Goldman Sachs drew on its expertise in inflation-linked bonds in an innovative 15-year issue for Agence France Trésor. Geraldine Lambe reports on how it suggested the move and helped make the deal.
Goldman Sachs is something of an expert in inflation-linked products: it has been leading the market with economic auctions and is a lead bank of the French debt management agency, Agence France Trésor.
“Over the past two or three years, Goldman Sachs has intensified coverage of the Trésor, because our focus on inflation products enables us to see exactly where the flows are going and therefore to have a more meaningful dialogue with this crucial issuer in the inflation-linked market,” says Alejandro Garcia, associate in debt capital markets at Goldman Sachs.
In January, Goldman, alongside BNP Paribas, Deutsche Bank and SG, was lead manager when Agence France Trésor issued the first euro-denominated 15-year index-linked bond. The e4bn issue completed the Trésor’s yield curve and filled a gap in the maturity profile of inflation-linked product.
The growth and popularity of this product, at a time of disinflation for most major economies, begs the question: why now?
Mr Garcia says there is a growing structural need among institutional investors and pension funds – it is simply a case of asset liability management. “Inflation-linked bonds are a natural hedge for such investors,” he says.
Interest rates shake-up
Another element feeding into linkers’ dynamic growth pattern is banking-related reform in countries such as France. From July this year, the interest rates offered by local French deposit accounts – the so-called Livret A and Codevi accounts, in which about e350bn is already invested – will be linked to Euribor and French inflation (see page 55).
“When this regulation comes into force, it will create a huge demand for index-linked securities from all the banks wanting to match their liabilities in such deposit accounts,” believes Alban de Clermont-Tonnerre, executive director, responsible for French clients’ origination.
The Trésor is the biggest European issuer in the inflation-linked sector – it is committed to issuing at least 10% of total government debt in linkers, which this year will probably amount to e12bn to e13bn.
So why has it left it until now to tap into the 15-year market? It is a response to investor demand and the French reforms, but, says Mr de Clermont-Tonnerre, it also signals the Trésor’s long-term plans to build a yield curve. “When you launch a product, you begin with the five- or 10-year securities as the 15-year is not seen so much as a benchmark issue. But now that the other maturities are well established, the 15- year bond is a logical step – it closes the gap in the Trésor’s yield curve.”
Detecting investor demand
According to Mr Garcia, external forces also helped to shape the Trésor’s strategy: “We advised the Trésor to issue a European-linked new line and, because last year Italy tapped the five-year market, we believed that segment had already been satisfied by the e10bn issue. The 15-year was therefore seen as a good opportunity to tap investor demand and complete the yield curve.”
In the division of roles between the four joint leads, Goldman Sachs was responsible for developing the pricing methodology. As it was a new point in the curve, this was not a straightforward task. First, there was the question of whether to price the new bond as a spread over the 2012 OATi (Obligation Assimilables du Trésor – a medium-term bond) or as a break-even over the 2019 bond. Goldman believed that investors would be more comfortable with the former but the Trésor was concerned that, as the 2012 bond is not particularly liquid, it could cause some market manipulation. It therefore favoured a break-even analysis to the much more liquid 2019 nominal bond.
“It was decided that we would show the spread over the 2012 to investors because they were more comfortable with that, and then, in the final few hours before pricing, we switched to the break-even model,” says Mr de Clermont-Tonnerre. “We were lucky that the market wasn’t too volatile. There was a strong correspondence between the spread over the 2012 and the break-even to the 2019. But, of course, by switching from one to the other the night before pricing, we took a risk that the curve could have shifted.”
The four leads quickly agreed that it should be priced on a fair-value, rather than a premium, basis. “And we brought four different pricing methodologies to calculate fair value but they all came to a result that was within a four basis point range,” says Mr de Clermont-Tonnerre.
Another debate surrounded the desired maturity. Mr Garcia says that since it was a new point on the curve, the question was whether or not to issue a straight 15-year with a 2019 maturity or, as they ended up doing, a bond due in 2020.
Each option had its pros and cons. A straight 15-year issue would have been more familiar to investors, who were already having to deal with a new product. On the other hand, the Trésor has a big concentration of bonds that mature in 2019, so from that perspective – and bearing in mind that this latest issue could grow to e9bn or e10bn throughout its life – it was not ideal to keep adding to that same maturity.
“The 2020 issue has two key advantages that led to its selection. Firstly, it makes the life of the benchmark a bit longer. It also makes the Trésor’s life easier because of the smoother amortisation profile,” says Mr Garcia.
Consensus on price
To ease the process further, the four lead banks surveyed their investor base and found that a 2020 maturity did not cause any concern for them and the leads easily reached agreement on the correct pricing for the year’s extension. “There was a large consensus on what the spread should be between the 2019 and the 2020,” says Mr de Clermont-Tonnerre.
Ziad Awad, head of frequent borrower syndicate, says the distribution shows the investor base is expanding. “More and more central banks [which accounted for 10% of the allocated order book] have dedicated funds following inflation products,” he explains.
And, for the first time, Asian investors took part in an inflation-linked deal. Although they accounted for only 4% of final distribution, it is seen as another positive sign for the market. “It’s quite unusual for Asia to participate in such long-dated index-linked deals,” says Mr Awad. “As the central bank allocation increased, so too has Asian centralbank participation.”
Rosy future
Mr Awad says Asian investors initially were interested in bagging a larger percentage of the deal but ultimately declined because of market levels. “However, it shows that there is a growing potential investor base for the future.”
There are other reasons why the future looks very rosy for inflation-linked issuance, says Mr Awad. “As people look at potentially rising yields in a bear market, they will look to buying an inflation-linked product. With its lower beta, when yields are going up by 10 basis points we expect yields on inflation bonds to go up by only six basis points. This makes it a good defensive investment in a selling market.”
The pace of growth is also being driven by the swaps market. The increasing popularity of inflation swaps is helping to boost the index-linked market by increasing liquidity. “Demand for Italy’s five-year cash bond was driven by swaps traders,” says Mr Awad. “They are increasingly asking for new issues to hedge their books.”
All in all, it was a smooth deal, says the Goldman Sachs team: it involved an experienced, top-notch issuer, which was bringing to market an increasingly popular and structurally required product for thirsty investors. Were thereno dramas?
“The only real debate was over what picture we should use for the marketing literature,” says Mr de Clermont-Tonnerre. “We all had a long discussion over whether there should be a baby [the previous favourite] or a bridge. As it was essentially a new line, not a new product, and it was bridging the gap between the 10-year and the 30-year issues, the bridge won.”
