Recent weeks have seen the Eurozone sovereign debt crisis return with a vengeance on the back of a political crisis in Italy. This involved the unprecedented step of the President Sergio Mattarella vetoing the appointment of Paolo Savona, a Eurosceptic who called Italy’s entry to the Eurozone a “historic mistake”. The move provoked a tense stand off with the two political parties trying to form a government with threats of impeachment proceedings against the President. This episode led to some explosive movements in Italian government bond yields with the two-year jumping from 0.9% to 2.83% and the five year by almost 100bps over the course of the same session, as investors reacted to the threat of fresh elections and an even stronger mandate for Eurosceptic parties in what has traditionally been a core EU member state.
While these dramatic one-day moves were underpinned by genuine credit concerns, many market commentators suggested that they were amplified by a sudden deterioration in market liquidity and an effective seizing up of the Italian government bond market. Many market participants point to the post financial crisis regulatory environment which has reduced the liquidity that banks have traditionally provided to bond markets through their trading desks. Ring-fencing and tougher capital rules have seen the withdrawal of banks from proprietary trading activity which the increased use of technology in the form of electronic trading platforms and high frequency trading are perhaps behind the rising frequency of flash crashes such as those witnessed in Italy and earlier this year when the VIX volatility index made some dramatic moves.
While these market changes appear to work smoothly in benign market conditions, circuit breakers are designed to kick in when volatility increases which leaves markets virtually “bid-less” leading to extreme price movements. Interestingly, the US is currently consulting regulators and market participants on proposals to soften the impact of the Volcker Rule which was brought in after the financial crisis, as it is now felt to be having a negative impact on market liquidity and volatility. Exacerbating this decline in liquidity in government bond markets has been the role of central banks in recent years, which have intervened in order to contain borrowing costs. For example, around 16% of the Italian government bond market is owned by the ECB as part of the EUR 2 trillion plus bond buying blitz launched in support of Mario Draghi’s now famous pledge to do “whatever it takes” to hold the Eurozone together. Italian commercial banks are also big holders of Italian government securities although they have been selling down slightly over the last year or so, mainly to the Bank of Italy / ECB.
In our view, this volatility which is usually more associated with emerging bond markets will become an increasing feature of core economy bond markets over the coming years, as Central Banks seek to extract themselves from a decade of suppression of government and corporate bond yields. We take the opportunity here to once again point out that for borrowers of long term debt, interest rate upside (i.e. further falls) from here is limited. Arguably the limited movement in long-term rates over the last couple of years since the big falls in 2014 and early 2016 supports that. But the downside risk (i.e. risk of rate rises) is surely considerable based on any objective historical measure.
The other component of long term borrowing costs is of course investor demand as expressed in spread versus gilts. Although a limited number of HAs have tapped Asian, European and US investors, the vast majority of HAs have rightly looked to domestic institutional investors for their core funding requirements since the financial crisis. While we retain confidence in this market as the first port of call for the majority of borrowers, we would make the following observations:
- For the very largest and more frequent issuers, there are signs that name fatigue and single name limits are starting to bite at least within certain institutions. L&Q’s issuance in February 2018 vs. materially tighter spread achieved in July 2017 would be the textbook example. This underlines the fact that while the sterling market is deep, it has its limits in terms of volumes available for individual issuers.
- Investors are concerned about an asset class which they feel is on a clear downward credit trajectory. It is hard to argue with the logic of this although at least some of the actual credit deterioration as measured by external ratings is due to methodology and the UK sovereign rating. Nonetheless, increasing commercial risk and deteriorating metrics are also a factor here. One of the concerns cited by certain investors is the impact of capital requirements under the Solvency 2 regime as borrowing counterparties drop from single A to triple B ratings levels.
- For housing associations, +/- 30 year maturities seem to be the sweet spot and a lot of deals come in this part of the curve. Relatively few borrowers have issued at shorter (but still by most measures “long term”) maturities between 10-25 years. Long-dated is tempting with such a flat yield curve but while many of the investors for shorter dates deals are the same, there are other names which have more appetite for shorter term deals. So borrowers should be able to eke out a greater level of interest from the same investment managers by developing their own credit curve and in some cases this could mean going longer rather than shorter.
So we consider that there will be continued and on-going demand for this asset class within the sterling market. In particular, small borrowers can access a growing and healthy private placement market with little or no concern around name fatigue or single name limits. But for larger and more frequent borrowers we believe that it may be time to start thinking about a wider capital markets strategy which gives greater optionality and enables them to access global liquidity as well as mitigating execution risk by having Plans A, B & C as opposed to being a captive issuer to sterling investors.
Such strategies are not without risk and they will involve boards being made comfortable with outright and contingent cross currency swap risks. Treasury teams need to be appropriately resourced and with the systems in place to monitor and manage these and the associated counterparty risks in the way that many large corporate treasury teams are used to doing. Clearly this will only be appropriate for certain HAs and we have and will continue to caution smaller and less sophisticated borrowers and boards from exposing themselves to unnecessary risk from more complex funding structures. Nonetheless, for those with an incentive to reduce their reliance on the traditional sterling investor base, it may be time to start looking further afield.
Briefly looking at May issuance, Longhurst issued their second own-name bond (£150m issued, £100m retained, A3 Moody’s rating) at a spread of 148 bps, slightly wider than the two issues in April being Clarion and Bromford.
Financial Markets and Economics Overview
May has been characterized by mixed market data, the economy grew by 0.1% during the first quarter of 2018, the employment rate reached a record high of 75.6% in March, but inflation fell more sharply than expected, raising questions with regards to the timing of the future rate hikes.
Despite the positive economic sentiment in the UK, as shown in the GfK business confidence, and the strong labour data issued, UK inflation unexpectedly fell for the second consecutive month in April. Annual change in the consumer price index fell to 2.4% during the month of April, from 2.5% in March. This development reduces pressure on Bank of England to increase interest rates in June.
The Bank of England, during the May committee meeting, played down signs of economic weakness, but voted to hold interest rates at 0.5%, staying in “wait-and-see” mode. The governor, during his speech in the House of Commons to the Treasury select committee, stated that “interest rates are more likely to go up than not, but at a gentle rate”. It would be difficult for the BoE to explain a decision to raise rates now, on the back of downgrades to growth and inflation, at least not before there is clear evidence suggesting that this weakness is temporary or not. Market are now pricing a 40% probability of an August bank rate hike in the UK and a 90% probability for an increase before year-end.
UK equities have rallied for a second consecutive month, as the depreciation of the sterling continues to boost the attractiveness of stocks. A further easing of tensions between US and China and stronger commodity prices encouraged the FTSE to continue its steady rise towards its 8,000 record target.
Increased geopolitical concerns in the Eurozone, combined with the sentimental view of weak growth and inflation figures, made investors to seek for safer havens such as UK and US bonds. The 30 year Gilt yield was 13bps down on a monthly basis. LIBOR followed a similar trend, with the 30 year 6ML being 9bps down during the same period.
UK annual house price growth, as shown in the Nationwide House Price Index, slowed in May to 2.4% from 2.6% in April. The squeeze on household incomes and weaker economic backdrop weighed on the property market. Low stock levels and cheap borrowings are expected to prevent a material decline in prices, albeit at cost of enhancing the trend towards private renting.