The Market for Government Bonds in the Euro Area

Transcription

1 37 The Market for Government Bonds in the Euro Area Lars Krogh Jessen and Anders Matzen, Financial Markets Department INTRODUCTION The commencement of the 3rd stage of Economic and Monetary Union (EMU) on 1 January 1999 brought major changes in the framework for the bond markets of the euro area. The lapse of exchange-rate uncertainty and the transition to a single monetary policy eliminated some of the most important factors behind government-bond yield differentials among the euro-area member states. The expectations with regard to the development in the European bond markets after 1 January 1999 were to a great extent based on experience from other currency unions, e.g. the USA and Canada. Comparisons of the size of the bond markets in respectively the euro area and the USA gave rise to expectations of increased liquidity in the European bond markets taken as one. It was also expected that a certain yield differential among the government bonds of the individual euroarea member states would continue to exist, due to differences in credit risk 1. The work to prepare for EMU by government debt offices indicated that competition among government issuers would intensify considerably after 1 January A central issue was which government securities would achieve benchmark status for the entire euro area. As a consequence, most government issuers focused on building up large liquid bond series. The purpose of this article is to examine whether the expectations of the government bond market in the euro area have been fulfilled. First a description is given of the market for government securities in the euro area. To a degree, the bond markets are still segmented according to national borders. It is also observed that there are still considerable yield differentials among the countries. 1 Cf. Bertil From, Yield Differentials in the Future EMU, Danmarks Nationalbank, Monetary Review, May 1997.

2 38 The yield differentials are explained in the following two sections, with focus on respectively credit risk and liquidity. As expected, credit risk has a certain influence on yield differentials. The liquidity of the individual bond issues is another important element in the explanation of yield differentials. In this connection various aspects of importance to liquidity are outlined, including the work by government debt offices to build up liquidity, and the market conditions. The transition to the euro has also led to considerable changes in the market for non-government bonds. This subject is not considered here, since the article focuses solely on the development in the market for government bonds in the euro area. THE MARKET FOR GOVERNMENT SECURITIES IN THE EURO AREA The redenomination of almost all domestic government debt entails that as from the commencement of EMU the basis was created for the establishment of a large-scale market for government securities for the entire euro area. Furthermore, the market conventions were harmonised in connection with the transition to the third stage of EMU. Finally, the importance of regulatory requirements of placements in national currencies by institutional investors has lapsed 1. The euro area's bond market is the second-largest in the world, exceeded only by the US bond market, cf. Table 1. Public issuers are central governments, federal states, etc. Government bonds account for a good 3,000 billion euro of total general-government issues in both the USA and the euro area 2. Although the markets for government securities in the euro area and the USA are of similar magnitude, there are major differences. There is still some segmentation into national markets of the government securities market in the euro area, while in the USA it constitutes one single market. This is related to the fact that the government securities of the euro-area member states are not perfect substitutes. One explanation is variations in the member states' credit standing and a continuing tendency for government securities to be purchased particularly by domestic investors. Despite the overall magnitude of the government securities 1 2 The consistency provisions of the 3rd EU life assurance directive whereby 80 per cent of the technical reserves must be in the same currency as the future disbursements are no longer limited to investments within the euro area. Outstanding government securities in the euro area are calculated for the following countries: Austria, Belgium, Finland, France, Germany, Italy, the Netherlands and Spain. This compilation is based on all negotiable domestic debt instruments, i.e. both government bonds and Treasury bills. In the USA, apart from government bonds the federal government has debt in non-negotiable debt instruments amounting to 2,163 billion euro. Source: National government debt offices.

3 39 OUTSTANDING BONDS AT END-1998 Table 1 Euro billion Government issuers Private issuers EU ,875 3,331 EU ,763 4,381 USA 1)... 7,632 6,405 Japan 1)... 3,626 1,661 Source: Bank for International Settlements; International Banking and Financial Market Developments. Note: The figures comprise both domestic and foreign issues by the stated countries or country groups. 1) Converted into euro at the exchange rate on 30 June market in the euro area this segmentation entails less liquidity in the market as a whole than is the case in the USA. Yield differentials between government securities in the individual countries continue to exist, despite the lapse of the exchange-rate risk. This appears from Chart 1 which illustrates yields to maturity for government securities in the euro area. The chart also shows a tendency for yield differentials to widen in step with maturity. Chart 2 presents the development in yield differentials in the 10-year maturity segment. Prior to the commencement of the third stage of EMU the expectation was that yield differentials would continue to exist among the member states. In mid-1998 the 1-year forward yields on 10-year maturities thus indicated yield differentials equivalent to the actual differentials in July YIELDS TO MATURITY AND MATURITIES OF EURO-DENOMINATED GOVERNMENT BONDS Chart 1 Per cent Maturity, years Note: 14 July Source: Reuters.

4 40 10-YIELD DIFFERENTIALS TO GERMANY OF SELECTED EMU COUNTRIES, 1999 Chart 2 Per cent January February March April May June July August France Netherlands Austria Spain Belgium Italy Portugal Note: Weekly averages Differentials between bonds with the same maturity can be attributed primarily to variations in credit risk and liquidity. Benchmark bonds for the euro area Benchmark bonds are used as a reference for the pricing of other bonds. They are very liquid, which is usually reflected in a relatively high trading volume and a small spread between bid and offer prices. The focus on liquidity entails that only bonds with relatively substantial outstanding amounts can function as benchmarks for the euro area. Whether a bond achieves benchmark status is determined by the leading bond dealers. Achieving benchmark status is of interest to the issuer since this implies lower borrowing costs. The yields to maturity on the benchmark securities in the individual maturities form a "benchmark curve". This might indicate that all maturity segments are equally important. In practice, however, most of the issues in the euro area are in maturities of less than 10 years. Issuing and trading activity is concentrated particularly in the 2-, 5- and 10-year maturity segments. By tradition, German government bonds have been viewed as the benchmark securities for the European countries. Prior to the transition to the third stage of EMU there was some speculation as to whether other countries' government bonds might achieve the status of benchmark securities in a common yield curve for the euro area. The back-

5 41 SECURITIES IN THE EURO BENCHMARK CURVE Table 2 Maturity Reuters Bloomberg 2-year... Bund Schatz 3 per cent 01 BTAN 3 per cent 01 3-year... BOBL s per cent 02 BTAN 4.5 per cent 02 4-year... BOBL s per cent 03 OAT 6.75 per cent 03 5-year... BOBL s per cent 04 BTAN 3.5 per cent 04 6-year... OAT 7.75 per cent 05 OAT 7.5 per cent 05 7-year... OAT 6.5 per cent 06 OAT 7.25 per cent 06 8-year... OAT 5.5 per cent 07 OAT 5.5 per cent 07 9-year... BUND 5.25 per cent 08 BUND per cent year... BUND 4 per cent 09 BUND 4 per cent year... BUND 6 per cent 16 OAT 8.5 per cent year... OAT 5.5 per cent 29 BUND 4.75 per cent 28 Source: Reuters and Bloomberg on 15 July Note: German securities: Bund Schatz, BOBL, BUND; French securities: BTAN, OAT. ground included that certain countries had larger government bond series than Germany. However, the first half-year has shown that no unequivocal yield curve has arisen for benchmark securities in euro. This is due to such factors as the continued segmentation of government bond markets in the euro area. In the important 10-year maturity segment the relevant German government bond is the undisputed benchmark. With regard to other maturities the government securities of several different countries are named as benchmarks for the euro area. This appears from the euro benchmark curve, cf. Table 2, compiled by the two financial news agencies, Reuters and Bloomberg. Market participants also mention Italian government bonds as benchmark securities for the euro area at the short end of the maturity spectrum. This is related to the large series volumes, as well as to the fact that the credit risk is of less significance for the shorter maturities, cf. the next section. Despite the diverging views on which securities are included in the euro benchmark curve it is noteworthy that the curve includes government bonds from other countries besides Germany. However, only government bonds from the major euro-area member states have achieved benchmark status. Before 1 January 1999 the swap yield curve in euro was named by several market participants as the most obvious reference for price-fixing of euro-denominated bonds 1. The basis for this expectation was that the 1 A swap is an agreement between two parties to exchange payment flows during the maturity of the swap. A simple example of an interest-rate swap is an agreement between two parties, A and B, to exchange payment flows based on respectively fixed and variable interest rates. For example, according to the agreement payments from B to A are subject to a fixed interest rate, while payments in the other direction are subject to a floating interest rate. The swap yield curve is based on the interest rates for the fixed interest payments for the various swap maturities.

6 42 swap yield curve is independent of a single issuer's credit rating and that price formation is comparatively predictable in view of the ample liquidity in the market for interest-rate swaps in euro. However, the euro swap yield curve has not achieved benchmark curve status. The background is the great volatility of swap interest rates as a result of the unrest on international markets in the wake of Russia's financial crisis in the autumn of A bond which is included in the benchmark curve for the euro area does not necessarily have the lowest yield in the relevant maturity. The yield spreads between government securities are determined by several factors, of which credit risk and liquidity are the most important. The significance of credit risk and liquidity to yield differentials is described in further detail in the following sections. CREDIT RISK The credit risk is the risk of suffering a financial loss in the event of default by a counterparty on payment obligations. The credit risk associated with bonds relates to the issuer and is assumed to be relatively constant from year to year. The credit risk related to domestic government debt is normally considered to be very limited due to the central government's ability to levy taxes. By tradition another factor is the access to monetary financing of the debt. In practice, its significance is limited. EU member states are subject to Article 101 of the EU Treaty which prohibits borrowing from the central bank, and thereby monetary financing of debt. It follows that in principle it is a member state's willingness to pay its debt by levying taxes which determines the credit risk related to the EU member states. The responsibility for fiscal policy continues to rest with the individual euro-area member states. The responsibility for financing government expenditure, including the issue of government bonds, is thus a national concern. Article 103 of the EU Treaty, the "no bail-out clause", stipulates that each member state is liable for its own national debt. As a consequence, the assessment of the credit risk related to the government issuers is of importance to the yield spreads among the individual euro-area member states. The credit risk related to a bond issuer is often measured in terms of a rating, which is an overall assessment of the issuer's ability to meet payment obligations. All euro-area member states have a relatively high rating. Standard & Poor's has given four euro-area member states the top rating of AAA, which means that the credit risk associated with in-

7 43 YIELD DIFFERENTIALS TO GERMANY AND RATING Chart 3 Per cent year yield differentials 10-year yield differentials AA AA+ AAA AA AA+ AAA Portugal Italy Spain Finland Belgium Ireland Austria Netherlands France Source: Bloomberg, Standard & Poor's. Note: Yield differentials in July "Generic" 5- and 10-year securities have been used, i.e. typically the most recent issue in a given maturity segment. As a result, the maturity is not necessarily identical to the maturity stated here. Furthermore, there may be considerable variation in the size of the issues. These two factors may explain e.g. Ireland's relatively wide yield differential in the 5-year maturity segment. It should also be noted that the remaining maturity of the German 5-year bond is 4½ years. The likely implication is that the yield differentials are overvalued. vestment in bonds issued by these member states is almost non-existent. Two member states are rated AA+ and four are rated AA. For comparison, Denmark is rated AA+ for foreign-currency denominated debt and AAA for krone-denominated debt. According to Standard & Poor's principles the former rating is most comparable with the ratings of euro-area member states 1. Chart 3 shows the relationship between rating and yield differential. The chart shows 5- and 10-year yield differentials to Germany and to a degree confirms the assumption that the yield differentials tend to increase in step with the credit risk. However, this does not apply in all cases. For example, Belgium is rated AA+ but has a higher yield than Spain, rated AA. Moreover, France and the Netherlands, also rated AAA, have yield differentials to Germany of basis points. This may be attributed to the market participants' perception that Germany is nonetheless more creditworthy. However, this explanation probably holds true for only a small proportion of the yield differential. These examples show that other factors, primarily liquidity, also play a role. 1 Cf. the description in Kristian Sparre Andersen and Anders Matzen, The Use of Ratings in the European Capital Markets, Danmarks Nationalbank, Monetary Review, 3rd quarter 1998.

8 44 10-YEAR YIELD DIFFERENTIALS TO GERMANY Chart 4 Per cent May June July Italy Belgium Note: May-July The chart also shows generally wider yield differentials for the 10-year maturity than for the 5-year maturity. This indicates that the market participants tend to attach greater importance to the credit risk for the longer maturities. Furthermore, market participants' perception of the credit risk associated with a given country may vary over time, even if the rating is unchanged. This is illustrated by an example from May On 25 May the EU ministers of finance approved Italy's upward adjustment of its budget deficit for 1999 from 2.0 per cent of GDP to 2.4 per cent of GDP, if the economic conditions in Italy make this appropriate. After this decision the euro weakened and Italy's yield differential to Germany widened. Chart 4 shows the 10-year yield differentials to Germany of Italy and Belgium. It appears that the differential to Germany widened in connection with the agreement on Italy's budget deficit. The differentials of other euro-area member states with a relatively low rating and a relatively high government debt also widened. In the chart Belgium is a representative example. The widening of the yield differentials for these countries can also be taken to indicate that for a time there was greater uncertainty concerning the future of EMU. The yield differentials subsequently narrowed to previous levels. To some extent the above confirms the expectation that credit risk would be of great significance to yield levels for bonds issued by gov-

9 45 ernment borrowers. It is also clear, however, that credit risk is not the only explanation for yield differentials among the individual countries. A high credit rating is thus not enough to warrant low yield differentials. Experience from the 1st half of 1999 shows that liquidity is at least as important to yield levels. LIQUIDITY Liquidity expresses the degree of negotiability of the bonds. In contrast to credit risk, liquidity is to a high degree related to the individual bond series. Moreover, in the short term an issuer may also influence the liquidity of a given paper and a given market. Issuers do not have the same degree of influence on market participants' perception of credit risk. Bonds which are liquid are normally characterised by a large volume in circulation, a high trading volume and a small spread between bid and offer prices. Liquidity also depends on whether the bond market is generally perceived to be well-functioning and efficient. A more transparent issuing policy among government issuers may contribute to this perception. The efficiency of the government bond market also depends on the existence of well-functioning repo markets, and on whether the bonds can be delivered in a futures contract subject to high turnover. In general, investors are willing to pay a premium for a more liquid bond. The influence of government issuers on liquidity Government issuers can influence liquidity via size of series, choice of instrument, method of issuing, etc. The intensified competition among government issuers after the transition to the euro has therefore led to an adjustment of the government-debt strategy of most euro-area member states. In recent years building up large bond series has become an established element of the issuing strategy of government borrowers in Europe. This creates the right preconditions for ample liquidity and thereby lower financing costs. The commencement of the third stage of EMU has put greater focus on large series. In the 1st half of 1999 this was demonstrated by a number of member states' buy-back of outstanding bonds in order to compress issues into fewer series. This particularly applied to smaller member states. A case in point is the Netherlands, which intends to reduce the number of outstanding series from 35 to between 12 and 15 by buying back existing loans.

10 46 OUTSTANDING 10-YEAR GOVERNMENT BONDS ON 15 JULY 1999 Table 3 Euro million Portugal... 3,337 Finland... 5,087 Ireland... 5,574 Belgum... 9,122 Netherlands... 9,613 Spain... 11,261 France... 22,522 Italy 23,028 Germany 1)... 20,000 Source: Bloomberg, 1) New 4.5-per-cent 2009 bond, opened on 6 July Both Bloomberg and Reuters apply the German 4-per-cent 2009 as the 10-year benchmark for the euro area, Table 3 shows that the major euro-area member states have 10-year bonds with an outstanding volume of around 20 billion euro or more, while the small member states' outstanding 10-year bonds amount to less than 10 billion euro. A large outstanding volume does not necessarily imply a narrow yield differential since liquidity depends on other factors besides the size of the series. This appears from Chart 5 which shows the relationship between yield differentials to Germany and the size of the series of current 10-year government securities of the euro-area member states. With regard to choice of instruments, the euro-area member states almost exclusively tend to use fixed-interest bullet issues, primarily in the 10-year maturity segment. As a supplement to the fixed-interest bullet issues, all euro-area member states offer stripping, i.e. splitting up each bond into interest and instalment payments. With the exception of a French issue of a long-term index-linked bond and a few structured Italian loans, there have been no innovations with regard to types of loan. Innovation by government issuers has been dedicated to increased use of buy-backs and interest-rate swaps. The purpose of these measures is to concentrate borrowing on a few large issues in a situation with a small financing requirement and greater focus on risk in relation to government debt. The use of interest-rate swaps in particular offers an opportunity to concentrate issues on a few maturity segments without affecting the desired risk profile for the government debt. Buy-backs also make it possible to convert the debt to securities at coupon rates which conform to market levels. Auctions are the most frequently used method of issuing government securities. This method makes it possible to quickly build up a relatively

11 47 CURRENT 10-YEAR BENCHMARK AND AVERAGE YIELD DIFFERENTIAL Chart 5 Per cent ,000 10,000 15,000 20,000 25,000 AA AA+ AAA Euro million Note: July Source: Bloomberg. large volume of outstanding bonds. Due to their limited financing requirements the small member states cannot compete with the liquidity of issues by the large member states. Several of these countries have resorted to syndicated bond issues rather than auctions, when opening new series. Syndicated issues are targeted more towards the endinvestor and enable the issuing countries to reach a wider group of investors. All euro-area member states apply a more or less formalised "primary-dealer" system on a varying scale. Primary dealers are financial institutions holding the exclusive right to buy bonds at issue. They are normally committed to creating liquidity and trading volume in specific government securities. In the run-up to EMU there was a general tendency to include primary dealers from other countries. Today, most countries thus use a mixture of national and international financial institutions as primary dealers. This reflects the wish to reach a wider group of investors, especially foreign investors. Finally, a number of government issuers offer bonds in open government securities series. The purpose of these schemes is to assure investors that there will always be a "lender of last resort" to prevent locking-in of the market. Such measures are normally assumed to contribute to the liquidity of the securities open for new issues and to enhance the efficiency of trading in government bonds.

12 48 NUMBER OF FUTURES CONTRACTS BASED ON 10-YEAR GOVERNMENT BONDS IN EURO Table 4 1,000 contracts End-July 1998 End-July 1999 EUREX MATIF LIFFE 1) Source: Bloomberg. Note: The number is compiled as the total number of open positions in a given futures contract. 1) Trading in the Bund future on LIFFE was suspended at the beginning of Market-related factors of significance to liquidity Factors such as the distribution of investors, the markets for financial derivatives and the design of trading systems also affect the degree of liquidity. Issuers have limited scope to influence these factors. Special factors concerning the placement of outstanding securities may affect the liquidity of the market. For example, despite large issues, the French market for government securities is regarded as less liquid than the German market. One explanation given by market participants is that French government securities are held primarily by domestic investors. Non-residents thus own less than 20 per cent of the total outstanding volume of French government bonds, while the corresponding figure for Germany is around 50 per cent. Since foreign investors are generally more active traders of bonds the small proportion in foreign ownership indicates a relatively lower trading volume in the French market, and thereby poorer liquidity. The poorer liquidity helps to explain the yield spread between France and Germany of more than 10 basis points for the 10-year maturity. The existence of a highly-traded futures contract makes it easier for investors to hedge their positions and may thus contribute to the liquidity of the underlying government bonds. Prior to the transition to the euro there was intense competition among the derivative exchanges for the dominant position in the important futures contract based on 10-year government bonds. The competition primarily involved EUREX (previously Deutsche Termins Börse) of Germany and Switzerland, LIFFE of the UK and MATIF of France. At present EUREX is clearly the leader in the dominating futures contract, cf. Table 4. While at MATIF 1 both French and German bonds can be delivered in the most important 10-year contract, at EUREX only German government bonds can be delivered in the 10-year contract. The development on the futures markets 1 MATIF has also introduced a multi-issuer futures contract for 10-year maturities which can deliver bonds from all 11 euro-area member states. However, the activity in this contract is very modest.

13 49 has thus supported the dominating role of the German 10-year government bond. The introduction of the euro has brought considerable changes with regard to trading in government bonds. There has been a tendency for the size of individual transactions to increase. According to market participants German government bonds are now traded in the same nominal denominations in euro as was previously the case for D-mark bonds, i.e. transaction sizes have doubled. However, there are no indications of an increase in total trading volume. Furthermore, an increasing degree of integration can be observed for the marketplaces for bond trading. This is for example shown by the establishment of a number of alliances between stock exchanges in EU member states, and by the establishment of joint trading systems for the largest bond series. Previously, government bonds were traded mainly in national trading systems. After the introduction in April 1999 of "EuroMTS", an electronic trading system for the most liquid European government bonds with an outstanding volume exceeding 5 billion euro, the foundation has been established for concentrating trading of the large benchmark bonds in one system. EuroMTS is owned by a group of private banks which decides which bonds may be traded in the system. So far these are government bonds issued by Germany, France and Italy. The establishment of EuroMTS will probably support the grouping into large and small countries which has been observed since the introduction of the euro. SUMMARY The transition to the third stage of EMU reinforced the tendency for increased integration of the European bond markets. Experience from the 1st half-year after the transition can be summarised as follows: Despite the creation of preconditions for the establishment of a single bond market for the euro area, the market is still to some extent segmented according to national borders. No euro-area wide benchmark curve has been established. The issue of government bonds continues to be concentrated on the 2-, 5- and 10-year maturity segments. Yield differentials between government bonds in the individual countries continue to exist, but for some countries have narrowed considerably. The factors underlying the current yield differentials are differences in credit risk and liquidity. Competition among government issuers has intensified. The most important parameter of competition is a good level of liquidity in the

14 50 bonds issued. This is because even in the short term the liquidity can be affected by the government issuers. In contrast, the market's perception of credit risk is more difficult for issuers to influence. It is sought to achieve a good level of liquidity primarily by building up large bond series. This has led to a grouping of the euro-area member states into small and large countries. The trend towards greater integration of the bond market of the euro area is expected to continue in the coming years. Yield differentials among government bonds in the euro area will continue to exist in the future due to variations in credit risk and liquidity. Liquidity will be the most important parameter of competition. Together with the continuing trend towards greater integration of marketplaces and trading systems, this reinforces the grouping into large and small issuers. The small countries must thus be expected to resort to innovative use of instruments and issuing strategies.