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.
At the beginning of each year, the treasury announces its overall funding requirements, as set out in the official state budget, but it is not obliged to provide a strict timetable of its financing programme and is therefore at liberty to choose the timing, pricing, size and currency of its issues. Indeed, since February 1994 and during the first half of 1995, the Spanish treasury returned to using six-month and one-year T-bills leaving most of the bond auctions deserted. But since the second half of 1995, the treasury committed itself to issue bonds at the monthly auctions and introduced some positive change with its financing programme after realizing that only through regular bond auctions would it be able to attract investors and project a more serious image. Every Friday prior to the bond auction, the treasury (after meeting the primary dealers) sets a minimum, maximum and desired amount to issue in the three- and 10-year bonds (together) and in the five- and 15-year bonds (also together). Although the minimum amounts for each three-, five- and 10-year are Pta30 billion and Pta15 billion for the 15-year, the Spanish treasury has always issued what they have announced as their desired issuing amount. This guarantees that market participants can always short the bonds prior to the auction, thereby giving more liquidity and dynamism to the market.
ECONOMIC OVERVIEW
The recent improvements in its economic fundamentals are an indication that Spain is well on its way to shedding its “high-yielder” label.
The commitment of the socialist government to meet convergence criteria by 1999 has proved, if not yet successful, at least very encouraging. Budget deficit has dropped from 6.7% to 5.8% and is expected to drop close to 4.5% in 1996. For the first time in several years, inflation has dropped significantly to reach 3.9% by January 1996 and should stabilize at around 3.5% this current year. The structural reforms implemented in the past to reduce social spending will be reinforced, together with some changes in the service sector. Hence, the peseta has gained stability against all major crosses and the spread with bonos has been reduced from 525bp in the beginning of 1995 to 320bp today.
The uncertainty regarding general elections should not weigh too negatively as the right wing PP will almost certainly be the winner with either an absolute majority as suggested by the latest polls or at least a possible coalition with minor regional parties (including Catalan Ciu). Also investors have suffered from socialist party corruption scandals throughout 1995. A change of government should be viewed as a positive factor for stabilizing the political atmosphere. Finally, the PP has shown through its programme an even more austere attitude as regards to spending and as much commitment to the monetary union as the socialist party.
Hence, the opening of the Spanish market is not only an undeniable fact but it is also a firmly established and on-going process. After abolishing the withholding tax for non-residents, foreign exchange controls were rescinded in 1992 and the cut in reserve requirements to 2% (from 17% in 1989 and 5% in 1991) reduced the difference between the Europe and domestic Peseta interest rates to almost zero.
Special efforts were made by the international clearing systems, Euroclear and Cedel, to simplify the settlements procedures. The MEFF (Mercado Espanol de Futuros Financieros) daily average volume now reaches 60,000 contracts, which is still far from the 150,000 MATIF daily average with the same underlying nominal amount, but represents twice as much as the 1993 average of 27,000 contracts a day.
The development of the Spanish bond market will be slower from now on, although it is still catching up with the more sophisticated markets. The option market is still far from being liquid and the strips market is non-existent. Also, the market still lacks a very long bond (30 year), while variable-rate instruments have never been successful and the corporate bonds market maintains its interest generally only in the primary market.
Nevertheless, what has been achieved so far in Spain is a solid basis upon which the financial authorities can continue to build a more efficient bond market. As time goes by and with the assistance of the fast-developing derivatives sector, the bond market will soon offer the diversified investment and arbitrage opportunities found in more modern bond markets.
MARKET STRUCTURE
Outstanding government debt is approximately Pta32 trillion at February 1996 with bonos del estado and obligaciones del estado issues contributing significantly to this figure (60%). Bonos (three- and five-year maturities) and obligaciones (10- and 15-year maturities) have outstanding amounts of Pta500 billion to Pta1 trillion, but are regularly re-opened to around Pta1 trillion. The typical denomination is Pta10,000.
Spanish bonds are issued in book-entry form. About 40% of transactions are executed through a system of inter-dealer brokers instituted by the Bank of Spain. Minimum quotes on this system are for Pta100 million. The Madrid Stock Exchange does list bonds but the volume traded on it is negligible. Bonos are non-callable with bullet maturities while obligaciones are no longer issued with put and call features. Bonds trade on a clean-price basis and there are no commissions or transaction costs. There is no tax on foreigners investing in bonds, except for residents of the 48 ‘tax havens’ identified by the Bank of Spain. Issuance is through monthly auction, even for the 15-year bonds which were auctioned every two months up until 1994. Three- and 10-year paper bids are submitted before 10:30 am on every first Tuesday of the month whereas five- and 15-year is every first Wednesday of the month. Results are announced the same day around 12:30pm. Payment is two weeks later.
Settlement through Euroclear and Cedel, with recent improvements can take three days while domestic settlement is still seven days. Settlement is done on a delivery-versus-payment basis for all transactions between interbank market participants. Interest payment is on an annual or semi-annual basis, depending on the bond. Since March 1989, all new issues have carried annual coupons. Interest accrues from the previous coupon (inclusive) to the settlement date (exclusive), so value date equals the settlement date. Yield is calculated on an actual/365-year basis, using ISMA, although a special modification is used for bonds prior to their nominated date.
Bonds team
Sales
Patrick Daries, Pablo Lladó,
María Guzmán, Patricia Martinez
Trading
Nicolas Linares, Jesús Bartolomé,
Jose Angel Zabalegui
Tel: 34-1 432-7808
Fax: 34-1-432-7503
Reuter Code: ISMD, ISME
