Rates rise takes sheen off government spread products
* Supras and agencies must make pick-ups more alluring
* Key central bank investors sidelined amid volatility
* Bank pressure to raise fees could also affect spreads
By John Geddie
LONDON, Oct 4 (IFR) - Supranationals and agencies will have to accept higher relative funding costs compared to their sovereign backers in the coming months as rising rates start to dull investor appetite for spread products.
Scant order books and heavy secondary trading in recent deals are already starting to demonstrate the absence of key accounts, and with rates on an upwards trajectory, borrowers will have to make their products more appealing to ensure they are able to offload their funding programmes next year.
"As rates rise, these issuers are going to have to shift their pricing to encourage demand," said Matthew Cairns, senior credit strategist at AXA Investment Managers.
"Spreads will have to change and adjust over time as we go back to the new normal."
This trend has already started to appear in longer-dated debt as investors look to shed interest rate risk in the wake of a sell-off in government securities precipitated by the US Federal Reserve's plans to taper its quantitative easing programme.
Europe's largest supranational issuer, the European Investment Bank, issued a new EUR3bn 2% April 2023 EARN in June at a spread of 49.2bp over the 1.5% February 2023 Bund. Those bonds are currently bid around 7bp wider at a spread of 56bp.
"You see widening of spreads if there is a huge move in rates, because quite simply investors try to shed duration if rates are going higher. The SSA space is less liquid than governments, so there is a bigger impact," said Josef Prokes, portfolio manager at Blackrock Fixed Income.
At the short end, however, this spread adjustment has not yet set in, and some quasi-sovereign bonds have even outperformed their government guarantors.
For instance, Europe's largest agency, German development bank KfW, issued a new five-year benchmark in June at a spread of 30.2bp over the OBL 0.25% April 2018. After pricing, the spread between the two securities tightened to around 23bp until mid-August, but has since gapped out to around 30bp, indicating that the outperformance might not last.
"If yields stabilise at very different levels from where we are now, then we will have to see more spread because the liquidity premium is something that is a percentage of the outright yield," said Marie-Anne Allier, head of euro aggregate fixed income at Amundi.
"The front end is probably more susceptible to some re-pricing in the short term because we have seen tremendously tight levels over the past 12-18 months given investors were expecting rates to remain low for a long time," added Prokes at Blackrock.
This underlying rates volatility is making investors much more price sensitive, and issuers should heed the warnings of recent failures.
The African Development Bank, which issued a USD1bn five-year bond back in January offering a 20.45bp pick-up to US Treasuries, came unstuck last week despite a more generously priced five-year.
The bonds were offered at mid-swaps plus 6bp, which equated to a 24.1bp pick-up to Treasuries. But even this was not sufficient to attract enough investor demand.
Meanwhile, the pullback from a number of emerging markets central bank investors in US dollar debt sales as they fight to prop up their ailing currencies has also impacted deals.
Bank treasury demand has, till now, helped to stem this tide with incoming liquidity coverage regulation forcing them to buy high-quality assets.
This demand is finite, however, with research by ratings agency Fitch back in June concluding that banks in the UK, Germany and France may already be hitting saturation point.
"Some banks are concluding they now have too much liquidity," said Bridget Gandy, managing director in the financial institutions group at Fitch. "The crisis mentality is ebbing and the pressure is on to increase profitability, and we're going to see some selling out of low-yield liquid assets."
Lower-yielding government bonds will be trimmed first, but the more expensive quasi sovereign names could also start to feel the effects of waning interest from these investors.
Aside from the demand dynamics, pressure to hike up fees could also affect spreads.
"If issuers relent to bank demands for higher fees, then this is also going to affect their funding levels because they will pass the costs straight through to the investor," said Cairns at AXA IM.
Fees have dropped 2.5 cents across the curve since 2010, much to the chagrin of bankers, although they are still above pre-crisis levels.
Deal originators covering supranational and sub-sovereign clients complain about the lack of profitability in the sector, given the punitive asymmetric swap agreements and sparse secondary trading.
"Issuance from sovereign, supranational and agency clients counts for around 60% of total volumes in a fixed income franchise, but just around 10% of total profits. It's increasingly hard to make a business case for it," said one head of SSA origination. (Reporting by John Geddie; editing by Helene Durand and Julian Baker)
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