A EUROMONEY SURVEY - MARCH 1996
MARKET DEVELOPMENTS
The Spanish bond market, currently among the so-called European high-yielders, has developed at an amazing rate over the last six years. Spain still wore the "emerging market" label as late as 1988; the public debt markets did not offer any satisfactory liquidity in periods beyond three years when the withholding tax for non-residents was abolished in 1991. In the following three years, the Spanish bond market was able to offer a wide range of liquid instruments in all maturities from six months to 15 years and also developed a series of reliable hedging instruments (futures and derivatives).
The question remains whether this spectacular rate of development will survive the changing trends in the fixed-income markets if interest rates rise throughout Europe? There are strong reasons to believe that the fixed-income market rally of the last three years, which allowed such rapid developments, has enabled Spain to join the "modern markets" club.
The first signs of change came with the announcement in late 1990 that the withholding tax for non-residents would be abolished, as from the January 1 1991. That set off a chain reaction. Strong expectations of interest rate falls in Spain and a record period of peseta stability - the peseta spent the best part of two years at the top of the former EMS currency grid, which required constant interventions by the Bank of Spain in the sterling/peseta to control the situation - drove non-resident money into Spain.
The proportion of total public debt in the hands of non-residents jumped from 27% in early 1991 to more than 34% two years later, and to more than 40% if the speculative buying by hedge funds, especially during 1993, is included. The Spanish treasury, in order to be able to respond to such an increase in demand, began to adapt its auction rhythm in late 1991 by issuing 10-year paper once a month instead of once every two months. At the same time, the Spanish monetary authorities, realizing that non-resident inflows would not last forever, decided to encourage stronger domestic demand. Some fiscal advantages were implemented to promote the new
fondos de inversion (mutual funds which also offer low fees), which started to capture domestic savings, thus increasing institutional investors' already strong appetite for Spanish treasury bonds. Today, these mutual funds represent Pta13 trillion worth of bonds, ie 40% of total government debt. This has proven to be a great success as the treasury is now guaranteed to channel its debt through these type of funds. The recent launch of another type of fondos de inversion called fondos garantizados should also increase investors' appetite.
The chain reaction continued: in a bullish market of this kind, the bulk of demand moved to the long end of the curve, which made it essential to create appropriate hedging instruments to assist the domestic banks in their market-making role and, furthermore, enable them to stand up to their London-based competitors. In late 1991, and shortly after the introduction of three- and five-year futures contracts which are no longer traded, the 10-year futures contract was born. In addition, the need for short-term hedging instruments resulted in the creation of the three-month Mibor-90 and one-year Mibor-360 contracts. All this was met with overwhelming success. Not only was the Spanish bond market responding better than expected to the surprisingly strong worldwide demand, but it also caused the Spanish treasury to intensify its auction programme, issuing regular and sizeable amounts in various maturities. During 1991 and early 1992, before the Danish rejection of the Maastricht treaty, the average amount issued was approximately Pta1 trillion per month in letras (T-bills) and around Pta500 billion per month in bonos, up to five years, and obligaciones, up to 10 years. This was about twice the average monthly amount issued prior to this period. As a direct result of this increased liquidity and the wider range of hedging instruments available, Spanish market-makers became accustomed to quoting for larger amounts. Also, the treasury started issuing 10-year paper on a regular basis. The climax of this rapid development was reached in December 1993 with the launch of a new 15-year bond, which was the treasury's most notable response to the growth in demand for long-term paper and at the same time provided them with another opportunity to lengthen the duration of its debt.
In little more than three years, Spain had managed to turn an emerging bond market into a mature, reliable and professional one. But after the first thunderblast of the rise in US interest rates signalled in February 1994, global bond markets started to shake and the "high-yielders" tumbled.
Although the Spanish treasury had quickly seen the importance of developing a domestic market in order to counterbalance the excessive weight of non-resident holding of public debt, the amount issued on long-term maturities to respond to such aggressive non-resident demand was much more than natural 10-year Spanish buyers would ever be able to absorb. The Bund/bono 10-year benchmark yield spread reached a low of 200bp by the end of 1993, having reached an all-time high during the Maastricht crisis of 650bp. Spanish institutional long-term investors, in the form of pension funds and insurance companies, were hardly able to absorb more than 11% of the amount issued in 1993 in the 10-year and 15-year maturities. The rest was distributed among non-resident investors and resident mutual funds. This meant that in the case of a changing market, 85% of the long-term paper issued in 1993 (mainly in hands of international speculators), such as hedge funds, could be immediately sold, only finding reasonable support with an additional and substantial risk premium. The correction in the US market and its effects on Europe served to highlight the fragility of this still young market.
The euphoria had reached such a high level during the "one-way year" of 1993 that investors in the Spanish market were under the false illusion that the market was firmly established with the basis of a reliable, strong and powerful primary dealership framework. The real situation was different. The treasury and the Bank of Spain, although officially requiring the 12 primary dealers to guarantee the liquidity of all the references of the yield curve, always tolerated a certain flexibility in this respect. At the first signs of a change in trend (March 1994), the quotation spread suddenly widened, and the liquidity on the 10-year futures contract decreased substantially, and consequently so did that of the 10-year cash bonds. It took only three months to transform the Spanish curve, with more than 15 different cash securities covering all maturities from one to 15 years, into a simplified curve where only reduced liquidity could be found for three main areas: the three-year, five-year and 10-year benchmarks.
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