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Introduction
The international investor will not be surprised to hear that the Dutch bond market has been one of the star performers compared to other bond markets in recent years, measured in local currencies as well as in Deutschmarks. The continually low inflation, the absolute clarity with respect to monetary policy, the strong guilder and the political and social stability form the ingredients of one of the most attractive bond markets in the world.
In 1995 also, the Dutch bond market (incidentally the oldest bond market in the world) was one of the star performers. According to the EFFAS methodology, the total return (measured in Deutschmarks) for a bond portfolio with maturities longer than 1 year amounted to 18.1%.
Although we are not yet half way through 1996, it is already certain that the fixed income investor will not be heading for a fantastic year, certainly when compared to 1995. Investors and analysts are even asking themselves apprehensively whether history (1994) will repeat itself. We do not share this opinion. The differences with 1994 are so great that an increase of the 10-year bond yields to more than 7% appears to be quite out of the question for the coming twelve months. On the other hand, a decrease to less than 6% appears to be equally unlikely, so that the space within which interest rates can fluctuate will be rather limited. We expect that in 12 months, 10-year bond yields in the Netherlands could decline to 6.25%.
Structure of the Dutch bond market
The primary Dutch bond market is strongly dominated by the Dutch government. But there has been increasing activity on the Euroguilder bond market, with sovereigns, supra-nationals, banks, insurance companies and corporates apparently able to rate the primary guilder market at its true value, an assessment which is justified in our opinion. Investors as well are increasingly interested in guilder paper from debtors other than the government, although the majority of the fixed income portfolios will consist of plain vanilla government bonds. The vast majority of government bonds are 10-year bullets, although bullets with other tenors (15 years and 30 years) have been issued in the past years. On the secondary market, the dominance of government bonds is even stronger; they account for more than 90% of daily turnover. Therefore we will confine our attention to government bonds.
The demand side of the bond market is much more varied. Institutional investors (pension funds and life insurance companies) are the most important party (representing 50%), although banks and private investors have a respectable share of the issued government bonds in portfolio (27%). The quite significant role of foreign parties in the absorption of the bond supply is striking (23%). The Agency of the Ministry of Finance (the Ministry of Finance body which issues government bonds and which is responsible for the management of the public debt) has played an important role in the internationalization of the Dutch bond market. By means of various innovations (see box 1) the liquidity of the Dutch bond market has increased substantially.
Macro-economic background
One of the most important characteristics of the Dutch economy is the low level of inflation. From 1985 to 1994, only the Japanese CPI was on average lower than the Dutch CPI. This excellent performance was mainly achieved by means of the monetary policy pursued by the Dutch central bank (DNB), which is directed towards the full pegging of the guilder to the Deutschmark. Germany and the Netherlands have agreed to guarantee the original 2.25% ERM bandwidth, while the other countries in the ERM switched to a 15% bandwidth after September 1993.
By pegging the guilder to the Deutschmark the Bundesbank’s anti-inflation policy is imported. Economic developments in Germany and the Netherlands are reasonably synchronous, except for that the cyclical swings are greater in Germany than in the Netherlands, because of the larger share of the cyclically-sensitive industrial sector in Germany.
The essentials of the spread
It appears that the absolute level of Dutch long-term bond yields is actually determined in Germany. In other words, there is a perfect coupling between German and Dutch interest rates, with about 95% of Dutch long-term interest rates being determined by German fundamentals and the remainder (the Dutch German spread in practical terms) by the Dutch fundamentals. It appears from graph 1 that this spread has moved within a fairly narrow band during the past few years: -20 to +20 basis points. One question which immediately arises is: what sets this spread in motion?
Experience has shown that the inflation differential between both countries, government finances, political and social stability, as well as the supply and demand ratios on the bond market are the essentials of the spread. Bunds often traded under DSLs in the past because in the perception of investors the Dutch bond market was less liquid than the German bond market. It should be pointed out that there is no longer any question of this at present, partly on account of the above-mentioned innovations by the Agency of the Ministry of Finance (see box 1).
Economic outlook and yield forecasts
Since the absolute interest level is actually determined in Germany, economic developments in that country should be analysed in order to make a well-founded judgement about the future direction of Dutch interest rates.
Furthermore, it should be borne in mind that developments on the German bond market are strongly influenced by developments in the US, notwithstanding the decoupling since the beginning of April of 1996. The ING growth and inflation estimates for both economic superpowers are substantially lower than the consensus estimates. A strong rise in bond yields is therefore unlikely. On the other hand, we do not see any room for a substantial decline in bond yields either. In the US, monetary policy will remain on hold for the time being (which is a major difference with 1994, when monetary policy was tightened), while a budget agreement will not be concluded in the short term. In Germany, investors continue to desire a ‘risk premium’ on account of the uncertainty with regard to the Emu.
The starting point for the Dutch bond market is therefore neither favourable nor unfavourable. Given the economic fundamentals in the USA and Germany, we expect Dutch 10-year bond yields to decline to 6.25% in 12 months time.
PSBR is the key
Of all the factors which influence the Dutch-German spread, the decisive factor for the coming twelve months will be the development of the PSBR. As shown in graph 2, the PSBR falls considerably in 1996 and 1997. This is partly because of a reduction of the budget deficit, but particularly on account of the decrease of the redemptions. The reduction of the budget deficit is mainly connected with the grossing operation on public housing, which was basically a balance sheet reduction, which inflated the budget deficit in 1995. The significant decline in redemptions is connected with the fact that few government loans were issued ten years ago.
The result of all this is a substantial fall in the PSBR in 1996 and 1997, and thus a relative scarcity of Dutch government bonds both this year and next. Since the government has already covered more than 50% of the PSBR this year, the Agency of the Ministry of Finance decided not to issue a new loan in the second quarter of this year, but only to allow a tender for an existing loan. In the medium term, this relative scarcity will result in Dutch 10-year bonds being traded under German 10-year bonds (Dutch yields lower than German yields), as has been the case since March of this year.
Dutch government bonds are issued via a tap (Dutch auction) or a tender (the reopening of an existing loan). In this way, the Agency of the Ministry of Finance increases the liquidity of individual loans. While a seize of Fl 1 billion was considered to be a substantial loan 10 years ago, nowadays a seize of Fl 15 billion is no longer an exception. The emphasis lies in the 10-year area, although loans with a longer life have been issued. This fits within the Agency’s strategy to extend the life of funded public debt, besides realizing the funding as cheaply and as smoothly as possible. It should also be noted that the Agency publishes an issue calendar at the beginning of each quarter.
Technical aspects
In the Netherlands, there is an annual coupon, with the coupon date normally falling on the 1st or the 15th of the month. The interest is calculated on the basis of a 30-day month / 360-day year, while the price of a bond is always quoted exclusive accrued interest. Settlement takes place three working days after the transaction date. In the Netherlands, interest payments are currently not subject to withholding tax, while stock exchange tax was abolished on 1 July 1990.
ING Bank Amsterdam
For further information and advice please contact:
Treasury, Trading&Sales
Sales Fixed Income: (31 20) 563 8110
Sales Private Placements: (31 20) 563 8107
Trading Fixed Income: (31 20) 563 8120
ING Barings ResearchFI and Currencies: H. de Bruijne: (3120) 563 8778
ING Bank, Treasury, Trading&Sales
General Management: Th. de Vries (chairman), B. Kok
Senior Manager Fixed Income: L. Veldink, (31 20) 563 8011
Address: Treasury Center,
Foppingadreef
7 / P.O. Box 1800,
1000 BV Amsterdam,
The Netherlands
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