Last year was a first for many in the bond markets – the first time they’d experienced rapidly rising and highly volatile interest rates and yield curves that turned flat or, in some currencies, inverted. By Nick Herbert.
Inflationary pressure was already building in the global economy before Russia’s invasion of Ukraine sent oil, coal and gas prices surging higher. Higher energy costs reinforced the underlying inflationary trend, which combined with tight labour markets, sent price rises in the UK, for example, to levels not seen for over 40 years.
Central banks around the world reacted to the jump in wholesale and retail prices by rapidly increasing short-term interest rates. The US Federal Reserve, for instance, raised interest rates from close to zero at the beginning of 2022, in a momentous series of hikes to target 4.75%–5% in March 2023 – the highest borrowing costs in the US since 2007. In Europe, the ECB’s deposit facility moved from –0.5% at the beginning of 2020 to 3% in March 2023. Yields in 10-year German government bonds also turned positive – reaching 2.4% in February 2023 from all-time lows of around –0.58% in November 2022.
The consequent volatile impact of higher rates on bond prices resulted in greater levels of cautiousness among fixed-rate investors – and uncovered evidence of instability in the banking sector.
Raising debt at any time for any borrower has its challenges, but the recent magnitude of interest rate volatility and the establishment of negative-sloping yield curves provide a novel test.
“Every year has been different in terms of challenges: there's been Covid, a war, then there's inflation, and all the problems with the banking sector. There's always something around the corner that you cannot forecast,” said Antti Kontio, head of funding at Municipality Finance.
The effect is compounded by the withdrawal of underlying support for bond markets that came from the quantitative easing programmes initiated following the last financial crisis and the Covid pandemic.
The European Asset Purchase Programme, which initiated operations in October 2014, began to wind down in July 2022 with no net purchases being made, and from March 2023, only partial reinvestments of redemptions will be made.
“The purchase programmes massively supported the economy and the financial sector,” said Kontio. “When this goes away, it has an effect on inflation, on the economy as a whole, and on bond yields.”
For those issuers headquartered in Europe and issuing in euros, it has made for a slightly soggy secondary market.
“You always had a buyer for bonds – perhaps not in the primary markets, but in secondary,” he said.
Shorter interest
Conventional wisdom suggests that in times of flat or downward-sloping yield curves, investors are more comfortable buying short-dated securities, avoiding the huge duration-linked price swings of holding bonds with longer maturities. Something that caught out UK pension funds in 2022 and US banks in 2023.
“With curves flat or inverted in most currencies, short-term maturities are generally more attractive for investors, because why would you want to invest in super-long maturities if returns are lower?” said Kontio. “What is more important on the funding side is, of course, trying to understand investor appetite in different markets.
“This would be a very easy task if yield curves were upward-sloping, but it's not the case,” he said. “It's something we discuss quite a lot with investors – just to understand where the sweet spot exists for the investor community.”
According to Refinitiv data, issuance from sovereigns, supranationals and agencies has marginally reflected the attractiveness of bonds at the front of the curve.
To April 18 2023, five-year issuance from SSA borrowers represented a 17.7% share of total volumes, versus 14.8% over the equivalent period in 2022. In the seven-year maturity, bond supply was 9.6% of the total versus 8.9% in 2022, and in the 10-year maturity it was 21.9% versus 22.1%.
The lack of a marked adjustment in issuance maturity profiles is explained by the number of different types of investors in the bond markets and their asset and liability matching strategies: central banks at the short end, banks in the intermediate maturities and asset managers/insurance companies in the longer end.
“But then, of course, depending on market conditions, the composition of investor buying on any one day may be different,” said Kontio.
There has been a corresponding impact on issuance behaviour within the issuer group and that has been revealed in the maturity profile of incremental new issuance – although here again it has not been pronounced.
“We’re talking about small, small changes,” said Kontio. “But also driving that move is what’s happening on the lending side where customers are also taking out shorter loans. It’s been a happy coincidence in an environment where the market is going for shorter dates anyway.”
It’s a similar story at IFC, where the weighted average maturity of its funding aligns with the weighted average maturity of its loan book. The average maturity of the loan book has shortened in recent years as long-term project financings have slowed following Covid and demand for working capital and corporate loans has increased.
“As our loan book has shortened in terms of weighted average maturity, it happens that our shorter-dated needs have aligned with investor interest in shorter-dated paper," said Flora Chao, IFC’s global head of funding. "So, our benchmark last year was a three-year, where traditionally we'd do a five-year.”
In September 2022, IFC launched a US$2bn three-year deal at 25bp over mid-swaps.
At NIB, the average maturity of its new issuance has lengthened, but that can be partly attributed to the choice of this year’s benchmark maturity date.
“Last year, the average maturity of our funding was about four and a half years but this year it’s already around five and a half years,” said Jens Hellerup, head of funding at NIB. “We’re not the biggest issuer in the first place and we chose to do a five-year benchmark rather than a three-year in March. We still expect to do a three-year US dollar benchmark later in the year, which will bring down the maturity.
“It's true that there is an incentive to go shorter with a flat curve, but if you think rates should come down at some stage, maybe faster than expected, then for investors maybe a five-year was a good choice for us to tap into,” he said.
For the World Bank, there was an observable lack of depth in the dollar markets at the longer end of the yield curve. In recent years, it had successfully been extending its portfolio of jumbo trades out past the five-year tenor into the seven-year and 10-year part of the curve. It was a phenomenon determined by the paucity of yield levels during a period of zero and negative short-term interest rates.
“Investors that we used to see only going out to five years, were willing to move out to the seven and 10-year maturity deals,” said Andrea Dore, head of funding of the World Bank.
With interest rates moving back into positive territory, the need for investors to look further out the curve to secure returns has diminished. That shift in investor sentiment partly explains the World Bank’s change in issuance activity. Launching shorter-dated bonds also reflects a change in strategy at the borrower.
“We took a strategic approach few years ago to extend the average duration of our issuance to reflect investor demand looking for yield further out the curve and to smooth out our redemption profile,” said Dore. “By issuing longer-dated bonds, we moved the average duration of our new borrowings from roughly four or five years out closer to eight or nine years.”
Last year, the World Bank issued less in the longer end of the curve.
“We decided we could bring maturities of new bonds down by at least a couple of years,” said Dore. “We're now about six or seven years on our incremental borrowings.”
The EBRD found a sweet spot for its benchmark paper further out the curve than initially anticipated.
“It’s interesting,” said Isabelle Laurent, head of funding at EBRD. “In January and February, when we were thinking of doing a benchmark, central banks were said to be looking at two and three-year maturities, partly because of the volatility and partly because of the shape of the curve, which would make it difficult to get good central bank demand for anything longer.”
In early March, EBRD priced a US$2bn five-year at SOFR mid-swaps plus 31bp, 4bp through initial price thoughts of 35bp area, for a new issue concession of just 1bp.
“We weren’t looking for significant volumes of two or three-year money,” said Laurent. “So, we timed coming at five-years when we thought markets were stable enough to get a decent following. In the end, we placed around 60% of the deal with central banks and official institutions – and we'd only been looking to do a billion. It was very fortunate and rather unexpected.”
Open and shut
Understanding the maturity preference for investors has proved essential in choosing the right part of the curve to tap to ensure a successful reception for a deal over the last 12 months, but judging the best time to price has been critical.
The timing within which borrowers can successfully approach the market has been just as volatile as the underlying interest rates, with the window of opportunity for launching deals prone to quickly slam shut, at unexpected moments and across data points that would normally be dismissed as insignificant.
It’s an example of the skittishness of the markets.
“There was always certain data that you would avoid pricing over – nonfarm payrolls or CPI or similar – but now even seemingly historically innocuous data could upset the market,” said Laurent. “Trying to find the moment where you can do a deal, where you're not catching any particular data announcement, has been very important.”
It is an experience widely shared.
“Increased volatility does have an impact in terms of timing deals,” said Dore. “And what we have observed over the last year or so is that a lot of data that used to be seen as benign can really influence our decision to launch from a timing perspective. It’s having a greater impact.”
Choosing to launch deals across data points is risky, but delaying deals runs the risk of borrowers joining a queue of peers also looking to tap the market at the same time.
“Timing is important because, with the market volatility you have issuers on the sidelines at certain points because of market accessibility,” said Chao. “And that just means that windows to issue are much narrower or more crowded.”
For IFC, the pressure to launch is perhaps less profound than some of its more regular bond-issuing peers, since it typically launches just one US dollar benchmark per year.
“We maybe have less pressure accessing the market during a crowded window,” said Chao. “We can wait.”
Paying for quality
Pricing successful deals requires good timing – and perhaps a large slice of good fortune. But when all the stars are aligned, then there’s still cash to be put to work. The top borrowers can still realise some tight pricing.
“I don’t know whether to frame it as good timing or plain lucky, but we came with our five-year benchmark just three days before the Silicon Valley Bank failure,” said Hellerup.
On March 7, NIB priced a five-year US$1.5bn Global bond, its first US dollar benchmark of the year, drumming up the borrower’s largest US dollar order book to date (US$4bn-plus) and achieving a tight mid-swap spread.
It was priced with a spread of 11.15bp over the 4% February 2028 Treasury, equivalent to SOFR mid-swaps plus 30bp.
The outcome for its yearly five-year dollar benchmark outing proved the quality of NIB’s name within the international investor community. It also suggested that the borrower is a beneficiary of a flight to quality during the market volatility and insecurity.
“We saw a good chance to issue following a fairly quiet period of business in the primary bond markets,” said Hellerup. “And I think investors were keen to get hold of paper from a top credit because, at around 11bp over US Treasuries, the level we achieved is historically tight for us.”
It indicates that investors are happy enough to pay a little bit extra for paper from a highly rated issuer despite an overall widening of margins against swaps.
“During the good times, when there was lots of liquidity in the market and a big compression in spreads, there was not much difference between us and our second-tier peers in terms of margin,” said Hellerup. “But now we see that differential coming back a bit. This must be a reflection that investors prefer to have the stronger names.”
Big and beautiful
In times of volatility and market insecurity, it is understandable for investors to show a preference, not only for shorter-dated securities, but also for liquid assets.
The trend towards issuers launching larger deals is not necessarily a consequence of the recent bout of interest rate volatility but it has been a feature of the markets in recent years.
“We see the market favouring public transactions as a long-term trend,” said Kontio. “We used to be quite heavily focused on structured deals, but allocations to that product have dropped and we’re focusing more on public deals. The question then becomes one of size.”
MuniFin has a funding target of around €8bn–9bn for 2023.
“Our aim is to add liquidity,” said Kontio. “We want to show commitment to the market. We can do that with public benchmarks in the core currencies, and especially in euros where we have the capacity to tap existing bonds.”
Larger deals do not always guarantee asset liquidity, however.
“It depends on the definition of liquidity,” said Dore. “It’s true that we're getting accustomed to jumbo trades, but I think liquidity goes beyond just the size of the transaction itself.
“A lot of these trades are placed with high-quality accounts that might hold paper to maturity, so you may not necessarily see a lot of turnover in secondary,” she said. “Some investors do have certain size targets, however, maybe requiring a deal of US$1bn or more before buying paper, and for some investors the size of the deal is obviously an indication of the number of investors in the transaction. Size is not the only criterion for liquidity.”
Eggs and baskets
Benchmark-sized issuance in core currencies may bring welcome receipts for issuers, but a reliance on this funding route comes with its own risks and limitations.
“Even in times of volatility when it seems that none of the markets work, it’s often the case that something works,” said Kontio. “And then, of course, it makes sense to have a diversified funding base: in sterling, Aussie dollars, the Nordic currencies, for instance.”
Diversification is important for those borrowers on-lending in frontier currencies.
“I thought that with absolute interest rates going up in dollars and euros we might see interest in frontier funds diminishing, but actually that hasn't transpired at this point,” said Laurent. “We've done €6bn of an €8bn borrowing programme this year and a significant portion of that has come in exotic currencies.”
It is also important for those issuers able to hit tight funding targets when swapping back to base currencies. Basis swaps have been notably accommodating in the Australian dollar market this year, where there is constant demand for top-rated issuer paper from domestic investors.
“We've had a lot of positive demand in Australia,” said Chao. “This year, almost 30% of our issuance has been in Aussie dollars. Historically, it's closer to 10%–20%. The cross-currency basis has worked in our favour. We have been able to tap our existing lines at our private placement or reverse enquiry levels across the curve, so that's been very good for us this year.”
Many of its peer group have also been keen to look to Antipodean demand, with a raft of Triple A SSA borrowers appearing in the Kangaroo market as well as in New Zealand Kauri bonds.
Volatility in the fixed-income markets and downward-sloping yield curves may present challenges in determining the sweet spot of investor interest in terms of maturity, timing and currency, but for those borrowers with a fully floating-rate balance sheet, they are largely immunised from absolute levels of underlying interest rates. A flight to quality in uncertain conditions could even work in their favour.
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