Portugal became a full member of the euro club in January 1999, thereby eliminating exchange rate risk on its domestic sovereign debt.
However, its bonds have continued to trade at a substantial spread premium to comparable German or French issues. That’s attractive for investors, but a challenge to the country’s sovereign liability managers.
Most analysts attribute this premium to one of several factors: poor liquidity for many issues in the secondary market, the way the debt is structured, continuing borrowing requirements, and the overall health of and outlook for the Portuguese economy. Depending on whom you talk to, the mix is different. The fact remains that spreads on Portugal’s five-year and 10-year issues have moved between 29 and 41 basis points over Germany’s throughout the last year.
“It is our purpose to do something to improve this situation”, says Vasco Pereira, president and CEO of the Instituto de Gestão de Crédito Público (IGCP), the autonomous organization that has been responsible since 1997 for managing Portugal’s sovereign debt. Just back in Lisbon from a European roadshow, and with the views and criticisms of major institutional bond investors still ringing in his ears, Pereira is nonetheless in ebullient form.
“The prime reason”, he explains, “why the IGCP was created out of two departments in the finance ministry was to have a single and independent agency for central government debt issuing and management within the euro environment. Previously, most debt was in escudos and placed in domestic markets. But now, without there being any currency risk, domestic investors have diversified their portfolios and by far the greatest demand for Portuguese debt is coming from non-domestic investors.” Whereas before about 40% of treasury bonds were placed through non-resident primary dealers, these days it is closer to 80% of new issues.
“Our strategy has been to enlarge and consolidate our distribution channels by broadening the primary dealership network,” Pereira says. Before 1997, this was the preserve of Portuguese banks. Nowadays, nine of the 13 primary dealers in Portuguese debt issues are foreign.
Marketing Portuguese bonds has been no easy ride for these dealers. The market’s initial appetite for the attractive yields has tailed off – largely, says Pereira, because of poor liquidity in secondary markets. This is partly because of scale and Portugal’s relatively small size within euroland, where its economy contributes just 1.32% of the euro-12’s total GDP.
Waning enthusiasm has also been exacerbated by the Portuguese government’s borrowing requirements coming down as the economy grows at higher then the EU average.
“Yes, liquidity became an issue”, Pereira admits, “and our response was to concentrate our financing requirements into a smaller number of standard instruments – mainly T-bonds. We have reduced the number of lines we open each year – from three or four not long ago to just one last year. For 2001 we have again only one line.”
With gross borrowing needs of e7.7 billion ($7 billion) this year, the guidelines are that this will be focused on the issuance of obrigações de tesouro (OTs) – fixed-rate T-bonds with mainly longer and more liquid maturities. The reduction in the number of instruments issued means they will be larger and should consequently benefit from greater liquidity. “Also, we will be launching new OT lines through a syndication rather than through open auction,” says Pereira.
Initially, the IGCP went for issues of e1.5 billion to e2.5 billion, and last year the split was between maturities of five and 10 years. This year it will concentrate on a 10-year OT due in late March with a group of primary dealers forming an underwriting syndicate. “We have still to choose the lead-managers”, says Pereira, adding that the initial offering will be in the region of e1.5 to e2 billion. “From then on we will increase the amount of debt to e5 billion through to the third quarter of 2001 by regular auctions.”
The local banks may have lost market share as primary dealers, but this has been partly offset by the recent round of mergers and consolidation in Portugal’s banking sector.
The number of domestic primary dealers has shrunk from six to four – Banco Comercial Português de Investimento, Banco Espirito Santo, Banco Português de Investimento and state-owned Caixa Geral de Depósitos. Even so, the domestic players have faced tough competition from larger and better-capitalized competitors in France, Germany, Spain and the US. Margins have been squeezed, and it is suggested that domestic players have at times withdrawn from the ring quite willingly.
Although local banks have lost their traditional dominance over the domestic bond market, they, along with other Portuguese institutions, have profited from the opening up of pan-European markets to diversify their own bond portfolios and, even more importantly, their funding sources.
The recent credit boom and fall in domestic savings has meant that all Portuguese banks have broadened their capital base by issuing more medium-term to long-term debt. Filomena Raquel de Oliveira, head of Caixa Geral’s treasury and capital markets team, says that to compete in broader markets, “we have had to be more innovative”. Faced with stronger competition in the enlarged euro market, all of the larger domestic banks have had to come up with new strategies.
“We are a relative newcomer in international markets”, Oliveira admits. But Caixa has launched a e5 billion programme, completing two public transactions worth e1 billion apiece denominated in US dollars and euros respectively, while the rest is being raised through private transactions. “We receive many proposals of financing”, she notes, “working on a reverse enquiry basis. So we are expanding our investment base, having placed paper in Europe, America and Asia.” Oliveira says that “our latest offering is targeted at Japanese life insurance companies”, and says the bank is very happy with the results.
“We are getting very good cost levels in terms of funding,” she says. “Caixa enjoys high visibility and liquidity, so we are able to be very aggressive on cost conditions. Naturally, in the public market we pay the market price, and so keep the broader investor base happy. But in private deals we can be much more aggressive.”
This is all far removed from Caixa’s traditionally staid image. The pace of change may be greater at Caixa than at such privately held banks as Espirito Santo or those quoted on the Lisbon exchange, for they had tapped into international markets much earlier. But the two-way shift – seeking investors in their own bonds abroad while restructuring their investment portfolios to include more foreign sovereign and corporate bonds – is a common theme.
Herein lies one of the headaches for Pereira and his 63-strong team at IGCP. If the trend is for Portuguese debt to be held mainly by international investors as a marginal rather than core element of their portfolios, this tends to reduce liquidity and raises the potential for increased volatility. And since the main attraction of holding Portuguese bonds is their prevailing 30bp spread over the equivalent German Bund, it is an uphill task for IGCP to massage down the premium and so render government borrowing more economical.
The key, as Pereira is the first to admit, is liquidity. But how can a market where domestic investors are withdrawing maintain that essential liquidity?
Pereira’s answer is to simplify the structure of Portugal’s sovereign debt. Hence the concentration of all new funding requirements into a single 10-year OT issue. Equally important is the restructuring of Portugal’s existing stock of sovereign liabilities through the IGCP’s debt exchange programme.
Again, the aim is to concentrate existing government debt currently held in a multiplicity of different instruments of varying maturities into a few larger, more readily tradable, bond issues.
The refinancing needs associated with these buy-backs will be met primarily by reopening the larger and more liquid OT lines of recent years. Pereira says that the most recent buy-back held last February, covering six old Eurobonds and global bonds in legacy currencies through a buy-back window, had been highly successful.
“We may continue over the next year with buy-backs of approximately e20 billion of debt now held as zero-coupon bonds and other OTs out of line with current market yields, globals, old T-bonds close to maturity, and various smaller issues – mostly of short duration and in non-standards formats.” For those investors, such as insurance companies, that want to keep the bonds because, for instance, they are now over par on account of the coupons, and that do not wish to sell because of capital gains tax, the debt exchange programme offers a way to shift from old to newer bonds with greater liquidity. As Pereira points out, e20 billion is about a quarter of total sovereign debt. To shift that into a handful of straightforward bond issues should greatly enhance the size and liquidity of the market.
To some extent, liquidity depends on what trading platforms and settlement systems are used. “We were looking to have OTs traded on the main EuroMTS, which requires a minimum of e5 billion”, says Pereira, “but until our 10-year OT was admitted in 1999 we didn’t have anything of such large size.” Currently, two OTs are being traded, and the big 10-year issue scheduled for this spring would make that three.
Enhanced liquidity may also help move Portuguese debt up a notch or two on the international indices – Portugal’s weightings range from 0.28% of MSCI’s Euro Credit Index to 1.42% of Merrill Lynch’s EMU Direct Government Index – thereby encouraging further international buying of OTs and perhaps greater liquidity still.
There has recently been a slight convergence in spreads between Portugal and other euro-12 countries, particularly Belgium and Italy. That said, the OT spreads over the German Bund remain around 10bp higher than they were a year ago. And with Greece’s accession to the euro-12, there is yet more competition at the higher-yielding end of the market.
