Bonds move into the mainstream as crisis deepens

Greek drama formed the template for a horrendous year for Irish sovereign debt, writes SUZANNE LYNCH

THIS WAS the year when bonds, bond yields and spreads were no longer things that kept investment fund managers awake at night but instead became matters that could make or break countries.

Coverage of the bond markets moved into the mainstream media this year, as the euro zone debt crisis became one of the biggest news stories of 2010, culminating in two bailouts by the EU and the International Monetary Fund (IMF), first in Greece and, seven months later, in Ireland.

Concerns about the financial health of Greece’s economy, which centred on the country’s budget deficit, were evident from the beginning of the year and were manifested in rising bond yields and widening spreads between Germany and Greece. In January, the European Commission condemned Greece for falsifying data about its public finances. Later that month, Greece unveiled an ambitious three-year stability programme which pledged to cut its budget deficit from 12.7 per cent in 2009 to 2.8 per cent of GDP in 2012.

In an admonitory warning of what was to happen a few months later in Ireland, reassurances from the EU and the IMF failed to stem market scepticism.

On April 23rd, Greece formally requested a bailout following a climactic sell-off in Greek debt markets the previous day, during which two-year bond yields reached 11 per cent.

A few days later, the Greek debt rating was decreased to the first levels of junk status by Standard Poor’s amid fears of default by the Greek government. Yields on Greek government two-year bonds rose to 15.3 per cent following the downgrading, although only a handful of bonds were changing hands at that stage.

In early May, a €110 billion package was agreed for Greece by the EU and IMF. Following the Greek bailout, the European Financial Stability Facility (EFSF) was put in place, though Europe resisted calls to implement a major bond-buying programme along the lines of the quantitative easing programme adopted by the US.

While the bailout removed the need for Greece to borrow for more than two years, yields remain high, again presaging developments in Ireland a few months later.

Ironically, in light of what happened towards the end of the year, the Irish sovereign debt market got off to a relatively good start in 2010. The second half of 2009 had been reasonably good for Ireland’s sovereign debt: Ireland’s funding costs had hit a peak in March 2009 but fell back in the latter half of the year.

AS IN 2009, the Government moved early to take advantage of January decisions by fund managers and went into the bond markets during the first half of the month. A series of monthly bond auctions followed, which by September had allowed the State to raise €20 billion to fund itself.

Although yields were higher, demand for Irish Government debt was fairly strong in the first half of the year, assuaging concerns about contagion from the Greek emergency.

In March, Ireland sold €1.5 billion in bonds at a yield of 4.426 per cent, representing the smallest premium over the equivalent in safer German government bonds since December 2008 and 1.58 per cent below the peak spread in March 2009.

Despite the bullish rhetoric from the National Treasury management Agency (NTMA) and the Minister for Finance, Irish sovereign debt, along with the debt of the other so-called Pigs nations – Portugal, Greece and Spain – was feeling the pressure, with the spread on 10-year Irish bonds remaining more than 3 per cent above the benchmark German in early summer.

Things took a turn for the worse as the summer drew to a close. While investor concern had initially focused on Portugal, by September the extra yield investors demanded to hold Irish bonds had surged to record highs because of worries about the State’s ability to manage the cost of its bank bailout, fuelled in large part by uncertainty about the final cost of the Anglo bailout.

On September 24th, Irish borrowing costs hit a new high of 6.546 per cent, while the spread between 10-year Irish bonds and German bunds rose to a euro lifetime high of 451 basis points. Brian Lenihan said there was a “concerted attack” on euro zone nations.

The European Central Bank was reported to being buying Irish Government debt on the secondary markets in a bid to halt the slide in its price.

IN SEPTEMBER, THE NTMA announced it would cancel its remaining bond auctions for the rest of the year. Although the agency pointed out, correctly, that the country was fully funded to the middle of 2011, the decision not to go to the market was a measure of the severity of the debt crisis.

What happened next has been well-documented. Irish bond yields continued to rise inexorably throughout October and November as the markets lost confidence in Ireland’s ability to meet its debts. London clearing-house LCH Clearnet increased the margin it required on Ireland’s bonds and a sense of panic took hold among investors.

Despite repeated assurances from the Government that Ireland was in control of its finances, yields on 10-year Government bonds surpassed the psychologically-important barrier of 9 per cent.

After weeks of denial by the Irish authorities, on November 18th EU and IMF negotiators arrived in Dublin for talks about a rescue plan for Ireland, which resulted in a €85 billion rescue package. It was announced that under the terms of the bailout, Ireland would be out of the market for three years and would instead draw on the fund as required, subject to a blended interest rate of 5.8 per cent.

Since then, as happened with Greece, Irish bond yields failed to fall significantly. At time of writing, yields on 10-year Irish Government debt was 8.87 per cent.

Meanwhile, investor concern has switched to the sovereign debts of Spain and Portugal, amid widespread fears of a contagion effect, while a proposal, floated after the Irish bailout, to introduce new so- called euro bonds appears to have lost ground.

Despite a horrendous year for Irish sovereign debt issuance, the picture on secondary markets was a lot brighter. Fixed income investments delivered strong performances for investors, while there was heavy turnover in Government bonds, particularly in the first three-quarters of the year.

Data from the Irish Stock Exchange show that turnover in Irish Government bonds and treasury bills was up more than 75 per cent in the first nine months of the year, €197 billion, compared with €112 billion in the same period last year. However, the market came under pressure in the last couple of months.

“There was a very strong performance in the first three quarters of the year, though this was given back to some extent in the final quarter,” said Oliver Mangan, chief bond economist at AIB.

Barry Nangle, head of bonds at Davy stockbrokers, said the slowdown in the final quarter was due in part to the fact that new investors were slow in coming to the market, while the widening bid-offer spread meant people were less inclined to deal.

Irish bank debt also had a tumultuous year, as the debate about burden-sharing by the holders of Irish bank debt intensified, particularly towards the end of the year.

Fergal O’Leary of Glas Securities notes that the market was active, with volumes in bank debt seeing broadly similar increases in turnover as Irish Government bonds, which increased in volume by approximately 38 per cent on last year.

Irish Banks issued a total of €21.4 billion of Irish Government-guaranteed debt over the course of the year, largely issued in the first five months of the year,” O’Leary adds. “This issuance was in the most part due to the €30 billion of bond maturities in September, which arose as a direct result of bonds previously issued under the September 2008 guarantee.”

Nangle also notes that trade in subordinated bank debt was particularly active in the final quarter of the year.

“As the price dropped and the status was downgraded, some of the big pension funds and insurance companies became forced sellers, with the result that new buyers, such as hedge funds and high-yield fund managers, came into the market.”

IN TERMS OF returns for investors, Irish Government bonds had a poor year. The Iseq bond indices, which measure the return on Irish Government securities, showed a negative return during quarter three, with returns in the range of -2.39 per cent to -7.13 per cent, following returns in the range of -1.8 per cent to -4.8 per cent in the first half of 2010.

According to O’Leary, 10-year Irish Government bonds had a -19 per cent total return to December 20th, versus 7 per cent in the equivalent maturity in Germany, while Greek 10- year bonds posted a -27.7 per cent return for the same period. However, he points out that in contrast, shorter-dated Irish Government bonds posted a positive return for the year.

Despite the poor return from Irish Government bonds, the broader picture for Irish pension funds and investors was positive, due to the fact that only a small amount (less than 5 per cent on average) of most pension funds held Irish sovereign debt.

According to the data management provider MoneyMate, Irish gross domestic funds invested in fixed-interest products, including Government and corporate bonds and debt-related securities, returned 2.4 per cent during the year.

One of the more interesting developments to watch in 2011 will be a new sovereign annuities scheme, which was announced on December 17th, which will allow Irish investors to increase their holding of Irish Government debt.

After that, the question of what will happen to interest rates – which is closely involved with the performance of the bond market – will be the other main issue to consider next year, with some commentators predicting that interest rates may not increase until 2012.