Sovereign, supranational and agency (SSA) bankers could have been forgiven for taking extended summer holidays this year. Once again, the world’s leading SSA issuers have taken advantage of outstanding funding conditions to front-load their borrowing programs, but there are other reasons why total issuance – especially of benchmark bonds – is likely to be more subdued in the last quarter of 2014 than usual. By Philip Moore
One of these is that with interest rates at an all-time low in the Eurozone, it is now more expensive than ever for borrowers to hold excess cash on their balance sheets. That is decreasing the attractiveness of issuing jumbo benchmarks, but it also means that pre-funding is considerably less appealing than it has been in previous years. “At a time when hoarding liquidity comes at a cost, we would only consider pre-funding if there were very clear indications that medium and long term funding costs after a swap into six-month Euribor would deteriorate,” says Stefan Goebel, Head of Treasury at Rentenbank in Frankfurt. “I don’t see that on the cards at the moment.”
The most important factor that will limit supply of new SSA paper over the next few months, however, is the size of major borrowers’ funding programs, many of which are either reduced or flat. Between them, the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM) raised €68 billion in 2013. In 2014, their combined requirement has fallen to €51.5 billion. EIB, meanwhile, has a funding program for 2014 of €70 billion, compared with €72.1 billion issued in 2013. KfW, which raised €65.4 billion in 2013, expects to issue between €55 billion and €60 billion this year, which is well below the peak of almost €80 billion which it raised in 2011.
A small handful of SSA borrowers is expecting to buck the general trend by raising slightly more this year than they originally expected. Rentenbank, for one, is likely to raise €500m to €750m more than the €10 billion it had anticipated at the start of the year. “The overall investment climate in the German agricultural sector is quite brisk, which is driving loan demand at Rentenbank,” says Goebel.
Net new issuance is smallest in year
The overall trend, however, is clear. “Net new supply in the SSA market is the lowest I can recall for many years,” says Ulrik Ross, head of EMEA public sector origination at HSBC in London.
Reduced funding requirements from a number of public sector lenders in Europe should be good news for the Eurozone’s economy, because it suggests that its recovery is gathering momentum. Take the example of Spain’s Instituto de Crédito Oficial (ICO), the mission of which is to “support and foster economic activities which contribute to the growth and the improved distribution of national wealth.” That means ICO plays a pivotal role in the Spanish economy; but Spain clearly needed a lot more supporting and nurturing at the height of the Eurozone crisis than it does today.
“We play a countercyclical role in the economy, complementing bank lending,” explains Sergio Sierra of the capital markets department at ICO’s Madrid headquarters. “This is why our funding requirement reached a peak of €27.4 billion in 2011. We are now back to an annual funding program of about €9 billion to €10 billion, and we expect this to decline further to a more normal level of €6 billion to €7 billion.”
This smaller program, twinned with the continued improvement in Spain’s economic fundamentals and investors’ search for yield, has given ICO access to a broadening investor base at increasingly attractive spreads, says Sierra. The clearest evidence of this came in March, when ICO returned to the dollar market for the first time for four years, raising $500 million at 60 basis points over swaps in a deal led by Goldman Sachs and JP Morgan.
Back to dollar investors
Sierra says that re-engaging the dollar investor base was more important to ICO than shaving a few basis points off the cost of funding after the proceeds of the dollar trade were swapped back into euros. For other European-based SSA borrowers, however, the dollar-euro basis swap was an important consideration earlier this year. “At the start of this year our main focus was on the likely deterioration of arbitrage opportunities in the dollar market because of the tightening in the euro-dollar basis and its potential impact on other foreign currency-denominated funding costs,” says Goebel at Rentenbank. “This was the trigger for us to issue a five-year US dollar global early in the year.”
More generally, Sierra says that the benefits of a smaller funding program are reflected in ICO’s reduced spreads versus the government. “It is also clear that our lower funding needs are giving us more flexibility in the primary market,” he says.
One by-product of this, he adds, is that ICO is able to explore more opportunities in smaller, more targeted private placements. “We will maintain our commitment to investors by providing liquid benchmarks, but we also expect to focus more on opportunities to optimize funding costs,” he says.
Others agree that benign borrowing conditions for SSAs is allowing them adopt much more selective funding strategies. “When it comes to arbitrage or searching for the most cost-effective funding, we are in cherry-picking mode,” says Goebel at Rentenbank.
Bankers say that the reduced supply from SSA borrowers is dovetailing with continued strong demand from investors. “As far as investors are concerned, there is quite an uncomfortable supply/demand imbalance in the SSA market at the moment,” says Spencer Dove, managing director, SSA DCM at Nomura. “Going into the summer break, most borrowers had completed about 65 percent of their programs. At the same time, the compression we’ve seen at the front end of the yield curve in dollars and euros is leading many investors to look beyond the core sovereign market to pick up spread.” Obvious places for them to look, adds Dove, are supranationals, peripheral sovereigns and, for some investors, covered bonds.
This is creating what HSBC’s Ross describes as a “perfect storm” for SSA borrowers. That, he adds, has given SSAs more scope for liability management, with borrowers able to take advantage of declining funding costs to retire existing, costlier debt.
Normalizing Spanish debt
Among European sovereign borrowers, one of the most striking exponents of this strategy has been the Spanish Treasury. In 2013, Spain’s principal focus was on normalizing its government debt market. This, according to the Tesoro, meant that Spain “recovered full market access in all tenors and funding formats, laying the groundwork for a full recovery of its investor base.”
As Ross says, in 2014 this has allowed Spain to focus on fine-tuning its primary market strategy. Having raised €10 billion in a 10-year benchmark in January, which was priced at 178bp over swaps and generated demand of €40 billion, Spain returned to the market with a similarly sized 10-year issue in June, priced at 118bp over mid-swaps. The novel feature of June’s deal, led by CaixaBank, Citi, Credit Agricole, HSBC, Morgan Stanley and Santander, was that it was split into a €5.3 billion cash portion and a €3.66 billion exchange of debt maturing in April, July and October 2015.
Ross says that another way in which SSA borrowers have been able to use benign funding conditions to fine-tune their funding strategies has been by capitalizing on rising investor demand in the inflation-linked market.
Spain, for example, launched its inaugural bond linked to euro inflation in May 2014. Other more seasoned sovereign borrowers in the market have been able to focus on adding liquidity to their inflation-linked programs. In June, France saw unusually high demand of €6 billion for its €3.5 billion inflation-linked bond maturing in 2030. The UK followed soon afterwards, with a £5 billion linker which generated orders of over £14 billion, a record for the inflation-linked market in syndicated format.
SSA issuers gave also been able to harness continued strong demand for top-quality credits by fine-tuning the maturity profile of their debt, issuing across the curve, and tapping into a wider range of currencies.
EFSF was able to generate a book of almost €8 billion for a three-year bond in June; the following month, it was able to sell its first syndicated 30-year issue, a €4 billion transaction. Dena Bellamy, head of public sector and frequent borrowers at Commerzbank in London, says that the strength of investor demand for SSA exposure was reflected not just in the size and composition of the book, but also in the pricing of the 30-year bond. “To generate demand of €6 billion for such a long maturity was a great outcome for the borrower and allowed us to tighten pricing to 31bp over swaps, compared with guidance in the mid-30s,” she says. “Demand was led by asset managers and bank treasuries, but 8 percent was placed with central banks and sovereign wealth funds, which is unusually high for a 30-year issue.”
More innovative debt instruments
SSA borrowers’ preference for more targeted transactions instead of benchmarks is encouraging many issuers to explore a range of more innovative funding instruments, the most conspicuous of which are environmental or green bonds. “Because they have such good access to liquidity and duration, issuers are able to look at other ways of delivering value to investors,” says Ross at HSBC. “The green bond is one example of a compelling value proposition.”
Among SSA issuers, a landmark for the environmental bond market was passed in July when KfW issued its debut green bond with a €1.5 billion five-year transaction, led by Credit Agricole, Deutsche Bank and SEB. Petra Wehlert, head of public new issues at KfW’s Frankfurt headquarters, says that as the German development bank is one of the largest environmental lenders and among the most prolific issuers in the world, its recent transaction marks another important step in the evolution of green bonds from a niche product into a mainstream asset class.
KfW’s maiden green bond allowed it to access new investors – always an important consideration for a borrower with one of the biggest annual funding requirements outside the sovereign sector. “Usually demand for our bonds is driven by central banks and bank treasuries,” says Wehlert. “But in the case of the green bond, 75 percent was taken up by asset managers, funds and insurance companies in much smaller tickets than we see in our benchmark program, so we clearly attracted new investors.”
Some SSA borrowers say that while they are attracted by the potential for green bonds, they do not necessarily subscribe to the view that benchmark bonds are the best format in which to issue. “We’ve already done two green bond private placements,” says Goebel at Rentenbank. “We think that if you issue in benchmark format, the risk is that you have less control over the allocation process. Issuing green bonds as private placements allows you to develop a direct dialogue with investors which can be more efficient from an asset-liability management perspective.”