October 9, 2015 / 8:24 AM / 3 years ago

Cracks appear in usually solid public sector bond market

* Ontario cancels, IADB falls short in tricky market

* Investors turn picky in the face of rates volatility

* Banks and central banks scale back SSA paper purchases

By Abhinav Ramnarayan

LONDON, Oct 9 (IFR) - Rates volatility and a shrinking investor base are disrupting a public sector debt market that was once a byword for its dependability and strength in the face of adversity.

Investors are proving unforgiving if the structure of deals or price tags are not spot on. This week, the Canadian province of Ontario became the first SSA issuer of the year to cancel a deal and Inter-American Development Bank ended up printing an uncovered US$1bn four-year - its smallest benchmark trade in two years.

The trades that did enjoy success, such as Italy’s 3.5bn September 2032 inflation-linked bond and the European Investment Bank’s US$4bn five-year benchmark, were timed and priced in a cautious manner that took into account any potential volatility.

Italy announced its transaction well after the European market closed to avoid potential shocks, and EIB, having waited for weeks for the right window, still priced its deal with a healthy new issue premium.

“It shows there is no room for complacency in this market,” said a banker at one of the lead managers on the Ontario trade. “You are beholden to a smaller number of investors than perhaps you were historically.”

Rates volatility is the immediate concern, with quantitative easing in Europe creating distortions in the euro market, and an impending rate hike pulling spreads in different directions in the US dollar market.


The bigger concern though is that two dependable sources of demand for SSA paper - central banks and bank treasuries - are both scaling back, albeit for different reasons.

“Some investor types that typically make up the largest components of demand for SSA deals have been operating at reduced levels,” said Alex Barnes, head of SSA syndicate at Citigroup.

“On the central bank front, the emerging markets situation that developed over the summer prompted a shift from buying to selling, although we’ve seen some signs of burgeoning interest of late.”

Many emerging market central banks have been busy deploying reserves to shore up weakening currencies, reducing the cash available to make SSA purchases.

For example, China’s central bank, a mammoth buyer of SSA paper, used US$94bn of its foreign exchange reserves in August to stabilise the renminbi after the currency’s shock devaluation.

At one point the People’s Bank of China could be depended upon to provide as much as 30% of demand for public sector deals, one banker reckons, but in recent weeks it has become much less active.

China is not the only country struggling with this issue: Malaysia, Indonesia, Turkey, Brazil, Mexico and Chile have all seen their currencies fall sharply against the US dollar this year.

The slowdown in central bank demand has coincided with a more tempered bank treasury bid for public sector debt.

“On the bank treasury side, for a long time they were aggressively adding to their SSA portfolios, but a lot of those accounts are now reaching [the limits of liquidity coverage ratio] compliance,” said Citigroup’s Barnes.

“They are in much more of a steady state situation - having to maintain rather than grow their portfolios means they are not coming into deals with such large order sizes as before.”

Kerr Finlayson, an SSA syndicate official at RBC, said he thought there was at least a year or so left in terms of the big guys.

“But it’s probably fair to be a bit concerned about the investor base going forward, particularly with some Asian central bank demand going missing,” he said.


Neither class has stopped buying SSA bonds. More than 75% of last week’s biggest euro and dollar trades - KfW’s 5bn three-year and World Bank’s US$5.25bn dual-tranche - were bought by the two sectors. However, they have become more selective.

“The traditional bank treasury bid is no longer there at tight mid-swap levels as banks’ funding costs have gone up. However, if you bring deals at a more attractive level, they are still likely to be involved,” said Damien Carde, head of frequent borrowers DCM at RBS.

“Given most of them are buy-and-hold investors, we have to be a bit more active in enticing these bank treasuries now, they are just being more picky. Some European/Asian central banks, who have also been quite active in many SSA deals, are now also very selective in terms of new issue premium versus secondary levels.”


The upshot of all of this is that execution of deals is more challenging and could become even more so.

In the case of Ontario, lead bankers said a variety of factors influenced the decision while observers suggested this was another sign that investors are becoming more finicky.

“Investors are more and more concerned about liquidity, and are sticking to the more liquid names that are eligible,” said one SSA syndicate official away from the deal.

A DCM official said he was concerned about the implications for the fourth-quarter and beyond.

“I know we expect a wall of issuance every January and we tend to believe nothing will stop that happening - but I’m not so sure this time,” he said. (Reporting By Abhinav Ramnarayan, Editing by Matthew Davies and Helene Durand)

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