In the final months of 2011, the lingering eurozone sovereign debt crisis instilled a growing sense of panic. Bank liquidity virtually evaporated amid increasing fears concerning the impact on lenders’ balance sheets. Institutional investors, unnerved by the inertia of European policy-makers, were conspicuous by their absence and every sovereign debt auction was greeted with trepidation.
“Investors were just looking for safety. They were simply focused on getting their money back so they sold off their exposure to peripheral bond markets and bought top-tier credits such as Germany, Netherlands and Finland,” says Hans von Zwol, senior portfolio manager at ING.
By the end of November, Italian two-year bond yields had shot up to 7.98%, Spanish yields to 6.15%, while German bund yields fell to just 0.46%. In less than a year, yields on peripheral sovereigns had doubled while yields for Germany more than halved.
Time for action
In December, the European Central Bank (ECB) took action, offering European banks access to cheap three-year loans and stressing that those who took advantage of this offer would not be stigmatised. Hard-pressed banks across the eurozone took this to heart and on December 21, it was announced they had borrowed a record €489bn from the ECB’s longer-term refinancing operation (LTRO).
The move had a dramatic effect beyond bank funding.
“The LTRO really changed the game. This has been extremely important for sovereigns, banks and by extension the entire market,” says Giles Hutson, head of European corporate, sovereigns, supranationals and agencies (SSA) and emerging markets debt capital markets at Bank of America-Merrill Lynch.
The result has been a short-term carry trade. In exchange for collateral, the ECB offered banks across the EU a limitless supply of three-year money at 1% interest. Having borrowed at 1%, these banks can buy government bonds at considerably higher yields, allowing sovereigns to fund their vast deficits and making a healthy margin for themselves in the process.
“The LTRO has provided liquidity to the banks so they can reinvest in short-dated government paper,” says Zeina Bignier, head of public sector at Société Générale.
Deep impact
The impact is plain to see, particularly for Spain and Italy. Having flirted with yields of 7% and 8% in mid-December, the two sovereigns saw yields coming down to between just over 2.5% and just over 3.5%, respectively, by the end of January, an extraordinary turnaround in the space of just a few weeks.
Apart from the immediate impact on liquidity, the LTRO has had an immediate impact on confidence, says Martin Weber, head of SSA origination and syndication at Goldman Sachs. “The sovereign crisis had been weighing on sentiment and the ECB threw a lifeline to the entire capital markets structure,” he adds.
It is unusual to see bankers so effusive. But then the situation in the eurozone has been far from normal. “Historically, when people chose to buy government bonds, they were looking at low-yielding assets in return for which they got the highest-quality credit. And spread differentials between issuers across the eurozone were very narrow. Since the crisis, analysis of the eurozone has been very different and investor perceptions of the risk profile of some of the sovereigns involved has changed considerably," says Charlie Berman, head of public sector global finance, Europe, the Middle East and Africa, at Barclays Capital.
In a market [such as this one], when there is a lot of uncertainty and conditions are highly volatile, syndicated bonds executed for sovereigns have a real attraction, even for well-established names
The shift has caused a fundamental reassessment of approach by the investor community; it has rediscovered credit analysis.
“Five or six years ago, the European government bond markets were driven by rates. Given the recent volatility, traders and investors need to also consider sovereign bonds from a credit perspective. They are analysing each country’s fundamentals,” says Greg Arkus, head of SSA capital markets at Credit Suisse.
Clouds linger
Clearly, the fundamentals do not look too bright, at least not for countries such as Greece, Spain, Portugal and Italy, where budget deficits are still under pressure, growth is still sluggish, unemployment is rising and austerity measures are being put in place all over Europe, says Ulrik Ross, global head of public sector debt capital markets at HSBC. “This is a technical market; not a fundamental market,” he adds. “Domestic banks are investing in their own sovereign paper. There is not a lot of real money being invested in southern Europe.”
Real money investment from institutional funds – which were badly burned in 2011 when the mood turned sour and spreads on peripheral European sovereigns widened dramatically – is still scarce. Many believe it will be a long time before such funds trust the southern European sovereign market again.
“Does the LTRO mean we are out of the woods? No. Does this mean that we no longer need major structural changes to take place in Europe? No. But the armageddon scenario is less likely than it was at the tail end of last year,” says Mr Weber.
Measured as this view may be, and bearing in mind continued concern about economic fundamentals, it is clear the ECB’s actions have had a ripple effect on the market. The LTRO offers banks cheap funds for up to three years but demand for sovereign paper has risen not just at the short end but across the maturity spectrum.
At the end of January, Italy raised €7.5bn in a 10-year auction at a yield of 6.08%, almost a full percentage point lower than the country obtained a month earlier. The price was still about 2% more expensive than it was able to achieve on 10-year paper two years ago, but it was still felt to be encouraging, particularly as the €7.5bn auction came just three days after rating agency Fitch cut Italy’s credit rating to A-.
Credit importance
The response highlights the higher profile of credit risk analysis, which has become increasingly noticeable since the financial crisis.
“More and more investors in Europe appear to be doing their own credit research and are forming their own views on the outlook for sovereigns rather than focusing on what the ratings agencies are saying. This is reflected in the fact that rating agencies seem to lag the market, with downgrades being priced into relative yields ahead of a rating agency announcement,” says Mr Arkus at Credit Suisse.
France, for example, lost its coveted AAA status in mid-January and still tapped the market for €7.9bn of 10-year funds in early February, attracting €19bn of orders and securing a lower yield after the downgrade than before. Austria too lost its AAA status but was still able to raise €5bn via a €3bn 10-year bond and a €2bn 50-year bond.
“Demand for Austria was phenomenal. We saw north of €5bn of orders for the 10-year and about €3bn of orders for the 50-year, which is currently the longest [economic and monetary union of Europe] sovereign bond” says Mr Weber.
Syndicated bond popularity
The lively response can be attributed to several factors. First, the release of liquidity into the market at the short-end has bolstered overall sentiment. Second, Austria and France may not have the lustre of neighbouring Germany but they are still regarded in a more positive light than the southern Mediterranean sovereigns. In Austria’s case, there is a third reason: it used the syndicated loan market rather than the more usual auction process.
“In a market [such as this one], when there is a lot of uncertainty and conditions are highly volatile, syndicated bonds executed for sovereigns have a real attraction, even for well-established names,” says Mr Berman at BarCap.
The appeal of syndicated loans may also increase as it allows institutional investors the opportunity to engage directly with sovereign issuers. These institutions are sitting on enormous amounts of capital, which they urgently need to deploy.
“Last year, between October and December, no one wanted to invest. As transactions matured, institutions invested in the money markets. Even now, pension funds, life assurers and other asset managers [have] about 7% in these liquid markets. That is a huge amount and it cannot remain uninvested,” says Ms Bignier at SocGen.
“This year, for example, in January alone, redemptions and coupon payments provided institutions with €220bn of liquidity. A further €200bn will come in April and another €250bn will come in July. This provides extensive support for the primary market,” she adds.
Hard landing to come?
The timing of this wall of redemptions could prove serendipitous. Eurozone sovereigns are expected to issue more than €800bn of debt this year as they struggle to fund gaping budget deficits. In the first month of 2012, issuance totalled €87bn, a strong start to the year but certainly not enough to give grounds for complacency. Greece remains a complete no-go area for investors, Portugal is not far behind and it is still far from clear whether policy-makers will find a solution to the eurozone’s problems or not.
“The mood is more positive and most people believe the eurozone will not be broken. Pricing remains attractive too so investors see momentum and value, a powerful combination. But it is still not clear whether we will have a soft landing or whether there will be several hard bumps along the way,” says HSBC's Mr Ross. In other words, significant risks remain.
Northern European countries, such as Germany, Finland, Sweden and the Netherlands, should continue to enjoy tight spreads as international investors seek out ‘safe haven’ assets, and peripheral countries in the eurozone are benefiting from the ECB’s LTRO programme for now. Whether it will buy them enough time remains an open question.
