Bond market risks dislocation as needs surge

A euro symbol at the ECB headquarters in Frankfurt, Germany. — Bloomberg

GOVERNMENTS are meeting more of their fundraising needs by raising debt not just through regular auctions, but also increasingly via the syndicated sales route of paying fees to investment banks to build an investor book.

The latter approach used to be dominated by companies and banks, but this year sovereign-related borrowing in the eurozone and United Kingdom constitutes half of all new syndicated debt.

There’s a risk that governments will crowd out companies needing access to the bond market

Total debt sales conducted in euros and sterling have risen 17% this year to a record €680bil (US$734bil) in the first quarter, from €582bil in the comparable period last year.

All 10 of the largest euro-denominated syndicated deals this year came from government-related issuers, with Italy alone raising €30bil this way.

Greedy sovereigns might want to consider reverting back to their own lane of issuing debt predominantly via direct auctions.

While healthy investor demand has satisfied the needs of all three categories of issuer so far, government borrowing is set to head inexorably higher just when central banks have turned from being the biggest buyers in the market to disposing of their vast bond holdings accumulated via quantitative easing.

Sovereigns, supranationals and agencies, known as SSAs, can compete aggressively with highly liquid benchmarks often with a generous new issue premium above existing debt.

Government bonds, whether sold via auction or syndication, are completely fungible.

It’s attractive for investors buying via syndication as it juices their returns to beat their benchmark indexes.

Average euro investment-grade corporate yields of 3.2% may start to look skimpy compared with the 3.3% available, for example, on five-year Italian government securities if financial conditions worsen; the greater liquidity, tighter bid-offer spreads and bigger trading sizes available in sovereign debt could tip the balance against private-sector issuers.

Sovereigns still mostly access their domestic bond markets via regular auctions, where investment banks act as primary dealers, taking positions onto their balance sheets before distributing the bonds; understandably, the banks prefer the lower risk and higher fees available on the syndicated option.

The United Kingdom government aims to raise £62bil (US$78bil) this quarter, a sharp jump from £23bil in the first three months of the year.

This includes at least two syndications of as much as £8bil each. The United Kingdom has borrowing needs of £265bil over the coming year. That’s a record draw on investors, net of redemptions.

Furthermore, the Bank of England is actively selling around £50il back into the market this year, as well as letting a similar amount mature without being reinvested.

Eurozone nations need to raise a gross €1.25 trillion in 2024. New cash will be around €450bil, but with the European Central Bank (ECB) running down its balance sheet, this effectively rises to €675bil. That’s at least €100bil more than last year. France and Germany are each borrowing €185bil. The European Union has rapidly become a major issuer, helping to finance its pandemic bailout programme. It’s aiming to raise €75bil in the first half. It issued the largest deal of March, selling €7bil of green debt.

Those increased government debt sales come just as companies face a wall of refinancing. Corporates were smart in raising plentiful amounts of debt at super-low interest rates in the second half of 2020 and into 2021.

Unfortunately, that means US$3 trillion across the United States and Europe matures in the next three years – a quarter of all outstanding corporate debt.

Euro high-yield issuers, for example, have seen their average bond maturities halve to four years from more than eight years a decade ago.

Most investment-grade corporates could weather credit spreads widening above government benchmarks.

Bigger, well-recognised or multinational firms can always access the deeper US market.

But for weaker companies with lower credit quality, market access may become more limited.

For the banking sector, it’s more complicated.

The withdrawal of super-generous funding programmes from the ECB means banks are having to replace funding, increasingly via top-quality secured covered bonds that ringfence large sections of assets. These typically yield close to government debt.

It’s not just institutional investor money that governments are tapping; they’re also targeting retail buyer for their bond sales. Belgium raised €22bil from retail investors last year. Italy has a long-standing relationship with its citizens, who’ve lent it €350bil – about 15% of its entire debt.

That’s money that would probably otherwise rest in bank accounts, depleting the deposit bases of the region’s banks.

As long as investors remain content to buy at yields that are higher now than during the pandemic, all should be well.

But with all sovereigns, companies and financial institutions all needing to raise prodigious amounts of finance simultaneously this year, the risks of bond market dislocation are escalating. — Bloomberg

Marcus Ashworth is a Bloomberg Opinion columnist. The views expressed here are the writer’s own.

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