Making new flexible friends

Gilt strips take the stage

Any discussion of European government bonds turns at some point to the advent of the euro. Countries that join in the first round in 1999 lose sovereignty over their domestic currencies and the right to print money. Secondly, their debt issuance will be restricted to 3% of their GDP.

The second requirement is unlikely to make much difference to government bond markets. Most EU member countries announce their borrowing requirements for the year in advance, and in the run-up to the single currency potential participants are keeping to the borrowing limits set out by the Maastricht treaty. So the restrictions will not change total issuance much. What will be different is the currency of issue. Member governments will have to issue new debt in euros or a currency other than their old domestic one.

This is likely to create a single-currency government bond market similar in size to that of the US. (It may also incidentally create confusion over the term Eurobond – is it a government bond issued in euros, or a bond issued in a currency other than that of the country or market in which it was issued?) And it will also also force investors in European government bonds to make choices between different issuers of euro-denominated bonds.

The choices will not be clear-cut until the new bond market is under way. But some countries look better placed than others to take advantage of the common currency. Governments can take measures to customize their bond markets to make them as attractive and distinctive as possible.

How effective these measures will be is another matter. Sentiment can outweigh ease of buying in a particular market. As one analyst says: “The Germans will always find it easy to issue.” The dominant position of the Deutschmark in Europe and the central role of Germany in the push towards a single currency makes it unlikely that German government debt will ever be unpopular despite its somewhat cumbersome issuance procedure. But what of the smaller members? When you can have German-issued euro bonds, who will want euro-denominated bonds from Austria when they have the same currency risk and the same yield curves?

EU member governments will need to make their bonds attractive to domestic and international investors. Some countries have a large proportion of domestic demand that may decamp to other countries. In Belgium, for example, 97% of government issuance is taken up by domestic investors. However, once the euro is in place a proportion of those investors will look to other euro-denominated government bond markets. International investors will therefore be needed to take up the slack in demand.

As a pre-euro move, the Belgian government plans to issue domestic bonds denominated in Deutschmarks and French francs. The bonds will be redenominated in euros, and after Emu both issues will be interchangeable with olos, the normal Belgian government bond. This is an attempt to broaden the distribution of Belgian domestic debt for 1999, and to provide a fungible benchmark for the single-currency market.

The government bonds of EU states will be differentiated by pricing spreads. Member countries with bad debt ratios that are near their maximum tax-raising potential will not be considered investments of the same grade as, say, Germany. Instead they may be treated much like low-grade corporates. This would imply wider spreads, which some estimate could go out as far as 100 basis points.

A counter to this possibility is the mutual guarantee of debt for Emu members, which would reduce risk and substantially narrow spreads. Here politics may prove more crucial than financial theory. Countries that cooperate politically with their single-currency partners may well be in a relatively strong position to seek financial assistance should the need arise. But if a member country, perhaps one of the smaller ones, were to take a politically divergent view, the spreads on its debt would probably widen.

Flexibilty vs liquidity

One way for smaller countries to distinguish their euro-denominated debt from others is by having the most flexible debt structure. “The way forward for these countries is through a flexible maturity rate, a feel for the market and judging what they can sell at the time,” says Peter Herrmann, vice-president of Credit Suisse First Boston. Flexibility is good, but can investors get too much of a good thing? Antti Ilmanen, vice-president, bond portfolio analysis, at Salomon Brothers, thinks they can: “If government debt gets too flexible, and there are too many fancy issues, it hurts liquidity. Flexibility is nice, but the important thing is to be as liquid as possible.”

Liquidity may be improved in government bond markets by the introduction of stripping – trading the coupons separately, thereby creating a market of zero-coupon bonds with diverse maturities. Although strip markets provide a basic instrument, they take a while to develop. Not all countries have the right investor base to provide sufficient demand. The UK strips market will begin next month and is widely expected to be a success. This is because large insurance and pension firms are strong in the UK and find the zero-coupon structure useful for their payment patterns. The German strip market, by contrast, has started badly. “They haven’t had much luck,” says one trader. And for a country like Spain, where the insurance industry is comparatively underdeveloped, the market for strips would probably not flourish. So are strips the way for smaller countries to dress up their bond markets? Perhaps not. Strips may be attractive to domestic investors, but international investors are likely to have little incentive to buy them. “Strips are a good instrument, and provide liquidity,” says one analyst. “But then again, you have to ask who is trading Austrian strips.” The demand is probably not from international clients. Strips help to flatten the yield curve, reducing the borrowing costs for governments, and may help to increase domestic bond market participation, but there the benefits may end.

The nitty-gritty

How can countries attract investors to their own particular brand of euro bond? Most countries already have tax-exemption clauses for international investors, so it is not likely that advantage will be gained through different tax structures. What may help to make up the minds of investors is simply how easy it is to get hold of the paper.

At present, the main European government bond markets have different issuing systems at different levels of development. The French system is the most advanced among the European states. Modernized in 1985, it is partly an electronic market and uses 20 primary market-makers – the SVPs. There are three types of repurchase agreement available and a strips market was introduced in 1991. Borrowing requirements are announced at the start of the year and there are specified issuance dates for each type of security. Auctions are made by sealed bid, with the svps permitted to bid at the average price accepted for a limited amount. Anyone with an account at the Bank of France may place a bid.

By contrast, for a major issuer, the German issuance procedure is particularly antiquated. Bids for German government bonds must go through several stages, all via phone or fax, and it is a long, inefficient process. A gradual upgrading process is under way, but the system is still too convoluted and time-consuming. The German repo market is very inactive in Germany, but flourishes in London. The strips market has not been a success. And the issuance of the main security, the Bund, is also awkward. The Bund is issued in three tranches. The 110-member Federal Bond Consortium receives 40%, another 40% is sold via auction, and the remaining 20% is kept by the Bundesbank for market support operations. The consortium receives its quota regardless and its members are given a placement commission of 0.875%. The German borrowing announcements are made quarterly. This system is not highly regarded. As one fund manager says: “The Bundesbank puts Bunds on its own book in an attempt to command market forces. In the end, you can’t.”

France and Germany are at opposite ends of the spectrum when it comes to issuance procedure. Each country has its own methods and time-scale. And the more investor-friendly the procedure, the more likely it is that the debt will be bought. For instance, the French, Austrian and Belgian governments are pushing to include international banks among their primary dealers. This would naturally increase the participation of international investors in their domestic bond markets. But while this may influence the decisions of some investors, the effect on the market overall may be limited. One banker says: “Markets tend to overlook the nitty-gritty, especially things like coupon payments. They can be worked out after yields.” Others doubt that issuance procedure will be a concern for investors at all. It may end up as a question for each government: “Which type of issuance procedure is taken as standard may end up being a stupid compromise for political gain,” says one bond investor.

Will governments need to sell hard in order to place their bonds? Government debt will always be a safe bet. As one senior investment manager says: “Quite simply, what investors don’t know, they don’t like. They try to second-guess the government, and don’t like uncertainty.”

Domestic demand in smaller countries within the single currency should remain, even if it is slightly diminished. But as one trader says: “There are a lot more interesting instruments than government bonds.” Uninteresting, homogenous, safe – not the best of recommendations. But there’s always the chance things may turn out differently.