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European bond flood to test investor appetite
Published: October 28 2008 19:10 | Last updated: October 28 2008 19:10
The European bond markets are about to get a little crowded. With governments and banks expected to swamp the markets with more than €2,600bn ($3,255bn) in new debt next year, competition among issuers to attract investors will never be greater.

This wall of issuance, estimated to comprise up to €1,000bn in government debt and up to €1,600bn in government-backed bank paper, comes just as the markets are deteriorating, making it harder to raise money.

‘This wall of supply will be hitting the market when demand is impaired’

In short, investors’ appetites will be tested to the limit in a buyers’ market that could could force issuers to offer higher coupon rates to get deals away and even shut some out of the market altogether.

Corporate issuers have perhaps most reason to be concerned, as they are already struggling to raise debt in the current environment. October is set to be the poorest month for these issuers in nearly two years, according to Dealogic.

Laurence Mutkin, head of European interest rates strategy at Morgan Stanley, says: “This wall of supply will be hitting the market when demand is impaired by deleveraging, balance sheet constraints and a shrinking dealer community.” Investment banks Bear Stearns and Lehman Brothers have collapsed, while Merrill Lynch is being taken over by Bank of America.

“Will the market be able to absorb this wall of paper? Will government bond yields fall together with policy rates or will they fail to go down?” Mr Mutkin asks.

European government bond issuance
Forecast, 2009 (€bn)
Recapitalisation plan Total maximum gross issuance
Germany 80 238
France 40 175
Italy 20 220
Spain 30 80
Holland 37 69.5
Belgium 1 24
Austria 15 32
Finland 0 6
Ireland 0 15
Greece 13 53
Portugal 0 12
Total 236 925
Source: Barclays Capital; Thomson Reuters; Dealogic
Analysts agree that the safest and strongest credits are likely to benefit as potential supply among eurozone governments could reach €925bn and rise above €1,000bn if the UK is included, according to Barclays Capital. The combined sum is a record that will probably surpass this year’s supply by about 30 per cent.
Germany, the classic beneficiary of a flight to quality in tough market conditions, is likely to be one of the winners, in spite of its large funding needs. It is expected to issue up to €240bn next year, more than any other European economy. This includes a possible €80bn for bank recapitalisations.

Its bonds are one of the safest and most liquid securities an investor can buy, a priceless quality at a time when many other markets have seized up.

In recent days, German bunds have sharply outperformed other government paper. For example, yield spreads between German bunds and those of the so-called peripheral nations of Italy and Greece have jumped to record wides.

Italian bond yields have risen to 96bp over Germany – a record since the launch of the euro in 1999 – from 69bp a week ago, while Greek bond yields have increased to 119bp – a record since 2001 when the country joined the single currency – from 86bp a week ago.

Italy, in particular, may be tested as it has big funding needs, with up to €220bn in new debt expected next year, second only to Germany. It also has the largest debt to gross domestic product ratio of 104 per cent in western Europe.

Huw Worthington, European strategist at Barclays Capital, says: “We are not at a crisis stage at the moment. But some countries such as Italy may run into problems next year as they need to refinance maturing bonds.”

Although analysts are not suggesting funding will dry up for these countries, they may be forced to pay higher coupon rates as investors – the large pension funds and insurance companies that often buy government paper – increasingly dictate the terms of deals.

Indeed, signs of trouble are already emerging. This week Austria became the third western European government to cancel a bond offering in the past month, following Spain and Belgium. All three countries cancelled deals because investors wanted higher premiums. Supply is expected to be particularly heavy in the first quarter of next year, which will only add to the problems for issuers.

Mr Mutkin says: “We should expect €210bn of government paper in the first three months of next year. That would be more than €16bn a week.”

‘The market is ugly. If it remains that way, the large supply could be a problem for some issuers’

However, like many analysts, he expects government bond yields will fall rather than rise as recession fears and falling interest rates offset the weight of supply. The US Federal Reserve is expected to cut rates aggressively on Wednesday, while the European Central Bank and the Bank of England are likely to loosen monetary policy next week.

Government bond yields, although much higher than the lows at the start of 2007, are also much lower than they were a few months ago. Italian 10-year bonds currently yield about 4.72 per cent, about 30bps lower than in July.

Riccardo Barbieri, a strategist at Bank of America, says: “We have to remember that yields for government bonds are now relatively low. Monetary loosening, recessionary fears and volatility in equities are all positive for government bonds.”

If the jury is still out on the impact of supply on government yields, the repercussions are already being felt by other issuers.

The European Investment Bank, the triple A-rated funding arm of the European Union, has seen yields rise dramatically on its latest issue. Yields on its $4bn three-year bond have jumped 60bp since it was launched three weeks ago amid expectations of increasing competition for top-rated paper.

Investment grade corporate issuance has also dropped sharply this month to $141bn, a 50 per cent drop compared with September, according to Dealogic, although GDF Suez, the French utility, bucked the trend with a successful deal.

Jean-Marc Mercier, of HSBC, says: “The market is ugly. If it remains that way, the large supply could be a problem for some issuers. But it’s not a disaster yet. The market is still open for many good-quality names.”