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EU enters the fray as SSA market shines brightly

By Lewis McLellan
11 Dec 2020

The SSA market faced unprecedented challenges in 2020. Funding requirements were inflated by unexpected needs from the pandemic, and the market was busier than ever thanks, in no small part, to the EU’s entrance as one of the sector’s biggest borrowers. But with the exception of a difficult period in March, SSA issuers made it through the year with scarcely a hiccup in their programmes. It’s an encouraging sign, but new challenges await next year. Some leading lights in the SSA community discuss the year they’ve had and the changes it has brought for them, as well as for capital markets more broadly.


Participants in the roundtable were:

Niall Bohan, director of asset, debt and financial risk management, EU

Otto Weyhausen-Brinkmann, head of funding, KfW

Patrick Seifert, head of primary markets, LBBW

Axel Bendiek, head of funding, Land NRW

Lee Heathman, portfolio manager, BlackRock 

Silke Weiss, acting head of funding and investor relations, ESM

Moderator: Lewis McLellan, GlobalCapital

GlobalCapital: This has been a unique year for all of us, but perhaps for none more so than for the European Commission. Niall, what has it been like scaling up the EU’s funding operations in such a dramatic way?

Niall Bohan, EU: There were certainly some challenges. But we benefited from some strong political tailwinds. The Support to mitigate Unemployment Risks in an Emergency (SURE) programme was agreed at pretty much breakneck speed. The Commission put the proposal on the table in April and it was a done deal by the end of May. For the member states to agree on a complex joint financial undertaking like this — a €100bn lending programme supported by callable national guarantees for €25bn — in such a short time is unprecedented.

It really attests to the fact that Europe was heading into very choppy waters and that the pandemic represented an unprecedented challenge. An early signal of strong solidarity was needed. SURE checked those boxes and it was agreed very swiftly.

There was, of course, some delay in getting the paperwork done. Getting the guarantee agreements, the loan agreements, the borrowing decisions and so on into place was something of a legislative steeplechase. Getting that finished took us until the end of September. Once that was done, we came to market within three weeks with our first deal and we were back in early November with the second.

GlobalCapital: Tell us a little more about the funding side of the programme.

Bohan, EU: The SURE programme is a straightforward back-to-back lending process, as the Commission has deployed for financial assistance support to third countries or during the sovereign crisis. We substitute ourselves for Member States in need of funding since we can obtain better terms based on our strong credit rating. We on-lend the proceeds on the same terms and maturity that we borrow so there is no maturity transformation or interest rate risk for the Commission.

In the course of 2020, we have raised close to €40bn for 15 Member States with an average maturity of around 14 years over three transactions. In addition to these 15 Member States, a further two will benefit from a further €50bn in loans financed by SURE issuance in 2021. The very large size of the order books for the first three deals (every deal was 12 times oversubscribed) testifies to a strong latent demand for this new credit in the current environment.

GlobalCapital: And what are the main challenges you have faced in putting this programme together so swiftly?

Bohan, EU: Well, the first one is that SURE is a multi-country programme served by a single issuance programme. That means that we cannot customise and tailor the loans to different member states, or provide them with the maturity or the size or sequencing of instalments that they might prefer. 

It’s simply not possible to cater to all the preferences of all beneficiary countries. There has to be an understanding that this is a collective exercise. DMOs and finance ministries have to accept that there will be money transferred to them at times and with maturities that they would not have chosen if they were doing their own issuance. 

Getting that understanding took a bit of discussion. However, once we had agreed on an issuance calendar for 2020, the process went very well and the pipeline has come together nicely. 

We’ll be faced with similar challenges on a bigger scale and for bigger volumes under the Next Generation EU programme, and this will call for different solutions.

The second challenge is the obvious point that €100bn is far in excess of anything the Commission has previously raised. Most years, we have not needed to raise more than €5bn-10bn across all our programmes. 

Market conditions have been very benign for the first three deals, so we have got off to a good start. We are hopeful that momentum and strong investor interest will be sustained. However, we are certainly not taking that for granted. Running a high frequency series of syndicated transactions for large volumes is a big job and we will have to work hard for every transaction.

The third challenge I would mention is that, while the size of order books we have seen is flattering and humbling, they bring their own issues. We have had to work hard on order allocation and to keep as many investors — old and new — as happy as possible. We want to be loyal to our traditional investors, but we also need to broaden the investor base to engage new international investors and new categories of institutional and ESG investor.

We have had to haircut all orders significantly, but hopefully we have kept the largest base of investors as happy as possible.

Finally, it’s important to remember that we have had three good primary deals, but we need to build the perception that investors can get in and out of these positions. They need to see a good secondary market and all the infrastructure that goes with it. We need to increasingly focus on the market conditions surrounding our trades to ensure that the market is able to function efficiently.

GlobalCapital: What about the other issuers here? How has the arrival of the EU’s huge funding programme affected your activities?

Otto Weyhausen-Brinkmann, KfW: The EU-Recovery plan and EU-SURE were announced in June. The size and magnitude were clearly a very strong signal for Europe, with huge solidarity among the member states in this crisis.

The unprecedented size of the programme lead to discussion in capital markets how such a volume could be raised in a rather short period of time. Hundreds of research papers were analysing scenarios and potential impacts. 

Of course, we also analysed potential impacts on our funding — crowding out, spread widening and increasing competition about issuance windows were a few of the questions. 

However, the implementation of EFSF/ESM a couple of years ago was a similar experience but smaller in size. Capital markets reacted quickly to the European rescue mechanisms, with limited spread impacts for other borrowers. Even if the competition on issuance windows increases with every new issuer, primary markets in SSAs still work remarkably well and orderly. 

In addition to that — and even more important — there is very strong monetary stimulus at the moment from the ECB. The effectiveness of the new PEPP programme has been demonstrated already, despite the challenges of Covid-19 spreads that are not increasing and are rather compressed at the moment. Given this strong tool from the ECB, we actually felt very confident about the EU funding and expected only marginal impact on our spreads.

The recent deals from the EU has clearly shown that any kind of panic was clearly overdone and that the market is functioning very well. We were surprised by the strength of demand. We have seen massive books already, but larger than €100bn is very special. 

There was a great performance in the secondary market as well. Indeed, I would actually argue that the entire SSA market has benefited from the EU’s first SURE transactions.

Patrick Seifert, LBBW: Otto, I believe KfW participated in the Targeted Longer Term Refinancing Operation for the first time this year. Was that in anticipation of EU supply or was it a standalone decision?

Weyhausen-Brinkmann, KFW: Going back to March, when the pandemic arrived in Europe, KfW played a significant role by providing loan facilities as liquidity aid for businesses in Germany affected by Covid-19.

At that time, the impact of the crisis was unclear and hence the amount of additional funding was unclear. 

As a result, we introduced new funding sources, in particular refinancing via the German Finanzagentur for all Covid-19 related loans. The decision to participate on TLTRO was more an economic decision; the attached sweetener offers cash at levels not achievable in capital markets. The TLTRO allows us to optimise our own funding costs and therefore increases the effectiveness of our promotional business.

GlobalCapital: March certainly was an extraordinary time. Axel, you issued right into the teeth of that volatility. What informed that decision, and what was the experience like?

Axel Bendiek, Land NRW: Back in March, it became clear quickly that we would need to upscale our funding programme by a significant amount. The state had decided to support the economy during the pandemic in two regards: namely, reimbursement for loss of revenue and additional spending. 

We were to cover that through a special budgetary entity called the rescue aid package. It is worth up to €25bn. Obviously, we didn’t know in spring how much we would need in the end but we were looking at a potential increase of our funding programme of that size. That would have brought the overall issuance programme to €40bn; €15bn regular refinancing needs and up to €25bn from the rescue package.

When the markets were fairly quiet in March, we didn’t exactly get nervous, but we didn’t want to fall behind either. We felt that the SSA market was really where funding activities should recommence and that we were among suitable issuers to do it.

We picked a fairly short tenor — three years — and we picked a bond that had a decent volume outstanding — €1.7bn — so there was some liquidity already there. We also decided that we would set the spread from the outset to provide maximum certainty for investors. It was quite clear at the time that spreads would widen, but by how much was difficult to evaluate. Secondary market quotations hadn’t moved much, so although I wouldn’t say they were meaningless, they were really not a very good guide.

The transaction went very well and we raised €1.3bn, bringing the bond outstanding to €3bn, which is always our target size for non-SRI euro benchmark bonds. Later on, we followed up with seven and 10 year deals, and then also five years. We pretty much hit all the benchmark tenors in the shorter part of the curve, which is where we want to cover the rescue fund needs. 

In the past, we have been focusing on the long and ultra-long end of the curve, up to 100 years. That gave us the flexibility to concentrate on the short end for this extraordinary requirement. It went very well. And, of course, it was the most economic approach, given that rates are so deeply negative in that part of the curve. Overall, we covered €11.2bn out of the €25bn rescue fund allowance. That is probably all we will need for this year. Since the rate on the funding is negative, it currently does not even raise our interest burden.

GlobalCapital: Silke, you’ve come to market just ahead of both EU Commission deals. Did you notice any effect on your deals?

Silke Weiss, ESM: The EFSF and ESM are both established bond issuers. We’ve been in the market for nearly 10 years. Our approach has always been to be a kind of sovereign-style issuer with a calendar we announce ahead of schedule, and a funding programme with exact amounts per quarter communicated ahead of time. 

Every time the EU was in the market, we also had scheduled issuance windows. We wanted the EU issuance to be a success and co-ordinated our actions to ensure this was beneficial to both issuers. We were in close contact with everybody on this panel and the funding team at the commission, [led by] Jean-Pierre Raes.

We were in a position of flexibility. Announcing the funding windows means that our process is transparent and investors can prepare for it. That means we can execute very quick intraday transactions. That has been useful this year, and we have done it several times. 

We’ve been surprised by the strength of the market. It seems everyone had massive order books, and we have ended up facing the same sort of challenge that Niall alluded to. You have to cut into loyal investors’ allocations. Everyone is facing that challenge just now, but it means that demand for our paper is strong.

GlobalCapital: What have been the big challenges of this year from the investor side, Lee?

Lee Heathman, Blackrock: It has been a really interesting year. It’s like a combination of the global financial crisis of 2007-2008, combined with a Japanese long and low scenario for interest rates. We have these two factors coming into play at the same time, especially in Europe. 

In March, a lot of people were working at home, and there was basically no liquidity in the market. Not many people were actually putting in orders for the new issues for SSA paper. In Japan, it was different. Covid didn’t really hit too hard here, so throughout this whole crisis, we have been working pretty steadily here. 

In March, when the Covid crisis really hit and spreads widened a lot, we were putting in really large orders for the new issues and taking down full allocations. Then the ECB got into action, and the markets came back and everything settled down. The last two months have been amazingly strong. Everybody is just grabbing for paper and trading on the lower for longer scenario, thanks to the ECB backdrop. 

Seifert, LBBW: I agree with Lee about the resemblance to 2008, but there are some major differences too. One of those is that we are seeing an unprecedented policy response from Europe. That’s why investors are so comfortable with the bond market just now.

Europe in the past was known for being too slow and doing too little; this time, neither is the case.

The policy measures, both on the fiscal and monetary side, have supported the market very well.

Heathman, Blackrock: There is another part of the picture in Japan and Europe as well: sustainability.

There is a definite trend there. The number of companies signing up to commit to sustainability goals, the number of investors that want to get in on the action and the number of ESG funds setting up… it’s incredible. 

The EU bonds coming with social bond documentation really hit the sweet spot. Every year there is more demand for these products.

GlobalCapital: Do you think that a new president in the White House will help shape attitudes to ESG over the next four years?

Seifert, LBBW: You could call it the icing on the cake. The announcement that the US will be re-joining the Paris Agreement was an unexpected surprise and sends a strong message.

However, as we stand, Europe doesn’t need the US’s help. Something like 70%-80% of the green bond market is in euros, so Europe is already in pole position.

The extra debt that has being raised, it’s not just to keep the status quo. It’s for a purpose, a transformation that was long overdue. 

GlobalCapital: Niall, in addition to setting up a huge new funding programme, you decided to set up a social bond framework as well. What was that process like?

Bohan, EU: The social bond framework was really a no-brainer for us. The use of proceeds foreseen — borrowing to lend to member states to finance temporary employment programmes —clearly has a strongly social character right from the start.

The Commission is very committed to sustainable finance. We have been leading from the front, with the sustainable finance expert group. There has been strong support for climate transition financing and ESG more generally. It was a natural step to take this opportunity to bring SURE bonds to market as social bonds reflecting the inherently social character of the use of proceeds. 

We were also able to build on the ESM’s experience with their social bond framework for pandemic crisis support.

We followed the same path, using the ICMA Social Bond Principles, putting it together with a second party opinion provider over the summer. 

It was a lot of extra work, but it has paid dividends. It has been a major contributing factor to the awareness of SURE bonds, and it has been reflected in the composition of the order books.

Some 63% of the final allocation of the first deal went to ESG investors. For the second deal, it was 40% because we were trying to rebalance and bring more treasury and fast money into play.

I think what this shows is that the constraint is not the demand for sustainable bonds, but how can we build the supply of bonds where the use of proceeds is demonstrably linked to green or social expenditure. This is where we need to see further development: the methodologies, frameworks and work on capacity building.

It’s relatively straightforward for governments or companies engaged in project finance, but for us as a supranational institution funding national governments, the challenges are somewhat greater, because we do not control the ultimate final expenditure.

But this is definitely a market that is going places, and we hope to continue to offer support, both through the remaining social bond issuance on SURE, and then hopefully with the green bond issuance for Next Generation.

GlobalCapital: Silke, what about your new social bond framework?

Weiss, ESM: We created a social bond framework in June this year to finance the Pandemic Crisis Support, part of the European response to this crisis. The Pandemic Crisis Support credit line was made available and approved by our governing body in May. It will remain available until the end of 2022. Euro area Member States can apply for Pandemic Crisis Support to support their direct and indirect healthcare costs related to Covid-19. The support is worth 2% of the applying country’s 2019 Gross Domestic Product.

The proceeds will therefore be directly linked to the health expenditure of the country requesting this facility. This means we can issue social bonds. Pandemic Crisis Support now awaits its first applications.

Our other programmes of macroeconomic assistance don’t have this social bond label, but they are social bonds in the sense that they help countries get back on their feet and encourage financial stability and social cohesion. 

GlobalCapital: The yields in the SSA sector have come down very aggressively, and the economic picture is still grim. Lee, do you still think there will be value in the European SSA sector in 2021?

Heathman, Blackrock: My big picture on economic growth, interest rates, and spreads is heavily influenced by my more than 20 years here in Japan. What we have seen is the demographics shifting to an aged society. 

With this, we get low growth, low inflation, constant fiscal deficits and we have the Bank of Japan constantly doing QE to keeping interest rates low. This works to keep credit spreads low too. 

We have seen banks and pensions shifting out of JGBs into higher yielding assets: foreign fixed income, real estate, infrastructure — anything to pick up yield. That’s also the case in the credit market — a constant grab for any spread available, pushing spreads down. 

I see this happening in Europe from a demographic standpoint. The ECB is playing the same role as the BoJ, keeping volatility down and keeping interest rates down and it drives this constant grabbing for spread. 

We’re in a Goldilocks scenario for SSA issuers, but it’s not so great for pension funds or investment managers like us to have to deal with this situation of low rates, low volatility and tight spreads.

GlobalCapital: What about the internationalisation of the euro? Niall, do you expect the greater supply of EU bonds from SURE and from Next Generation EU to contribute to this?

Bohan, EU: We’re still in a honeymoon period, so we don’t want to get ahead of ourselves, but the size of the order books says there is a very strong latent demand for this type of credit: high rated, euro denominated assets. 

That is the first lesson that everybody can draw from this first phase of SURE issuance. When you add up these issuance programmes, including EFSM and macro financial assistance issuance, we’re going to be issuing about €1tr in the period of up to 2026. That debt will remain in circulation for up to 30 years, and there will be refinancing operations along the process as well.

Is this a structural change in euro debt capital markets? Only time will tell whether this heralds the dawn of a longer-term EU presence in international capital markets. That will depend on whether policymakers conclude that the experience has demonstrated the utility of a collective debt-financed crisis response. 

In the short term, we have an opportunity to build the market for this benchmark asset through these programmes. We are trying to build the liquidity curve with benchmark issuances of five, 10, 20 and 30 years. We will continue to complete that liquidity curve and then maintain it.

This is a chance to push the boat out and build this curve for this new type of credit, and that’s what we are doing.

There was a huge amount of drama around the recovery plan and the negotiations in July. That, combined with the commentary around the safe asset character of the programmes, has helped to create huge awareness about these issuance programmes, and that has contributed to the successful take-up.

The environment has helped and we are seeing that reflected in the strong international footprint in the order books. The international participation is far higher for these deals than for any of the Commission’s previous deals. We are also seeing a broader mix across different types of investor. For example, we have attracted strong pension fund interest on the 30 year tranche. We’re seeing a lot of hedge fund macro accounts looking for positions or placing primary orders.

Putting it all together, I think we need to maybe come back to this next year and see whether this story is borne out, but I think there seems to be a strong demand for this type of credit.

Seifert, LBBW: To complement what Niall said, technically speaking those programmes are temporary in nature, but I think, given the magnitude of the order books, investors are voting with their feet. Order books of €200bn do not only reflect huge confidence in the measures that have been announced, but also clearly indicate anticipation that the European Union will become a new European reference point, or maybe a provider of risk-free assets. 

It’s not there yet, but I think those order books are telling us that investors are anticipating that kind of development. It is therefore also interesting that there is a general acceleration around this European integration. It’s not just around what the EU technically is doing. There are further side-effects around the capital market union and around the European bad bank, etc. 

It’s like the euro; one piece of the broader architecture moves ahead and the momentum creates a pull for other areas of Europe to bring everything else into place.

GlobalCapital: Looking ahead to next year, what do you think are the main challenges? Patrick, what advice will you be giving?

Seifert, LBBW: There is no one size fits all. We can’t operate like the European Union and say we have one approach that needs to fit everyone else. I think the advice would be very tailor-made. 

But Lee made a point earlier on about the high level of indebtedness that I think is generally applicable. Let’s be very clear about this: at some point, those levels of higher debt need to be justified by economic activity. 

Issuers, therefore, are well advised to seize good issuance windows knowing that the uncertain path to recovery commands some extra flexibility. 

This is where the individual credit stories matter. Perhaps we will need to see some deleveraging down the road. Maybe the debt needs to be shared differently across Europe. 

We’re seeing a new European architecture develop alongside very strong issuers on a national level. We have KfW here and NRW. They have been pioneers in a way, since they have been issuing in sustainable formats ever since 2014 and 2015 — a long time before the German sovereign, which only started in 2020. 

On the foundation of this very strong business model and a strong investor base, those issuers can continue the extremely good job they do, supporting the real economy’s needs closely.

My vision would be that greater integration on the European level can help individual countries to develop these kinds of issuers and support their economies into recovering at a similar pace. Strong national issuers are key to that process.

Let’s not forget that expectations of recovery ranged from 2022 to 2026. Hopefully, with the vaccine, that will be a little closer. 

What Lee mentioned is critical. SSAs are not delivering the extra yield, but it’s providing tremendous stability to your portfolio and duration. Based on this, you can pick and choose other asset classes. I think that will continue to be the role of SSAs — of course supported by the ECB.

We need to also make clear that the ECB cannot fix it alone. If we want a liquid market, the ECB cannot buy everything. We need investors to remain in the market to keep it active.

Weiss, ESM: If I may add to what Patrick was saying, there are a group of issuers in the same sector, but issuing at slightly different spreads. It’s a big diversification opportunity for investors. Back in March and April, there were a lot of outflows and certain investor types and fund managers had to get hold of cash to fund those outflows. Investors had to unwind positions so it’s key to have a diversified portfolio. On this roundtable, there are plenty of different assets available. It’s a benefit to investors to have this variety.

GlobalCapital: What about you, Otto? How does the trajectory of the virus recovery affect your funding programme for 2021?

Weyhausen-Brinkmann, KfW: We are in the process of making all the forecasts for next year about the planned loan commitments. From that, we will derive the expected funding demand for next year. We will disclose that and announce it to capital markets in mid-December.

We have a broad range of funding products. Aside from euros, we are very active in dollars and sterling and in many markets we are among the largest non-domestic government issuers with a large investor base.

Our strategy is to react very quickly to where the demand is. Thanks to our broad range of avenues, we feel very comfortable.

Of course, 2021 is an unknown, but we are confident we can run our funding programme smoothly and successfully next year.

On top of that, the ECB is very important. There are a lot of expectations on the next ECB meeting. That will pave the way for next year. There are also a lot of redemptions at the ECB, which will be reinvested, and the PEPP programme is a very powerful tool, so that should all help us to successfully run our borrowing programmes next year.

GlobalCapital: How long do you see the low interest rate environment lasting?

Heathman, Blackrock: Well, JGBs went zero to negative five years ago. Given the demographics of Europe and its ageing society, the need to fund social security programmes without rapid growth or inflation, this period could last a long time. 

Four or five years ago, I talked to people in the US about this scenario going on there: ageing demographics, low growth, low inflation. People said it wouldn’t happen, but in fact it is happening in the US, and it is happening in Europe. I think it has longer legs than a lot of people think.

Bohan, EU: As an issuer, I’m riding on the coattails of this phenomenon, this secular change to low-interest environments. However, from a broader growth and stability perspective, the prospect of Japanification is clearly worrying. 

One of my previous jobs was preparing the capital markets union blueprint for Jonathan Hill, former Commissioner for Financial Services and Capital Markets. We were trying to build a proposition that through integrating European Union capital markets we would deliver higher returns and create investment opportunities for equity, in particular where Europe has a structural deficit compared with the US. Capital markets are, however, a hard sell when returns are non-existent or even negative.

I listen to the conversations today and hope that the answer is here and I will get some enlightenment someday, but I think the search for yield that Lee referred to earlier is a challenge. 

Where do people go searching for yield? Commercial real estate? I can’t think of a sector, maybe after airlines, that is going to be more negatively impacted than commercial real estate. All the pension money that piled into that sector in ‘search for yield’ is at risk. 

I think some of the demand that we’re seeing from sovereign and SSA paper reflects this flight to safety mode. I think for as long as we’re in this uncertain period and it’s not clear how long this crisis is going to last and where the exits are, then I think we, as high credit issuers, will benefit from those tailwinds.

Clearly I have a vested interest in hoping that those tailwinds will support us through Next Generation EU, but clearly our long-term futures depend on some structural change and return to normality. As yet, it’s not clear where that comes from.

GlobalCapital: Could the arrival of a vaccine and the resumption of economic activity galvanise the European economy back into faster growth and create the policy space for the central banks to normalise rates?

Bohan, EU: Well, none of us has a crystal ball, so it’s tough to say how strong or when the rebound will be. Are we going to reset to the way things were before in tourism? Working at the office? Will the personal services impacted by the crisis recover to the previous levels, status quo ante?

The answers to those questions will determine where future investment is directed and how fast the rebound is.

I think that there will be a big financial market response to vaccine developments. We saw the first signs of euphoria on Monday evening after the Covid vaccine announcement: the shift into equity meant that the interest rate curve shifted against us by five basis points, which made us a bit nervous going into Tuesday’s transaction. 

This relationship between equity and debt could change very quickly as markets price in future recovery prospects. 

Seifert, LBBW: If you believe that Covid has been accelerating trends, like sustainability or digitalisation, then just coming back to the status quo is not good enough. 

Raising this amount of debt to just maintain the status quo, is not acceptable. It needs to be about financing an adjustment to future challenges and beating climate change.

From that point of view, it’s about undergoing that transition one way or another. The structural adjustments will be painful for some and beneficial to others. That process has barely begun. In Germany, for example, companies are still exempt from declaring bankruptcy.    GC

By Lewis McLellan
11 Dec 2020