EUROPEAN COMMISSION DIRECTORATE-GENERAL ECONOMIC AND FINANCIAL AFFAIRS. N 15 (April-June 2000) QUARTERLY NOTE ON THE EURO-DENOMINATED BOND MARKETS

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1 EUROPEAN COMMISSION DIRECTORATE-GENERAL ECONOMIC AND FINANCIAL AFFAIRS F1:Financial markets and financial intermediaries and SOF-B5: Borrowings and Treasury N 15 (April-June 2000) ECFIN/291/00-EN QUARTERLY NOTE ON THE EURO-DENOMINATED BOND MARKETS HIGHLIGHTS In this issue, we examine developments in April-June 2000 relative to the previous quarter. Second-quarter bond issues in euro totalled 329 billion. This implies a fall of almost 1 relative to the first quarter and is next to the lowest quarterly issuance (Q4/99) since the introduction of the euro. The decline in issuance can be attributed to lower sovereign borrowing needs but also to negative market conditions for much of the quarter. Several sovereign issuers retreated from the market as better-than-expected budgetary results and/or exceptional revenues have reduced their projected borrowing requirements. There was also a sharp reduction in issues from financials, while corporate issuance expanded. Conditions for issuance were unfavourable in April and May, as interest-rate uncertainties and price volatility depressed market sentiment and credit spreads widened. In this issue, we expand the analysis of market developments by introducing a more detailed description of coupon types, differentiating between four categories of bond issues - fixed rate, floating rate, zero coupon and other coupon-type bond issues. The featured item relates to the persistence and recent widening of spreads in euroarea government bond yields. This series of notes, and a statistical annex, are available from the European Commission website at:

2 THE EURO-DENOMINATED BOND MARKETS -APRIL-JUNE INTRODUCTION Issuance in euro-denominated bonds in the second quarter of 2000 declined relative to the impressive performance of the previous quarter. The flow of new issuance was adversely affected by a deterioration in market sentiment as price volatility and generalised uncertainty concerning credit spreads made investors reluctant to commit funds on a large scale. PART ONE:DOMESTIC AND INTERNATIONAL ISSUES BOND ISSUES Issuance in euro totalled 329 billion in the second quarter; compared to almost 370 billion in the previous quarter and a quarterly average of 350 billion in in EUR million GRAPH 1-ISSUING ACTIVITY IN 1999 AND Q Q Q Q Corporates Financials Pfandbriefe, Asset Backed Securities Governments, Agencies, Municipals, Supranationals 1 Note: data from previous quarters have been revised from previous editions of this report. All figures quoted are from the DG ECFIN SOF database unless stated otherwise. In this database, all euro denominated issues of an amount of 50 mn or more are recorded. It should be noted that the database includes all issues of a maturity of 1 year or more (incl. in particular Italian and French discounted paper of significant issue amount). Throughout this note, payment dates - as opposed to announcement dates - of new issues have been taken into account, unless otherwise stated otherwise. Data are subject to revision. 2

3 In respect of international bond issuance, market sources suggest that volumes denominated in US$ exceeded those denominated in euro. Analysts attributed this development partly to the fact that international investors are more accustomed to analysing private sector credit spreads in the United States, particularly in volatile market conditions. TOTAL 1999 Governments 619, , ,478 Other sovereign 70,548 11,909 16,689 Pfandbriefe+Asset Backed 294,629 63,814 66,229 Financials 280,483 70,925 56,880 Corporates 140,390 28,510 38,087 Total 1,405, , ,363 STRUCTURAL DEVELOPMENTS Type of issuer The second-quarter decline in euro-denominated bond issuance reflects a significant fall in sovereign issues and in issues from the financial sector. Sovereign issuance fell by more than 40 billion compared to the previous quarter as a result of front-loading in earlier months of this year. The share of government bonds in total issuance was 46% compared to 52% in the previous quarter, with the share of financials falling marginally to 17%. Early market projections had indicated that total sovereign issuance could be down by more than 10 % this year, but subsequent projections - taking account of exceptional revenues from UMTS licences - put the likely decline closer to 20 %. GRAPHS 2-DIFFERENT TYPES OF ISSUER, %OF TOTAL VOLUME ISSUED Corporates 8% Pfandbriefe 16% Agencies 2% Governments 52% Pfandbriefe 18% Corporates 12% Agencies 4% Governments 46% Financials 18% Asset Backed Securities 2% Supranationals Municipals Financials 17% Asset Backed Securities 2% Municipals In contrast, the corporate and pfandbreife sector have contributed actively to the supply of bonds to the market so that their combined share in total issuance rose to 30% from 3

4 24% in the previous quarter. The capacity of corporates to raise substantial amounts of funding through euro-denominated bond issues - even in unfavourable market conditions with widening spreads for corporate issuers and volatile equity markets - can be seen as evidence of robustness in the euro-denominated market as a whole. A notable event was Deutsche Telekom's launch of the world s largest Global Bond issue on 28 June, totalling 15.2bn (US$14.6bn). It was the first simultaneous four-currency global deal, consisting of several tranches in US dollar, euro, sterling and yen. It was also the largest corporate bond ever issued in the international capital markets, overshadowing the 9.4bn ($9bn) issue by Tecnost in 1999, which funded Olivetti s acquisition of Telecom Italia. The Pfandbriefe market was one of the success stories of 1999 and maintains a high share in total issuance. This situation is unlikely to change as mortgage lending continues to expand rapidly and as government issuers are expected to further reduce their presence in the market over the coming quarters. Issue size Reduced sovereign issuance resulted in a decrease in the average issue size in the second quarter, contributing to a more balanced distribution of issue size between the four categories. Private sector bonds continue to be issued in all sizes, highlighting the ease with which the market can satisfy a wide range of financing needs of the private sector. Looking ahead, the average issue size is likely to remain at the high levels of 1999 as liquidity has again emerged as a high priority among investors. The emphasis on large issues is most evident in the government sector but is gaining ground also among agency, corporate and pfandbreife issuers. It should be noted, however, that large issue sizes can also be accomplished by reopening issues and by exchange offers, so that a somewhat distorted picture is obtained when looking at new issues only. GRAPHS 3-ISSUE SIZE, %OF TOTAL VOLUME ISSUED 2 35% % 29% % % % 23% 26% Key: (1) between EUR million 50 and 500 (3) between EUR million 1000 and 2000 (2) between EUR million 500 and 1000 (4) more than EUR million It should be noted that if only international issues are considered the share of very big issues is substantially lower. This is due to domestic short-term instruments, which are of a very big size. 4

5 Credit quality Based on information from the Commission database (which does not provide complete coverage), the distribution of ratings in the second quarter of this year was as follows: Bond Rating/ Distribution of issues AAA AA A BBB BB B CCC NR % of total number of issues %oftotalvolumeofissues Compared to the first quarter, the share of AAA-rated issues increased slightly at the expense of issues rated below A. However, changes in the ratings of issuers have been rather insignificant over the last couple of quarters and there is no discernible trend in this respect. GRAPH 4-RATINGS, AS % OF TOTAL VOLUME ISSUED WITH A RATING NR 29% AAA 26% NR 28% AAA 30% B 2% BB BBB 3% A 1 AA 28% B BB BBB 2% A 1 AA 27% Geographical origin of demand and supply The geographical origin of issues has remained fairly steady from quarter to quarter. However, a fall in the share of issues coming from the non euro-area EU countries (from 5% to 2%) can be detected between the first and second quarters of this year. The strongest issuing activity outside the euro-area came from North America, where US multinationals are still raising substantial amounts of money in the euro corporate bond market. 5

6 GRAPHS 5 ORIGIN OF ISSUERS, AS % OF TOTAL VOLUME ISSUED Rest of Europe EU excl. Euro area 5% USA, Canada and Latin America 5% Rest of Europe 2% EU excl. Euro area 2% USA, Canada and Latin America 4% Japan, Asia and Oceania Euro area 89% Euro area 9 Maturity structure The trend toward shorter maturities seen in 1999 has resurfaced, with the share of 1-3 year issues rising to 28% in the second quarter from 24% in the previous quarter. This could be one effect of the decline in sovereign issuance, combined with increased volatility and uncertainty in the market. GRAPHS 6-MATURITY STRUCTURE: AS % OF TOTAL VOLUME ISSUED over 11 years 12% 1-3years 24% over 11 years 9% 1-3years 28% 7-11 years 29% 7-11 years 28% 3-7years 35% 3-7years 35% 6

7 Coupon types In this issue, we introduce a more detailed description of coupon types, differentiating between four categories of bond issues; fixed rate, floating rate, zero coupon and other coupon type bond issues. The trend towards concentration on plain vanilla fixed-rate coupon bonds was reversed in the second quarter of this year, as demand for floatingrate notes enjoyed a minor revival. GRAPHS 7 SHARE OF COUPON TYPE IN TOTAL VOLUME ISSUED Zero Coupon 14% Other Zero Coupon 14% Other Floating 13% Fixed 72% Floating 20% Fixed 65% Benchmarks The question of benchmark status for fixed rate bond issues remains open. At the 10- year maturity, the German bund is firmly established as a benchmark and the 5-year bund seems also to have acquired benchmark status. This development has been attributed to high turnover in their respective futures contracts and to a lively repo market. However, French issues appear to yield the lowest interest rates at intermediate maturities (3 and 7 years). The absence of a single benchmark complicates the pricing of new bond issues, requiring issuers to spend more time and resources in ascertaining the likely market-clearing price. 7

8 PART TWO:LONG-TERM INTEREST RATE EVOLUTION - YIELDS AND SPREADS The euro yield curve was stable in April, with only a slight increase evident in rates at the short end. Movement in the curve was more pronounced in May, reflecting a marked increase in rates at the short end and a modest reduction in rates at the long end. Stability returned in June, however, with a remarkably uneventful interest-rate environment and virtually no change at all in the curve. Analysts attributed movements in the curve over the quarter as a whole to monetary policy measures taken by the ECB, to inflation expectations and to developments on the US bond markets. GRAPH 8 EURO YIELD CURVE 3 Long-term interest rates are likely to reflect the interaction of a reduced supply of sovereign issuance and rising demand for long-dated bonds due to the continued growth in pension-related investments. Developments in the United States are seen as supporting this view, with analysts attributing significant importance to the reduced borrowing requirement and buy-back programme of the US Treasury in explaining the inversion of the US yield curve. 3 Source: Eurostat (A daily update of euro yield curve statistics can be found on the EUROSTAT internet site) 8

9 Maturity /01/ /03/ /06/ /09/ /12/ /03/ /06/ Movement in the euro yield curve early in the second quarter reduced the spread between two and ten-year rates to about 70 basis points. This flattening trend continued in May when this spread was reduced to an unprecedented low of 40 basis points. The spread remained stable for most of June and ended the quarter unchanged at 40 basis points. The flattening in the yield curve mirrors developments in the United States where the yield curve has been inverted for several quarters. GRAPH 9 EURO YIELD CURVE 1999 AND Q22000 Spreads between sovereign issuers Yield spreads among euro-area sovereign issuers widened slightly from a range of basis points early this year to a range of basis points during the second quarter. However, the spread widening has occurred in an environment of generally rising interest rates and a much more pronounced spread widening for other types of issuers. This behaviour is not uncommon in the bond markets, with periods of less favourable 9

10 market conditions characterised by widening spreads between different issuers. Another factor behind the spread widening, often quoted by market professionals, was the renewed focus on liquidity by major investors to the detriment of smaller bond issues from Member States with limited financing needs. GRAPHS 10 YIELD SPREADS ACROSS SOVEREIGN DEBT ISSUERS AVERAGE BENCHMARK 5Y AVERAGE BENCHMARK 5Y D F FIN NL A E PT I B IRL D F FIN NL A PT E IRL B I AVERAGE BENCHMARK 10Y AVERAGE BENCHMARK 10Y D F NL IRL L FIN E A I B PT NL F IRL FIN L E A PT B I D Source: Datastream It should be noted that this analysis of spreads focuses on the relative position of yields on 5 and 10-year securities. At other maturities, the picture is somewhat different. For example, French government bonds with 3 and 7-year maturities have consistently offered some of the lowest yields within the euro area. 10

11 - FEATURED TOPIC - Government bond spreads in EMU some preliminary reflections Why have the spreads on euro-area government bonds remained significant? The launch of EMU created a more homogenous capital market in the euro area. The elimination of exchange-rate risk between euro-area Member States and their generally high rating as sovereign issuers 4 was widely expected to result in a narrowing in yield spreads from pre-emu levels. This expectation was supported by the previous behaviour of yield spreads between Germany, the Netherlands and Austria. While the financial crisis of late 1998 led to some widening in EU yield spreads at that time, most observers viewed this as a short-term phenomenon. In fact, significant yield spreads have persisted over the past eighteen months and more recently have tended to widen (see Table 1) Table 1: Historical Yield Spreads against Germany in basis points Maturity 10 year ** 10 July Day 1 Mon 3 Mon 6 Mon 12 Mon 1/2000 (1/99)* German 10 y DBRS 1/4 07/ (1/99: 3.87) French 10 y FRTR 5 1/ (1/99: +3) Italian10y BTPS5 1/ (1/99:- +6) Spanish 10 y SPGB 4 01/ (1/99: +11) Dutch10yNETHER5 1/ (1/99: +5) Portuguese 10 y PGB / (1/99: +20) Belgian 10 y BGB3 3/4 03/ (1/99: +21) Austrian 10 y - RAGB 5 1/ (1/99: +14) Irish 10 y IRISH 5 3/ (1/99: +21) Finnish 10y RFGB 5 3/ (1/99: +17) * Spreads for 1/99 relate to the average of the first 3 trading days ** Indicated bonds are those used at present, historical data refer to different bonds Source: Bloomberg, 10 July Depending on the rating agency, about half of euro area members are rated AAA and the remainder are rated AA. 11

12 A number of possible factors can be identified as explaining the behaviour of euro-area yield spreads, although their relative importance is difficult to assess. These factors include: Market segmentation: The technical, legal, regulatory and supervisory differences that remain between euro-area bond markets create obstacles to the creation of an area-wide financial market. Such market segmentation is likely to be reflected in persistent yield spreads. Liquidity: In a broad sense, yield spreads between euro-area government bonds reflect a liquidity premium due to differences in market size, turnover, bid-ask spreads etc. Liquidity considerations are normally associated with corporate spreads, but have become more important for government issues in the context of EMU where investors are no longer confined to their domestic markets by exchange rate concerns. The possibility to hedge bond positions in the futures markets (as well as access to an active repo market) has also emerged as an important determinant of liquidity. The advantages of interaction between cash markets and derivative markets has led to a concentration of investor demand in so-called on the run issues, which are in high demand and trade at a premium even over similar off therun issuesbythesameissuer. Primary dealer systems and issuance techniques: Since the launch of EMU, euro-area sovereign issuers have faced greater competition in their own previously sheltered markets. In the absence of exchange risk, investors in euro-area government bonds have a greater incentive to opt for those markets with more efficient issuance and market making. This has focussed investor attention on issuance techniques and primary dealer systems. In some of the smaller euro-area Member States, bank consolidation has reduced the number of primary dealers and market makers to an extent that the functioning of the government bond market may be perceived as relatively inefficient. Scarcity: Budgetary consolidation across the euro area is reducing the supply of government bonds, albeit on a much smaller scale than in the United States. The result of this phenomenon is the emergence of a scarcity premium. This scarcity premium, which is positive for bond yields, may be more pronounced for benchmark issues and would thus contribute to a widening of spreads across the euro area. Why have euro-area yield spreads widened in recent months? Since April 2000, yield spreads on government bonds in the euro area have tended to widen (as illustrated by the charts for Belgium and Portugal below) although there have been exceptions such as Finland and the Netherlands. In explaining the recent spread widening, several factors have been cited by analysts, including: Short-term supply uncertainties: Market uncertainties concerning supply conditions due to sustained budgetary consolidation have been intensified in the short term by the scale of windfall receipts now expected from the sale of so-called UMTS licenses. On the basis of experience in the United Kingdom, a very significant reduction in the borrowing requirements of several euro-area Member Sates is now likely over the next couple of years. The timing and revenue 12

13 implications of UMTS license sales differ across Member States. In Germany, projected receipts (more than 60 billion) are the highest in the euro area and markets now expect the volume of German issuance in 2000 and 2001 to decline relative to issuance elsewhere in the area. As other Member Sates (e.g. Spain) have already sold their licenses and others (e.g. Portugal) will stagger receipts over a longer period, yield spreads against Germany are likely to have widened. Front-loading of issuance: Independent of the overall issuance volume expected this year, several euro-area sovereign issuers have chosen to front-load their activity. It is estimated that about one third of all issues for 2000 took place during Q1, with an estimated share of less than 20% now expected in Q4. Front-loading did not occur uniformly across the euro area and was most notable in Italy, Belgium and Portugal, which may explain some of the spread widening in these countries. A partial reversal of this seasonal trend may help to narrow spreads in the coming months, with issuance by Germany and France expected to be relatively high in the second half of the year. Interest-rate uncertainties: Another factor affecting yield spreads relates to market uncertainty about interest-rate prospects in the euro area and in the United States. The associated price volatility in equity markets is likely to have further unnerved bond investors. German bunds are traditionally favoured over other euro-area issues in volatile periods, not least because of the availability of cost-effective hedging possibilities. However, demand for bunds is likely to ease back as interest-rate uncertainty diminishes and investors again seek higher yields. Political uncertainties: It has been suggested that the some of the widening in yield spreads has been the result of recent political uncertainties, e.g. in Italy and Austria, which have emphasised the country-specific aspects of the euro-area bond markets. 13

14 Belgium 10 year Bund versus Belgian and Portuguese sovereign bonds 3/1/00 until 10/7/00 10 year spread versus Germany Source: Bloomberg Portugal Source: Bloomberg 14

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