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If anyone has benefited from the Eurozone crisis in the last two years, it’s the funding arms of the region’s strongest sovereigns. Whenever sentiment has turned toxic, or even just cautious, towards peripheral nations, investors have sought safety in the most trusted names, pushing borrowing costs down to remarkably low levels. “It is,” says Keith McIntosh, co-head of European rate trading at RBC Capital Markets, “a golden age for core rates because it’s far from a golden age for western economies.”

What, in this troubled modern Europe, is a core sovereign? “When the market speaks of core European sovereigns, it’s usually about Germany, France and Holland,” says Bill Northfield, head of sovereign, supranational and agency origination at Deutsche Bank. “Their debt will always find demand: it is hard to contemplate a market in which these three names would be shut out.” Others spread the net a little wider: to AAA-rated Finland, for example, and perhaps at the margins down to Belgium and Austria. It’s a small list.

At the top of the tree – now more than ever, since the downgrades for the UK, US and France – is clearly Germany, whose borrowing levels have at times become almost absurdly low. In the summer of 2012 two-year German bond yields became, in nominal terms, negative. As Gernot Griebling at LBBW puts it: “When you go to university or look in a book you are told this is impossible.” But it wasn’t: German bund yields were as low as minus 0.2% last year, creating what Griebling calls “the lowest nominal yields since the era of Bismarck,” 140 years ago.

As fear has eased in the Eurozone, those extraordinary circumstances have too, but even at the time of writing Germany was paying 1.5% for 10-year funds. “Germany has had a current account surplus for years,” says McIntosh. “There are very few reasons to be bearish on German fixed income if you believe growth is going to remain weak in Europe. I can envisage us taking the froth out of the market for the safe haven bid, but it’s hard to imagine a 150 basis point move higher in 10 year bunds unless it’s accompanied by something exceptional out of the US.”

The froth surely has gone from the safe haven bid, as – the Italian election notwithstanding – sentiment about the future of the Eurozone and the world economy has improved considerably in the last six months. “In the fourth quarter last year, a number of investors commented that they were solely focused on buying bunds, nothing else,” says Northfield. “This quarter we’ve seen a reversal of that trend, with more and more accounts in the Americas and Asia coming back aggressively into second-tier core markets and the peripherals.”

Yet still German rates don’t budge. “It’s interesting that despite the fact we’ve had a large risk-on move, with corporate and periphery spreads tightening and a strong equity market, none of these things has led to higher yields in Germany,” McIntosh says. “When other peripheries are in trouble, there’s a safe haven bid; but if the peripheries take measures to address their problems, that’s a drag on growth and core yields remain low.”

France: downgraded yet stronger

While Germany’s role as the top dog of European safe havens seems secure, it’s interesting to look at other core sovereigns and their borrowing relative to Germany.  “Spreads between France and Germany have evolved in recent years as people have become aware of credit differentials,” says Northfield. In France’s case, he says, that’s meant a rally in 10-year French debt from 140 over Bunds to 60 between May 2012 and March 2013. “Both sovereigns enjoy access across the curve; their ability to take down size is simply a question of price.

When France was downgraded – twice, in fact, by S&P in January 2012 and Moody’s in November – very little changed in any other respect, and this has been a theme of the late crisis era: people don’t stop thinking of a country as a core sovereign just because it drops a notch from AAA. “There is a ‘best of a bad bunch’ mentality,” says McIntosh. “For us, we haven’t seen any change in investor patterns for core countries when the threat of a downgrade has been there.”

In France’s case, if anything, things have got better since the downgrades. The sovereign borrowed 10-year funds at 3.29% in early 2012 as a AAA economy, and at 2.07% this year despite being a notch lower.  The average cost of funding for short term debt (T-bills) stands at 0.03% for the first quarter of 2013, according to Agence France Tresor, compared to 0.08% in 2012; the average cost of funding on medium to long term funding (BTANs or OATs) was 1.2% for the first two months of 2013 compared to 1.86% in 2012. So what’s happening?

“This is due to several factors,” says Ambroise Fayolle, CEO of Agence France Tresor. “First of all, the French republic remains among the highest on the scale of all major credit rating agencies.” This is clearly true: it’s not as if anyone has replaced France on the AAA list. France’s authorities, Fayolle adds, have committed to fiscal and structural reforms to consolidate public finances and strengthen potential growth while lowering social contributions on labour. On top of that, decisions by euro area leaders and the ECB in the summer of 2012 restored market confidence. In other words, there was plenty for investors to see to convince them of French creditworthiness regardless of the downgrades.

“Investors have taken the rating decisions for what they are: an opinion among others’ opinions,” says Fayolle. “During roadshows, many large institutional investors who rely on their own analysis of credit quality have indicated that they do not share the same vision as the credit rating agencies.”

Fayolloe has the historically low levels of French interest rates to support him in this conclusion.  AFT’s assumptions for 2013 interest rates are “cautious,” he says, with three month interest rates averaging 0.25% and 10-year rates averaging 2.9% in 2013. If that’s conservative – and it appears to be – then that says everything about the extraordinary funding environment in which safe havens find themselves.

One could have a simple rule of thumb to determine a core sovereign or safe haven: when the Italian election happened, did spreads go wider or tighter? In France’s case, yields decreased by 17 basis points in the two and a half weeks after the announcement of the election result.

Like all core sovereigns, France is highly transparent about its funding programmes, and has announced that its funding requirement for 2013 will be covered almost entirely by medium and long term borrowing through the BTAN and OAT formats, raising Eu169 billion, compared to Eu178 billion in 2012 and Eu188 billion, a peak, in 2010. This is a reflection of efforts to reduce the deficit. French borrowing will remain entirely in euros, with funding including a new two year benchmark, two five and two 10-year benchmarks (one new five-year OAT was launched in January). Fayolle says AFT will look at a 30-year deal “if the demand justifies the introduction of new references.” French CPI and Eurozone HICP index-linked bonds will account for 10% of medium to long term issuance.

[Subhead: Going Dutch]

Next off the rank among Eurozone core sovereigns is the Netherlands; one banker calls it a “poor cousin” of Germany and France in terms of size, but it has a loyal following.

If the Netherlands has scarcity value, it’s getting more acute: having raised Eu80 billion in money market funds in 2009, the country then set a target of just Eu30 billion per year. It’s not there yet: according to Peter Nijsse, head of money and capital markets at the Dutch State Treasury Agency, the Netherlands has an expected funding requirement of Eu90.3 billion in 2013, of which Eu50 billion will be financed through capital market instruments with a maturity of one year or longer, and the remainder through money markets. “Although this expected Eu40.3 billion of money market instruments outstanding by the end of 2013 is still above the Eu30 billion target that we had indicated before, there may not be much room for further reduction for now,” he says. That’s because part of the Netherlands’ money market funding comes from cash collateral on outstanding swaps. “This means that to ensure liquidity in the treasury bill market, and to keep our commercial paper program in the market, we are already close to our desired minimum volume of money market funding.”

The Netherlands is highly rated – still triple A, although all three agencies have put its ratings on a negative outlook – and admired for its transparency, with a clearly stated target for euro capital market issuance expressed each year. “Fluctuations in the expected and actual funding need will be handled in the money market and with foreign currency borrowing,” says Nijsse. A higher than expected funding need could mean more DTC or CP issuance, he says, or issues of dollar bonds; lower funding needs would mean less.

“Being a core sovereign is, of course, the result of many years of prudent economic and budgetary policy,” he says. Maintaining it has, apart from the strength of the Dutch economy itself, required “ensuring liquidity of our outstanding debt by creating large tradable benchmarks, ensuring market transparency through quotation obligations for primary dealers and providing a repo facility for primary dealers,” measures that are “at the core of our issuance policy, next to transparency, consistency and predictability of our funding program.” It is for this reason, he says, that “we have seen strong demand for our paper in times of market stress.”

As with France, the Netherlands’ spread versus Germany has moved around considerably in recent years. “This is mostly a result of sovereign credit risk being more at the forefront of investor decisions than in the past,” Nijsse says. And though he thinks volatility will eventually fade,  “it is likely that larger spread differentials between sovereigns will be the new normal, now that investors have experienced that policy differences between countries do matter.” He expects to stay at the tighter end of the range, given the Dutch government’s strong commitment to prudent budgetary policy.

[Subhead]The other last standing AAAs

Beyond the Netherlands, two other Eurozone nations continue to hang on to a AAA rating: Denmark and Finland. For many investors, these slip below the radar, lacking sufficient volume to interest them. “Owing to smaller budget deficits, [non-core sovereigns] have lower annual borrowing programmes and thus a less frequent need to call on the capital markets via auction or syndication,” says Northfield. “This limits their visibility in the markets.” But they appear to be in vogue again. “This year we have seen a resurgence of non-European appetite for non-core paper, either as a diversification play versus core Europe, or as a spread play versus Bunds.”

Teppo Koivisto, head of finance at the State Treasury, says Finland’s overall central government gross borrowing for 2013 will be Eu18.5 billion, including short-term funding; the same as last year. “The strategy is to return to the familiar 5/10 pattern where our financing programme consists of two new euro-denominated benchmark bonds and several tap auctions,” he says. 2012 saw 10, 15 and 30 year euro bonds, and 2013 should see a 10-year in the first half and a five-year in the second.

Koivisto says Finland has “witnessed a pronounced safe haven effect into our bonds for quite some years”, and not just because of its rating: it has also enjoyed renewed appetite for Nordic countries. “It seems that we are successfully competing in two leagues by the same token.”

Finland is interesting for being quite diverse within a somewhat limited total funding programme. After a euro tap auction, its next deal in 2013 was a privately placed Swedish krona deal. The primary driver, he says, is cost efficiency relative to Euribor funding levels; there’s also an annual dollar benchmark issue to serve investors who want their credit in the US currency.

Like many sovereigns that have benefited in terms of capital flows and funding terms from the Eurozone crisis, Koivisto is careful not to revel in it: “It is important to emphasize that political or economic uncertainties related to the Eurozone are not in the interest of any euro country,” he says. But really, funds are exceptionally cheap: Finland’s most recent deal came at 1.75%. Asked how long this can list, he is diplomatic. “As an issuer, it is not my job to make predictions. Our mission is to aim for the best possible outcome in any market conditions.”


And what of life outside the Eurozone?

The UK may no longer be universally AAA, but this hasn’t changed the enthusiasm for investors in Gilts. “We have not noticed any perceptible reaction to the Moody’s decision,” says Robert Stheeman, chief executive of the UK Debt Management Office. “The market appeared to take the downgrade in its stride, with a very muted reaction, which seems to support the proposition that such actions by the rating agencies are essentially lagging indicators.” Instead, gilt yields swiftly fell, in response to risk-off sentiment following the Italian elections (by 13 basis points in a single day, in fact); and the next two gilt sales, a 40-year index-linked gilt syndication and a five-year conventional auction, went well.

Stheeman, like Koivisto, is cautious about portraying any kind of benefit from the Eurozone crisis. “It is not part of our strategy to seek to preserve a safe haven status as such, since for the UK to be a safe haven implies difficulties in other markets, which we would rather not see,” he says. Instead, he says he hopes investors in gilts are doing so “having due regard for the depth and liquidity of the gilt market as well as the government’s commitment to fiscal consolidation and the fact that the UK has an independent central bank conducting monetary policy in the UK’s best interests.”

Indeed, that message appears to have got through. “Gilts have benefited enormously from an independent central bank, and an aggressive one as well,” says McIntosh. “When the euro crisis was in full flight a phenomenal amount of safe haven bid went into the market.  It seems there is going to continue to be accommodative policy there, and if there is any spike in gilt yields then QE is probably back on the cards.”

Northfield adds: “ Gilts benefited when the euro market was in turmoil: investors said they needed to diversify exposure, and the gilt market, being liquid and transparent, became a favoured alternate safe-haven,” the more so for offering several nominal and inflation-linked bonds in the 50-year part of the curve.

In its autumn statement in 2012, the UK DMO said it would look to launch new issuance in the 50-60 year maturity area in 2013-15. The popularity of these sorts of maturities reflects the long-term confidence in gilts themselves. “It may be a hostage to fortune to attempt to be definitive here, but I would just observe that the gilt market has a very good track record of resilience in the face of major shocks since 2008,” Stheeman says. Gilt sales requirements increased almost fourfold in two years from under GBP60 billion in 2007-8 to almost 230 billion in 2009-10. “As a consequence, the gilt market is now clearly much larger – it has quadrupled since 2008 – and is also deeper and considerably more liquid. This will be relevant in helping to face any future storms.”

So these are the invulnerable ones: the markets that pick up the fleeing capital when things are at their worst. Perhaps this is as good as it can ever get for the core sovereigns; logically rates this low can’t last forever. “They’re all still funding at incredibly low levels,” says McIntosh. But even if that stops, investor appetite never will. As Northfield says: “They should always have access.”

Chris Wright
Chris Wright
Chris is a journalist specialising in business and financial journalism across Asia, Australia and the Middle East. He is Asia editor for Euromoney magazine and has written for publications including the Financial Times, Institutional Investor, Forbes, Asiamoney, the Australian Financial Review, Discovery Channel Magazine, Qantas: The Australian Way and BRW. He is the author of No More Worlds to Conquer, published by HarperCollins.

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