Drowning in debt

Sovereign debt issuance on an unprecedented scale is about to be unleashed on the markets. Major countries, such as the US, the UK and those in the eurozone, face the double whammy of reviving their economies with a fiscal stimulus as well as paying the cost of financial sector bailouts.

The result will be a world drowning in debt and there are concerns that auctions will fail as investors become overwhelmed and fearful about the state of public finances. Governments’ attempts to sell their debt to their central banks – who pay for it by printing money – will only add to the worries. Could a major sovereign default or, alternatively use high inflation to pay off its debts, leaving investors holding Treasury bills in a depreciated currency?

Spend, spend, spend

So far, it has seemed as if governments could get away with it. Forced to bail out the banks and prop up other ailing industries, states across the world have been spending money with abandon and borrowing like there was no tomorrow. Yet even as finance ministers announced the need to issue unprecedented amounts of debt, the price of sovereign bonds remained stable or even rose, pushing yields down to record lows, sometimes into negative territory. The debate now is whether this can continue.

In just one week last December, for example, the US government sold $32bn of four-week Treasury bills at 0% interest, and demand still outstripped supply by four to one. In the UK, 10-year gilts were yielding 3.5% at the beginning of this year, a full 100 basis points (bps) lower than before Lehman Brothers collapsed last September. Appetite for such low-yielding paper was particularly extraordinary given the projected supply of government bonds this year.

The US is expected to issue between $1500bn and $2500bn of government bonds in fiscal 2009, more than double 2008 levels. In the eurozone, supply is estimated at €700bn, up by 30% from last year. And in the UK, issuance is forecast at about £146bn ($209bn) this year and about the same in 2010. Two years ago, it was just £63.5bn.

Other governments are also busy raising capital. Global issuance is forecast at about $4000bn, a phenomenal figure by any standards and one-third higher than in 2008, which was itself a year of intense activity.

But supply is further bloated on two counts. First, a number of governments, including the US and the UK, are guaranteeing bank paper, which turns it into quasi-sovereign debt, at least in the eyes of investors. Second, supranational agencies such as the European Investment Bank or the Multilateral Investment Guarantee Agency are issuing more debt, as demand for infrastructure and corporate finance increases. They could find themselves crowded out by the impact of the sovereign debt.

The enormity of supply is not in doubt, therefore. It is large, it is growing and it is likely to persist throughout 2009, quite possibly into 2010 and conceivably into 2011 and beyond. The big question marks hang over the demand side of the equation. How have governments got away with it so far and how long will they be able to do so?

The first question is more easily answered than the second. “Government bonds are not like other securities. They are unique,” says Laurence Mutkin, head of European interest rate strategy at Morgan Stanley. “In effect, they are the same as cash but with a date on them. There is clearly a lot of supply but increased supply does not lead particularly to a rise in yield levels. Typically, when an economy is slowing down, risk aversion increases, expectations for inflation come down and interest rates fall, which influences yield levels.”

Carl Norrey, head of rates securities trading at JPMorgan, believes this is the perfect climate for rates investors. “We are in a low-interest, deflationary environment,” he says.

That is the theory, at least – and through most of the second half of 2008, the theory held good. Many institutions were well rewarded by investing in government paper as every other asset class suffered. Towards the end of last year, however, cracks began to emerge, and in recent months, these have become deeper, more pronounced and much more dangerous.

Fatigue concerns

Concerns were raised at the beginning of 2009, when a key German fund-raising fell short of expectations. The ‘Sylvester Auction’ traditionally opens the German government debt season but this year, bidding banks took up just two-thirds of a €6bn sale of 10-year Bunds. Bund prices fell across the board, the rest of the eurozone followed suit and there was widespread talk of investor fatigue. The German Finance Agency put on a brave face.

“I was absolutely not concerned that the auction was uncovered, according to the bid-to-cover ratio,” says Carl Heinz Daube, managing director of the German Finance Agency. “We held 37 auctions in 2008 and nine did not achieve the result we expected. But there was no pattern in it – the response occurred in 10-year, five-year and two-year Bunds. Also, a couple of days after the first auction of this year, we held another €6bn auction and we received bids for €13bn of paper. I might be concerned if there were lots of uncovered auctions, but for the moment we are very happy with the banks in our bidding group. It is very much business as usual for us.”

Mr Daube might sound sanguine, but market observers are not. “There is pressure on spreads and as the year goes on, this will continue,” says Spencer Lake, head of debt capital markets at HSBC.

And Lena Komileva, head of G7 market economics at Tullett Prebon, says: “Concerns about the transfer of private sector default risk from financials to sovereigns and escalating government issuance have led to fears about the sustainability of public finances. These conditions persist across sovereign credits that the market perceives to be particularly vulnerable due to high debt levels at the start of the crisis, a recession in the real economy, a domestic banking crisis and limited policy flexibility, all of which prompt investors to demand higher yields as compensation. In other words, yields will have to rise to enable governments to raise record quantities of funding in the markets this year.”

The first few weeks of this year saw graphic evidence of this trend when the yield on the benchmark 10-year Treasury note rose from 2% to 2.95% as the US government announced plans for record debt sales and more frequent auctions.

Eurozone government yields are also rising, particularly those of the so-called peripheral economies: Spain, Portugal, Italy, Greece and Ireland. Germany is the largest and most liquid market in the region and every other market is priced against Bunds. Spreads have been increasing steadily since the last quarter of 2008 so Spain and Portugal are now yielding in excess of 60bps more than Germany, the yield on Italian paper is now more than 70bps higher than Bunds and the Greek yield is about 175bps higher. The shift is likely to become more pronounced over time. Spain, Portugal and Greece have had their credit ratings downgraded and Ireland has been put on notice so its rating could soon follow suit. Eurozone governments are particularly vulnerable to mood-swings in the investment community because they have fewer weapons in their arsenal.

“The US Federal Reserve can inject liquidity into the system. The Bank of England can do the same in the UK. But the European Central Bank does not have that mandate. It cannot inject liquidity and that’s why EU countries have to pay up,” says one debt capital markets director.

Desperate circumstances demand desperate measures and there have been suggestions that, in certain countries, banks are being pressurised to participate in auctions. “It is a case of ‘you scratch my back, I’ll scratch yours’. The banks have been brought back from the brink of collapse by government money – now they have to do their bit and buy domestic debt. This may well be the case in some of the weaker eurozone countries,” says one banking source.

It is also the case that investors have been drawn to government paper because there are so few appealing options elsewhere in the financial markets. Other asset classes, such as equities or property, have collapsed in value and most corporate debt has been viewed with mistrust, as institutions weigh up the possibility of defaults and restructurings in the private sector.

“US Treasury Bills are a classic barometer of fear and when they yield negative, you know the market is in ultra-fearful mode,” says Mr Norrey of JPMorgan.

Not only are investors attracted by the strength of government credit versus other securities, there has also been a shift in supply patterns. “Government issuance is at record levels – but a lot of issuers are not coming to the market. The covered bond market is dormant, mortgage-backed securities are not in evidence, there are virtually no initial public offerings and very few corporate bonds either,” says Mr Mutkin of Morgan Stanley.

Lack of choice

Government debt agencies are mindful of the paucity of choice facing investors. Robert Stheeman, chief executive of the UK Debt Management Office (DMO), says: “In April 2008, the [UK] government said it would be selling £80bn of gilts in the current financial year. But by November, that number had risen to more than £140bn, which meant £60bn of extra issuance in the last few months of the year. That would seem to be quite a challenge but so far, so good. In fact, the interesting thing is that supply does not seem to be the main driver of yields in this market. What determines yields and investor appetite seems to be the outlook for rates and the desire to hold government paper.”

But times are changing for debt management offices. Even if investors have played along so far, they are unlikely to continue to do so indefinitely. “Indigestion is likely at some stage,” predicts one leading banker.

No government wants to find itself facing an investor strike so many of them are taking pre-emptive action (or trying to). The UK DMO launched a consultation paper late last year, asking participants across the market to give their views on the most effective methods of distributing gilts. “At the moment, we sell debt exclusively through the auction process but we are asking the market if there are other ways that would be easier for them,” says Mr Stheeman. “The auction system is fundamentally sound and we don’t want to undermine it but in the UK, there is extremely strong demand from pension funds for index-linked gilts at the long end. We are looking at ways that might make it easier for these institutions to participate in the primary distribution phase,” he adds. “We would also consider syndication. The question is: would it help? Would pension funds like it?”

Banks certainly would. Most countries (although not Germany) pay banks to participate in their auctions. They then become primary dealers and while the rewards are relatively low, the status is coveted because it provides enhanced access to more highly paid transactions, such as syndicated loans. Some countries use this distribution method more than others. Spain and Greece, for example, rely on the syndicated market for about 40% of their annual debt requirements. Other countries, such as Germany, France, the UK and the US, rely almost entirely on the auction process.

Open mind required

But even the German Finance Agency is aware that the current market requires an open mind. “We have to use the most flexible instruments at our disposal. At the moment, there is extremely high demand for short-term instruments because the interbank market is not functioning properly. So we have added new short-term bills in maturities of three months, nine months and 12 months,” says Mr Daube. Intriguingly, he is looking at the syndicated market. “Certain circumstances might lend themselves to syndication. If we were introducing something completely new some time, like dollar-denominated paper or floating-rate notes, for example,” he says.

Syndicated loans are popular with the banking community because they confer greater status – and higher fees – on the arranging banks. But these deals also give institutional investors a much greater say in the pricing and allocation process.

“Issuers are going to have to be more creative as the year goes on. By the summer, interest rates may have bottomed out and investors may begin to lose interest. Issuers, such as the UK, are already showing more flexibility, which is good. They are also looking at syndicated debt. They have barely done this before, because they haven’t needed to. Now they do,” says one rates strategist.

“There is much less flexibility in the auction process. The market is so volatile at the moment that demand may not be there on the day a DMO is auctioning paper. With a syndicated deal, you can build up the order book in a more flexible way and investors can become directly engaged in the transaction,” he adds.

Syndicated issuance has crept up this year. Greece issued a €5.5bn five-year benchmark issue just days after it was downgraded by rating agency Standard & Poor’s. The deal attracted strong demand – with orders for more than €7bn of paper – but the yield was generous at a spread of around 260 points over Libor. Ireland also tapped the syndicated loan market with a €6bn five-year deal but the spread widened considerably after the launch, from 90bps to more than 170bps in a matter of weeks. The US is also looking actively at ways to stimulate demand for its multi-trillion dollar Treasury bill programme.

Scott Peng, head of US interest rate strategy at Citigroup, says: “The only way the Treasury market can accommodate the huge surge in supply is by looking closely at where demand is strongest. In the context of potential deleveraging by international investors, demand for the short end of the curve may weaken once the current flight-to-quality has abated. The long end should be well supported by pension reform. This is being phased in already and will be fully implemented by 2011 but it is already influencing pension fund appetite.”

George Goncalves, vice-president, US interest rate strategy at Morgan Stanley, adds: “Up until now, most issuance has been at the short end, where demand has been pretty strong as the market is very liquid. But this does incur risks because they will have to roll over a lot of paper in two to three years’ time, so there will be more issuance between five and 10-year notes in future. The point is, the Treasury has to be fully flexible across the yield curve but it would need to slowly push issuance out the curve.” Indeed, evidence of fears about the future can be seen from the range of measures they are prepared to undertake. The US Federal Reserve has openly admitted it is prepared to buy Treasuries and the Bank of England has also said it will buy gilts if necessary.

Easing comes at a cost

Quantitative easing, as it is known, would stimulate demand and keep yields low – but at a price. First, printing money to participate in the sovereign markets increases the risk of inflation. Second, it invariably causes currency depreciation, which can make government bonds less attractive to overseas investors. Since overseas investors account for about half of Treasury purchases and more than a third of gilt purchases, any fall-off in enthusiasm could have serious consequences. Third, quantitative easing is, ultimately, an artificial weapon.

“Central bank purchases of government debt will depress yields artificially but this can lead to heightened concerns among investors about valuation risk and fears of another asset ‘bubble’ down the line, as central banks would be expected to offload government securities once a recovery begins,” says Ms Komileva of Tullett Prebon. “This happened in Japan in 2003 and the sudden rise in yields caused a shock in the domestic banking sector.”

On the other hand, central banks may not have much choice but to beg, borrow and bludgeon the sovereign debt market into submission. The US Fed and the Bank of England can print money; European governments may need to use blunt persuasion and the promise of future transactions. But no government can afford to fail in their attempts to raise these unprecedented amounts of debt from the capital markets. “Governments need to incentivise banks to participate in auctions,” says Mr Norrey.

Traditionally, primary dealers buy debt at auction and sell it off to institutional investors. But these dealers are fewer in number after the collapse of several banks as well as some mergers. And those that are still in business have smaller balance sheets and are less willing – or able – to take government debt onto their books while they find end buyers. They need to feel absolutely confident that they will be able to sell the paper on and this implies a need for higher yields.

As yields become higher, two further problems arise: concern about governments’ ability to service debt and concern about the private sector’s ability to raise debt. “How can they service the debt? They could privatise assets, such as airports, roads and ports and this is clearly on many governments’ minds. They will also have to raise taxes and this clearly prolongs the economic downturn,” says one credit analyst.

Yield rise risk

If yields on government debt rises, this creates a challenging environment for the private sector as well, making it prohibitively expensive for companies to raise money. “If government yields rise, it will become increasingly difficult for the private sector to borrow and this will prolong the recession,” says Ms Komileva.

There are other pressures, too. Many economists believe interest rates might begin to rise again slowly some time in the second half of 2009. There is also a view that equity markets could show signs of life before the year end. If these early signs of recovery arise, government debt could swiftly lose what little lustre it has, a situation recognised by the DMOs themselves.

“At one point, the interest rate cycle will turn and rates will go up. Issuing when rates are rising could be a challenge. We have to be careful that our annual remit does not put an intolerable burden on the banks so we need to spread issuance across maturities and types of gilt,” says the UK DMO’s Mr Stheeman.

Governments are clearly looking at many options to encourage demand. But, with so many things to consider, at some stage it could go badly wrong – leading to surging yields, investor withdrawal and panic across the world stage. As JPMorgan’s Mr Norrey points out: “Everything is okay now but if it turns, it could be the biggest bear market of our time.” And when it comes to debt, in the words of English poet Stevie Smith, the world would be left “not waving but drowning”.