The sovereign, supranational and agency bond market has had a tumultous ride in 2022 as global economic growth slowed, inflation soared, interest rates climbed and central banks finally began to wind down their vast quantitative easing programmes — support measures that had, of course, greatly benefited the sale and price of public sector debt in recent years.
After a year of transitioning, public sector borrowers will enter 2023 where more challenges lie but so will opportunities, according to the results of a survey of public sector origination and syndicate bankers, undertaken in late October and early November by GlobalCapital.
About 72% of the SSA bankers surveyed believe that overall funding issuance volume is set to rise in 2023. But the view is split on how sharp that increase could be: half of them think volume will jump by more than 20%, with the other half expecting a more modest jump of less than that.
“There is no question that issuance volumes will go up next year, which will be felt more in the sovereign space. The response to the energy crisis is going to be a big driver of issuance,” says Kerr Finlayson, head of frequent borrowers group syndicate at NatWest Markets. He does not foresee issuance jumping by more than a fifth year-on-year, but expects government borrowing costs will be higher on the back of larger volume.
Finlayson is not alone. All respondents to the survey believe that the energy crisis in Europe will add to bond supply pressure in 2023, though the extent of the impact is not clear. A slight majority of 55% believe the impact on government borrowing requirements could be significant. Around 75% expect issuers to frontload their supply.
Governments across Europe have announced measures to help their citizens cope with soaring energy costs. Some €674bn of funding was allocated across the European Union, Norway and the UK between September 2021 when the energy crisis started — and was subsequently intensified by the Ukraine war — and October 20, 2022, according to Brussels-based think-tank Bruegel. Nearly 40% of that came from Germany alone.
ING expects around €1.2tr in gross European government bond issuance in 2023, up by €85bn from 2022 “with risks that [the increase] could turn out even higher”. Net issuance, however, should remain below €400bn, compared to €385bn this year, the bank said in its 2023 outlook.
A syndicate banker based in Europe said he is “almost sure” that the 2023 issuance volume could go back to the 2020 peak during the Covid-19 pandemic, as all governments are tasked with financing their own energy support packages and some possibly for the European Union.
But he thinks demand should rise in tandem with supply. “There will be more funding but the positive thing here is that there will be higher liquidity, too,” the banker said.
“Investors will allocate their money differently next year and more money will go into the SSA space for sure, because of higher yields. Some investors, particularly [pension and insurance] clients, were not there in the past five or six years but they will focus more on this liquid space instead of structured products, now that it’s more attractive from a yield perspective.”
Jamie Stirling, global head of SSA DCM at BNP Paribas, holds a similar view. “We’ve seen very difficult markets in all sectors, [and] SSA issuers, while they may have had to pay slightly higher spreads, still have had market access and have been raising money,” he says.
“The positive is that in this new environment, a lot of investors from the real money community — who haven’t been investing in SSAs for many years because of low rates — will return, because investment will be far more attractive than it has been in recent years.”
Spread and premium moves
The higher supply in sight and central banks unwinding some of the quantitative easing (QE) measures have left market participants wondering what will happen to SSA spreads.
A big selling point of European supranational and agency bonds this year, particularly in recent months, has been their relative value over government bonds. The average spread over govvies has risen to 68bp in the fourth quarter of 2022 as of November 14, from 45bp in the first quarter and 35bp in Q4 2021, according to data from GlobalCapital’s Primary Market Monitor.
From mid-October to mid-November, euro issuers were paying an average of 70.5bp over Bunds.
But the elevated spread versus Bunds is unlikely to be sustained going into 2023. Some 78% of bankers surveyed hold the view that the premium over Bunds will decline, with only 22% believing it will continue to climb.
“[SSA] spreads should tighten against Bunds but widen against mid-swaps,” NatWest’s Finlayson says. “We’ll see swap spreads tighten once we start getting more rhetoric around [quantitative tightening] from the ECB and by default, that means spread against mid-swaps should widen.”
Ten year swap spreads have been wide this year — at times more than 100bp over Bunds.
With the QE-induced pricing advantage disappearing and investors demanding more compensation as market volatility persists, SSA issuers have seen new issue premiums rise from nearly zero at the start of 2022, to mid-to-high single digits in late October and early November.
About 36% of the bankers that participated in the survey think the premiums paid by issuers will be considerably higher in 2023. Some of them think double-digit concession could be on the table.
However, a majority of 64% of SSA leads think premiums should fall after rising initially.
“We’ll have to see how spreads move in the next few weeks, and the big question mark is on January and how the market is going to digest all the potential supply, but there’s no doubt that larger concessions will be required next January versus January 2022,” says a senior SSA banker in London.
“But I don’t think we’ll see 15bp-20bp concessions like some people feared. The market is already going into the year-end with more cheapening, and that’s probably a good thing because it’ll provide attractive levels for the early part of next year, which would then give us some opportunity to see some performance.”
QT, inflation concerns
GlobalCapital also asked SSA bankers to identify the main factors that could in their view disrupt the SSA market in 2023.
Almost all of them (91%) pointed to the reverse of QE as their top concern, but many (64%) are also worried whether inflation will be brought under control. A recession (36%) and unforeseen volatilities (36%) are also very much at the back of bankers’ minds.
“The reverse of QE is the key thing,” says a senior banker at a US firm. “Clearly we’ll have a different environment versus to what we had earlier this year where a lot of the supply were already absorbed in the first half of the year with the help of QE. It’ll be interesting to see how that’s going to play out next year.”
The Europe-based syndicate says the ECB will not be as aggressive as some may think with QT. “There will be some balance sheet reduction but the impact of that will be outweighed by the comeback of liquidity next year, in my view,” he says. “I think the liquidity that’s coming back next year can absorb the effect of the central bank tapering that will come into play. The question is how investors will allocate the money that needs investing at the beginning of the year, which will depend on the economic and inflation outlook.”
The European Central Bank is set to decide how it will reduce its asset purchase programme monetary portfolio at its December 2022 policy meeting.
Market participants believe that, like the US Federal Reserve, the ECB might take a more gentle approach when it begins QT, starting by gradually reducing reinvestments in its conventional bond purchase programme, as opposed to the Bank of England (BoE), which has started to conduct outright sales of short and medium term Gilts.
“The ECB, when it starts QT likely next year, will take a more passive approach similar to the Fed, so it will not be as impactful on the bond market,” says a London-based fixed income investor, pointing to the much longer maturity profile of UK debt as the reason behind the BoE’s aggressive approach.
Economists at Société Générale expect the ECB to begin QT in March 2023, when the central bank will first reduce reinvestments in the private sector programmes, and then the public sector purchase programme (PSPP) in the third quarter and finally the pandemic emergency purchase programme (PEPP) in 2024.
Depending on the degree of QT, the market may need to absorb €100bn-€135bn of additional supply from eurozone governments and the EU, the French bank said in early November.
Silver linings
With the end of negative rates in Europe, the exit from QE and more uncertainty in the overall market, issuers are expected to adjust their priorities in 2023.
About 82% of bankers who took part in the survey believe SSA issuers’ main task in 2023 is to navigate through the calendar — between central bank meetings and economic data releases — to find the right issuance windows.
Having enjoyed ultra-low funding costs in recent years, SSAs will also have to accept that paying up is the new normal, according to 64% of the survey respondents. Bankers also put weight on getting large deal sizes done (55%) and pushing for longer tenors (45%) as part of the main focus for public sector borrowers.
As pricing windows are expected to be fewer and farther between, so dealing with competing supply also holds the key for issuers (45%).
“Unless the backdrop improves significantly, getting the same size deals done as before is not feasible so issuers will need to do more deals, simple as that,” says the senior banker in London. “But that means there is going to be more clashes of issuance and more conflicts. We will have smaller windows and they’ll be saturated much more so than previous years. And that could be the biggest issue we have.”
But market participants believe that SSAs, more so than issuers from other sectors, are well equipped to deal with the upcoming challenges.
Finlayson believes 2023 will not be “a year of crisis” but “a year of resetting and a year when we go back to a ‘normal’ or ‘standard’ market where yields are higher, after we’ve done some transitioning in 2022”.
“It’s part of the cycle,” he says. “It’ll be a tough market, no doubt, but we will adjust to it. Our issuers are not in panic mode because every one of them has lived through some kind of crisis before, so they are very pragmatic about paying what they have to pay, if higher concessions are required — they’ve done it before.” GC