shore up their returns.
“QE has driven yields to historically low levels and that has led investors to chase yield by moving up the yield curve and down the credit curve,” says Sean Taor, head of RBC Capital Markets’ DCM and syndicate in London.
Olivier Vion, Société Générale’s head of SSA DCM and syndicate in London, agrees. “Negative yields do reduce the investor base,” he says. “As well as looking for longer duration from SSAs, some investors look at EM or credit.”
That’s not to say there is any kind of technical shortage of demand for SSA paper. And, even among those who leave, “an army” remains poised to switch back into public sector paper to absorb any back-up in yields, according to James Athey, senior investment manager at Aberdeen Standard Investments in London.
For SSA borrowers in euros, demand has moved out further along the curve. However, bankers are less excited about the long end than they might have been in the past. Lee Cumbes, head of public sector DCM at Barclays in London, points out that the appetite for long end funding is limited. “Not every issuer has an infinite appetite for duration, and while long dated funding is attractive, the short end can be even more so, with issuers even being paid to borrow,” he says.
And with flat curves, the incentive for investors to lend indefinitely longer can disappear. Investors get very little pick-up in yield between three years and 10 years, and are in some cases returning to short end paper, rather than locking up sub-standard yields for the long term.
Beyond the eurozone
“Nothing really looks attractive” to Athey in Europe, although he remains reluctantly invested in core duration eurozone products.
For SSA bankers, catering to a yield-starved investor community when the majority of your products are trading with negative yields requires creativity and innovation. “Investors are being forced to pick up spread,” says Cumbes. “Often that means duration, but also diversifying into areas where they can get some kind of positive yield. Israel doing 10 years and a debut 30 years, then coming back for 50 years is a great example of investors being better encouraged to diversify.”
While borrowers within the eurozone benefit from the resumption of QE through the reduction of their borrowing costs, those outside the ECB’s purchase programme can sometimes benefit even more dramatically.
Israel’s economy is as robust as many of its European counterparts but it has undeniable issues around regional security, which keep its ratings limited and mean that it is not typically a first port of call for euro buyers. But low yields have persuaded investors to overlook such issues and explore credits like Israel. Finding more will remain a challenge. “While there are pockets of supply like that, Europe is an enormous market with a lot of savings to be invested, and we are searching for more supply to meet the demand,” says Cumbes.
Although issuing in euros is only economical for issuers outside of the eurozone when the cross-currency basis swap is favourable, that was the case for much of 2019, and bankers expect conditions to continue into 2020.
Barclays’ Cumbes will be putting a great deal of effort in 2020 into bringing non-eurozone borrowers to the euro market. “For next year, we’ll be looking at an increasing number of different issuers from outside the eurozone, bringing them very attractive euro market terms. There’s certainly appetite for high quality paper that isn’t directly targeted by QE.”
For those investors required by their mandate to stay in core SSA assets, they often have harder work to do in order to assess value when yields are south of zero.
“There’s a more dynamic assessment of relative value among investors,” says Kerr Finlayson, head of FBG syndicate at NatWest Markets in London. “Some of the big French investors have specific yield targets. In other cases, the spread to govvies is the relevant metric, we saw examples after the summer where short end trades worked well given the outperformance of the French curve at the short end.”
When compared to the world of government bonds, supranationals and agencies can typically offer a decent spread that should ensure they have a loyal base of buyers. “State-owned enterprises often have equivalent or even better credit quality than their governments, but still pay a spread over them,” says Athey.
While supranational and agency paper can generally not compete with the liquidity offered by sovereign curves, there is a loyal pool of investors prepared to forgo the liquidity in favour of the extra yield.
How long can rates stay low?
“We’re looking at a situation where economic data is fairly flat and the ECB is giving us another package of rate cuts, TLTRO, QE, and deposit tiering,” says Cumbes. “Their central mandate remains inflation, and the inflation path doesn’t look set to change any time soon, so we might expect more of the same next year: flat curves and negative rates.”
While voices are building in the ECB governing council that the present approach is not working to restore inflation and economic growth, most in the market are convinced that Lagarde will not have the option to impose an aggressive rate hike trajectory for several years.
Taor at RBC says: “Outgoing ECB president Mario Draghi spoke around symmetry of inflation — implying that the ECB would allow inflation to be over 2% for a period of time before acting. Given that inflation has averaged just 1.2% over the eight years of Draghi’s presidency it is therefore likely that European interest rates will stay low for a long period of time.”
“The trade war is taking its toll,” says Vion. “That has forced the ECB into reverse gear.”
But while a growing chorus of voices acknowledges that an expansive fiscal policy as well as monetary policies will be needed to drive growth, few expect a wave of borrowing to fund infrastructure investments.
“I don’t see fiscal policy in Europe turning suddenly more aggressive,” says Athey. “Draghi has openly requested an expansion of fiscal policy, but the political climate, particularly in Germany, is an impediment to increased government spending.”
Germany, once the engine of European growth, is suffering in the global slowdown because of its open, export-driven economy. It narrowly avoided a recession in the third quarter, posting 0.1% growth.
Without economic growth or inflation, the debt burdens accrued by Europe’s borrowers — particularly Italy, where the debt to GDP ratio is projected to trend around 137.4% in 2020 — could become an alarming problem. Italy is looking at zero growth for “the next couple of years”, and the weak growth, low inflation and wide budget deficits “look set to put the debt ratio on an unsustainable path,” according to Capital Economics.
“Defaults from countries that control their printing press are rare, but in the eurozone, sovereigns are effectively hard currency borrowers,” says Athey. Aberdeen is short Italian government debt.
The emergence of debt sustainability worries is likely to cause a widening of credit spreads although the top end of the SSA market will benefit from a flight to quality. While borrowing costs may climb, for most SSA issuers, these can effectively be passed to their clients without much harm to the balance sheet.
While the broader environment will keep yields suppressed, Taor believes that Bunds will move slightly higher over the next year, in spite of the resumption of QE.
Provided it is not accompanied by a surge in volatility, the higher yields will simply help SSAs to recapture investors who have fled elsewhere for better returns. GC