Posted by on May 16, 2017 4:22 pm
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Categories: Belgium Bond Business Economy Euro European Central Bank European debt crisis European Financial Stability Facility European Union Eurozone Finance Fixed income analysis france French government germany Investor Sentiment italy money Primary Market Reuters Stress Test Yield Yield Curve

In its first bond sale since the presidential election and the first big test of investor sentiment after Emmanuel Macron won the presidency, France received more than €31 billion in demand for a 30-year bond offering, once again demonstarting the unprecedented demand for duration on the yield-starved continent where the ECB is happily gobbling up every interest-yielding instrument. With some €7 billion in ultra-long duration paper sold via a syndicate of banks, pricing at 30Y FRTR +12, tighter than the +14 price talk, the issue was more than 4 times oversubscribed.

Investor appetite for the bond, which some said helped by a cheapening of French debt in past weeks, also sparked an outperformance of 30-year French bond yields, which fell 3 basis points in late trade. When France opened books on the deal around 0830 GMT on Tuesday, interest was already in excess of €18 billion even before it started taking orders, according to Retuers IFR.  It nearly doubled over the course of the day.

“The 30-year area has been relatively cheap so it is no surprise to see strong demand for this bond today,” said Patrick Jacq, rate strategist at BNP.

It goes without saying that a main driver for the investor interest is that while the bond matures in May 2048, three years later than the current 30-year benchmark, it is still eligible for ECB purchases in June,

Primary market demand for the long-end has persisted because while French government bonds rallied sharply since Macron emerged as the likely winner, longer-dated bonds had lagged the move; France’s 10s/30s yield spread growing to 108 bps, the widest since Dec 2014.

The sale could also indicate whether Japanese investors, key lenders to France, are returning. “Japanese investors have been large buyers of French securities and given that the political risk has reduced, we should see a gradual return to this market,” said Antoine Bouvet, rates strategist at Mizuho. Tuesday’s sale will also demonstrate investor appetite for duration, particularly with other long-dated bond sales expected from Germany, euro zone bailout fund EFSF and possibly Belgium.

In some ways the scramble to buy today’s issue was surprising: investors will have plenty of chances to purchase long-dated paper in the coming weeks. Germany is scheduled to sell 30-year bonds on Wednesday while Belgium has cancelled a bond auction for next week. Analysts said that may be because the Belgian debt agency is planning a 15- or 20-year bond sale this week. The EFSF is also expected to sell long-dated bonds this week, while Slovenia was selling bonds maturing in 2027 and 2040 on Tuesday.

Meanwhile, the relentless demand for yield coupled with signs of strength in the euro zone economy and renewed confidence in the European project boosted sentiment towards lower-rated peripheral bonds. According to Reuters, Portugal’s 10-year bond yield tumbled 9 bps to 3.29 percent , pushing the gap over German peers to its tightest in nine months at around 288 bps. Italian bond yields fell 6 bps 2.21 percent, while the Italian/German 10-year yield gap dropped below 180 basis points for the first time in a week. 

And while it is clear that for now there is no shortage of demand, an appropriate question is what will happen if and when the ECB tightens, and rates go higher.

Yet in the context of today’s blistering demand, just yesterday Ignazio Angeloni, a member of the ECB Supervisory board, warned that the ECB stress test this year will focus on interest-rate risk in Europe’s banking books.  In a speech in Milan, Angeloni said that “looking forward, the normalization of the interest-rate structure should provide relief” to banks’ earnings. “However, the transition and the ultimate effect is unlikely to be uniform across the bank population, depending on the composition of assets and liabilities, their maturity characteristics and technical forms.

Improvement in the euro-area economy is “good news” for banks, he says. “Banks’ balance sheets should benefit from a variety of channels, including the improvement in the condition of borrowers, a pick-up in credit demand, and a normalization of term premia in financial markets. Interest- rate risks ‘‘may add some extra uncertainty, but are expected to remain contained.”

What he was talking about is duration risk, and the potential for modest or outright massive losses should yields spike. The best visualization of that can be seen in the following chart from Goldman, which notes that the estimate loss of principal should European rates normalize, would range from 12% for Italy to as much as 18% for Germany, whose rates been record low in recent years.

As Goldman puts is simply, “Normalization of rates poses a problem.” Judging by the results of Today’s French auction, that particular problem is not one investors are worried about just yet.

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