Portugal - The quest for domestic investors

Strong economic growth, syndicated sovereign debt issues and the highest spread on treasury bonds in the eurozone have helped Portugal face up to increased competition as a government bond player on a pan-European level.

Joaquim Pina Moura

"We have seen domestic investors exchange the higher spreads available in Portugal for the greater liquidity offered by bigger European markets," says António Catana, head of fixed-income trading with Banco Português de Investimento.

At the same time, Portuguese spreads, now the highest in the single currency area, and the placing of up to 80% of government bond issues with non-residents have brought big new European investors into the market.

A prevailing spread on 10-year treasury bonds (known as OTs in Portugal) of 28 basis points over the equivalent German Bund is one of the attractions. The spread has fallen sharply from a peak of 45bp in August 1999. This year the spreads between so-called satellite borrowers have narrowed considerably and Portugal is now only 1bp above Belgium and 2bp to 3bp above Austria.

Strong growth and sound public finances mean that the Portuguese market rests on solid economic fundamentals. The government budget for 2000, approved only last month after a general election last October, is based on forecasts of 3.3% growth in GDP, up from 3.1% in 1999, and a slowdown in inflation to 2% from 2.3% last year.

The budget deficit target is 1.5% of GDP, down from 1.9% in 1999. In February, the centre-left socialist government, re-elected to a second four-year term, unveiled a medium-term programme designed to balance the budget by 2004.

"A new platform will be created to consolidate public finances for the period 2001-2004, involving the gradual elimination of the public deficit," finance and economy minister Joaquim Pina Moura told parliament.

Under this plan, GDP growth is projected at an average of 3.5% for 2000-2004, 1% above the forecast EU average. Economic growth is to be driven mainly by annual growth of 6.8% in investment and 7.2% in exports.

Growth in private consumption should fall below the GDP growth rate. The government forecasts public debt will fall to 46.6% of GDP in 2004, from 55.8% in 2000.

More spread, less liquidity

Despite these strong fundamentals, it is essentially lack of liquidity in the bond market that is keeping the spread in Portugal high. Daily volume in the secondary market, excluding Euroclear/Cedel trades, has fallen from an average of e553 million ($570 million) in 1999 to e285 million in the first two months of this year. Present volume is only a quarter of the peak reached when portfolios were being restructured before and immediately after the launch of the euro.

Volume has been affected because domestic investors have diversified away from the Portuguese market. And trading by new non-resident institutions, although welcome, is too sporadic to maintain continuous daily volumes at pre-single currency volumes.

"Non-resident investors are buying in the primary market but, although they follow the secondary market, they are not trading, because the volume is too low," says Catana at Banco Português. "It's impossible for a market to maintain liquidity on a continuous basis without the strong involvement of domestic investors. But I believe they can be attracted back."

It's all relative

In absolute terms, liquidity is considerably higher than levels before the euro. Trading in the OT market was substantially higher last year than in 1998, both in the main local market, Mercado Especial de Operacoes por Grosso (MEOG), which showed a 45% increase in trading volume, and abroad. Unofficial figures from Euroclear and Cedel indicate that turnover abroad increased fivefold in 1999.

In addition, Portugal's leading OT benchmark has been traded on the EuroMTS, the leading electronic trading platform for government bonds, since November 1999, diverting trade from other segments such as MEOG.

But size matters in the new single-currency environment. "Today, the liquidity issue is seen in relative terms, says Vitor Bento, president of the Instituto de Gestao do Crédito Público (IGCP), Portugal's public credit management institute. "By becoming a player on the 'common turf' of the single currency we fall under the label of 'small issuer' with Ireland, Finland and Austria. We now have to compete directly with the big issuers, Germany, France and Italy, and the medium-size issuers. Our debt represents 1.3% of the total sovereign debt of the Euro-11, while Italy's represents almost 30%. In this new context, our liquidity, although higher than before in absolute terms, is perceived as relatively low.

"In absolute terms, our debt is today much more liquid and tradable than it was before the euro," says Bento. "But in relative terms we are being compared against bigger benchmarks. This is a matter of perspective. Being small is not identifiable with inefficiency, it is a fact of life, like being blond, or tall, or short."

It is in this context that Portugal's public sector borrowing programme is being reshaped by the positive and negative consequences of the single currency. The euro has given the country access to a much wider investor base - its domestic market, in currency terms, has been greatly multiplied. But Portuguese debt now has to compete on a European level, on equal terms not only with other sovereign issuers but also with banks and corporations.

Meeting the challenge

"The fact that we are now viewed by the market as simply one among many players, without any special privileges, could be seen as a disadvantage," says Bento. "But we have turned this into a challenge to improve efficiency. It is making us work like an investment bank."

In terms of sovereign debt, the advent of the euro required Portugal to position itself to benefit from the expected outcome of economic convergence between the eurozone countries and, in particular, a sharp reduction in interest rates. "Because we had a very high spread vis-à-vis the core European countries, we knew that, whatever might happen to other interest rates, ours would be decreasing significantly," says Bento.

The strategy adopted involved a shift to short durations of debt issue, with frequent refixings of coupons, based on the principle that duration equals exposure to exchange-rate risk.

"During the convergence period leading up to the launch of the euro, we maintained a short duration in order to reap the benefits of the expected lowering of interest rates," says Bento. "Duration was 1.5 years in 1995 and 1.9 in 1997. With the approach of the euro and the end of the decreasing interest rate trend we started to increase the duration as a way to immunize the budget against interest rate volatility."

Duration at the end of 1999 was 2.9 years. This approach proved highly successful and, as a result, Portuguese debt now has one of the lowest implicit interest rates seen in the eurozone.

"We have reached the conclusion that this is best achieved with a declaration close to three years," says Bento.

Portugal committed itself to issuing debt almost wholly in euros from the outset of the single currency. The IGCP now taps markets outside the eurozone only to take advantage of niches where there are particularly favourable pricing conditions or special windows of opportunity for cost-effective borrowing.

Gross government borrowing needs in 2000 are estimated at about e10 billion. Portugal launched the first benchmark issue in the single currency this year. The e2.5 billion issue was the first placement in a new 10-year OT line and was made though a syndicate of primary dealers, known as Operador Especializado em Valores do Tesouro (OEVTs), led by Banque Nationale de Paris, state-owned Portuguese bank Caixa Geral de Depósitos and Deutsche Bank.

The issue was 2.5 times oversubscribed, allowing the offering to be priced at the tighter end of the indicated range. The bonds were priced to yield 34bp over German Bunds, and they tightened by 1bp in the secondary market. The line is to be increased through auctions to a total outstanding size of e5 billion.

A medium-term OT, expected to be a five-year line, is due to be launched in March, also through a syndicated tranche followed by regular auctions. This will be for a least e2.5 billion, but is unlikely to reach the e5 billion mark this year.

Portugal, like other small eurozone countries, is increasingly using banks to sell sovereign debt. A syndicated bond market issue rather than an auction offers better distribution, more competitive pricing and size. The size of such offerings also means they can be traded on EuroMTS.

Bigger countries such as France or Germany do not need to go through a syndicate as their issues are large enough to stand on their own in an auction. "A clear pattern has been established of small countries starting the year with a large syndicated issue instead of the tradition small auction," says IGCP's Bento. "Offering a large amount through an auction is too risky and expensive for small countries like ours."

Better debt management

The creation of the IGCP as an independently run body is in itself part of the transformation in debt management brought about by the euro. Created in 1996 from two bodies supervised by the government, the IGCP reached "cruising speed" last year after completing a complex transfer of responsibilities and staff without interrupting management of the debt. The staff of 75 is less than half the previous number and includes a significantly higher proportion of qualified technical specialists.

Technical advances are following rapidly. In February, the IGCP began using a new electronic system for primary auctions, which is run through Bloomberg. This has resulted in a significant improvement in efficiency, with the full results of the allocation being communicated to all the primary dealers about three minutes after the cut-off time for bids. This compares with up to 30 minutes under the previous system. Dealers have welcomed the move, which aims to make Portugal's auctions more competitive by reducing the risk for bidders.

Bento says the IGCP has sought to establish a stable and credible "partnership" with its group of primary dealers (OEVTs), which are seen as the main network for regular debt distribution worldwide. Its policy is to include all the OEVTs as underwriters in the syndicates and to take their performance in the auctions as the main guide for assigning the allotments. The group of OEVTs is widely diversified. About 75% of the amount placed at competitive auctions during 1999 was taken by non-Portuguese banks compared with less than 40% in 1998.

A bold step forward is planned in the next few months with the launch of MTS Portugal, a national electronic platform for the secondary bond market. A significant improvement in the liquidity and tradability of the debt market is expected as a result of introducing the system, which has already been adopted by Italy and the Netherlands and is being set up in France and Belgium. Transaction costs should also be lowered.

The MTS electronic trading system does not require proprietary hardware or dedicated terminals and can thus run on dealers' existing PCs and networks.

Launching MTS Portugal is seen as an important stimulus that will substantially improve the attraction of the Portuguese debt market by lifting liquidity and enhancing tradability. Catana at Banco Português sees the potential for daily volume to double on a sustained basis. Allied to the high spreads Portugal offers and a sound economic environment, the hoped-for result is not only an inflow of new non-resident institutions but also the return of domestic investors as the lifeblood of the market.

Portugal's big companies and financial groups are engaged in an unprecedented wave of acquisitions, mergers and overseas investments, so demand for funds is strong. But a withholding tax that deters non-resident investors has combined with the allure of more liquid euro markets to sap the domestic corporate bond market of volume and vitality.

Manuel Pinho

Although reductions in the rate resulting from double-taxation treaties may apply, the withholding tax effectively discourages all non-resident investors from trading in the corporate market.

This substantially limits volume and is contributing to an increasing trend for large Portuguese companies to abandon domestic bond issues in favour of the unified euro market.

Most of the country's big corporate issuers - companies such as Portugal Telecom and national power utility Electricidade de Portugal are investing heavily at home and abroad - now issue debt in the unified euro market through vehicles established outside Portugal.

Last year, for example, Portugal Telecom sold an issue of e509 million ($528 million) in exchangeable bonds in international markets through its wholly-owned subsidiary Portugal Telecom International Finance. The bonds carry the right to subscribe to or to acquire PT ordinary shares or ADSs at an exchange price of e53.625 per share. The nominal value and the subscription price were e5,000 for each bond with an annual interest rate of 1.5%.

The amount of the issue was raised from an original e400 million on strong response from domestic and international investors, resulting in demand 10 times higher than the final amount. The issue was seen as a success for Portugal Telecom that would reduce the cost of the group's debt and contribute to the diversification and internationalization of financing sources and the company's investor base.

Manuel Pinho, a board member of Banco Espírito Santo with special responsibilities for financial markets, says large companies are still achieving excellent prices on the domestic bond market. But he believes that, over time, spreads will align with those of other European markets. "They [Portuguese companies] are starting from very aggressive levels and I do not feel it will be a problem for them to accommodate to a gradual realignment of spreads," he says.

Average monthly trading in private debt is only about 5% of total capitalization, compared with about 130% for public debt. This low volume reflects both the absence of non-resident investors and the pull of more liquid euro markets for big institutional investors and issuers.

"Since the euro abolished exchange-rate risk, Portuguese institutional investors are faced with a stark alternative," says a Lisbon-based fixed-income market analyst. "On one hand they can buy a e1 billion issue by a company such as Volvo or Fiat, where they have a rating and a guarantee of a liquid secondary market. On the other, they can invest in a domestic Portuguese issue, usually in the range of only Esc5 billion to Esc10 billion [$25 million to $50 million], with no rating and a very illiquid secondary market. It is very difficult for the Portuguese domestic market to compete in this new environment."

Analysts say smaller companies that would previously have raised money on the domestic bond market are increasingly turning back to bank credit. "An issue in the euro market needs to be at least e100 million before investors will even look at your bond," says a Lisbon trader. "This is beyond the needs of many Portuguese companies and, as a result, they are becoming more dependent on bank credit."

A government move on the withholding tax issue is seen as essential to realize the full potential of the domestic corporate market. But this is unlikely before a resolution of the complex issue of a pan-European withholding tax. Ironically, Portugal, holder of the rotating EU presidency in the first half of 2000, is currently leading the EU's effort to overcome the UK's objections to the proposals.

Banco Espirito Santo's Pinho sees great potential in the market for securitization. The Portuguese government is finalizing a new law that authorizes securitized bond issues. Issues will not be subject to withholding tax, so unlike corporate bonds there will be no barrier to placing them internationally.

"Bank balance sheets have grown extremely fast over the last few years and there is a strong demand for securitization," says Pinho. "I believe this market will develop quickly and become an important means for banks to raise capital and create additional sources of funding."