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“Peculiar markets require a very flexible funding strategy,” says Germany’s KfW in its half-yearly update published in July. This year, funding conditions for frequent or sovereign, supranational and agency (SSA) issuers have certainly been unusual. In 2015, the world’s top borrowers have been called upon to manage their funding programs against a backdrop of uncertainty over distortions created by the ECB’s asset-purchase program and the timing of an anticipated increase in US interest rates.
At the same time, they have been required to navigate a market buffeted by concerns about Greece and, more recently, mayhem on the Chinese stock market. “SSA markets have certainly been challenged,” says Adrien de Naurois, SSA syndicate at Bank of America Merrill Lynch (BAML) in London. “Be it in US dollars, euros, Australian dollars or sterling, it has been much tougher for borrowers to issue at prices close to their secondary market valuations.”
Triple-A borrowers themselves confirm that it has been a tricky year. “What we have learned this year is that when you announce a large benchmark in euros or dollars you can’t take it for granted that you’ll automatically be able to raise €5 billion,” says Horst Seissinger, head of capital markets at KfW in Frankfurt.
This won’t prevent KfW from comfortably completing its €55-€60 billion funding program this year. Nor will it disrupt the financing plans of other SSA borrowers, many of which had satisfied much of their requirements by midsummer. “By July, we had raised €4.7 billion of our €6 billion target for the year, so we are well advanced with our funding activity,” says Rodrigo Robledo, Head of Capital Markets at the Spanish State Finance Agency, Instituto de Crédito Oficial (ICO).
This is at least partially a reflection of the progress European borrowers are making in distancing themselves from the Greek crisis and emphasizing the strength of their underlying fundamentals. “We have been completely unaffected by what has happened in Greece,” says Robledo. “Spain has been leading the recovery in European growth, and the reform program has clearly paid off in reducing the deficit and restoring confidence to the financial sector.”
Bankers agree that it is important not to over-egg the challenges facing SSA borrowers. “Are we talking about a scenario where borrowers can’t fund their programs effectively? Absolutely not,” says de Naurois. “Are they having to pay a new issue premium to do so? Yes.”
Philip Brown, Managing Director of SSA Origination at Citi in London, agrees. “The elasticity of demand to pricing has been huge,” he says. “Borrowers have found that if they pay a few extra basis points, demand increases exponentially.”
This is not to belittle the challenges confronted by SSA borrowers. Bankers say that European borrowers will be concerned by elevated funding costs and execution risk that have made the euro market relatively unattractive. This, twinned with a favorable basis swap, has prompted many European SSA issuers to look beyond their home currencies. KfW, for example, raised 70 percent of its funding in the first half of 2015 in currencies other than euros, which is an unusually high proportion.
Germany’s Rentenbank, meanwhile, had raised just 14 percent of its 2015 funding program in euros by mid-August. Leopold Olma, Head of Funding at Rentenbank’s Frankfurt headquarters, says that this compares with a euro share that is usually closer to 20 percent or 30 percent, which is generally accounted for by a benchmark issue. “We have remained active in euros by issuing private placements driven by reverse enquiry from investors looking for small clips in euros,” he says. “But at current levels it is impossible to price a primary issue based on the secondary curve.”
There are, however, signs that conditions in the euro market are starting to improve. The Dutch Local Government Funding Agency, BNG, is credited with reopening the market for euro benchmark issuance with the launch in late August of a €1.75 billion seven year transaction, and market participants think issuance will gather pace later this year. “Credit spreads in dollars are now widening, which is reducing the positive impact from the basis swap,” says Olma. “In the first half there was a 10bp or 15bp spread in favor of US issuance. This is now down to zero, so I expect we will look again at the possibility of a euro benchmark issue in the fourth quarter.”
While an improving outlook for issuance in euros will come as a relief for many SSA borrowers, the continued deterioration in the economic climate in the emerging market universe remains unsettling. As Citi’s Brown puts it, “China now seems to be the shark closest to the boat.”
This is because a prolonged slowdown in emerging markets is likely to lead to a further decline in appetite from central banks, historically the main source of demand for SSA paper. The good news, for SSA borrowers, is that regulatory change is pushing bank treasuries to take up much of the slack created by diminished central bank demand. “The liquidity coverage ratio (LCR) means that banks are having to put their excess liquidity into high quality assets, which has made bank treasuries the fastest-growing and most significant investor base in the SSA space,” says Brown.
Borrowers say that bank treasuries have a similar appetite for five to 10 year issues as central banks. “Although some bank treasuries can’t extend beyond five years, most are looking for Libor-plus spreads and are active in longer durations,” says Klaus-Peter Eitel, VP of New Issues, Capital Markets, at KfW. “So we have good access to duration in the current spread environment.”
It is in markets like today’s that many SSA borrowers are reaping the harvest of having built access to a deep range of funding options. “By diversifying into new markets ranging from green bonds in sterling and Australian dollars to RMB-denominated funding as well as benchmarks, we ensure that there is no need for us to be nervous about raising €55 billion or €60 billion,” says KfW’s Seissinger.
ICO has also been able to keep its funding costs low by casting its net across funding sources as varied as a highly successful euro-denominated social bond, dollar taps, private placements in Brazilian reals and bilateral facilities from the EIB. Not only has this helped ICO to minimize funding costs. As Robledo says, it may even allow it to keep pre-funding options open for 2016.
By Philip Moore