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DEBT REPORT: EUROPEAN LONG BONDS 58 But continued demand from the European pension fund community and its appointed managers is crucial to the success of any future ultra long issuance. Analysis of AFT’s 50 year February deal shows that pension and asset managers made up more than 50% of the €19.5bn order book, while hedge fund investors, insurance buyers and banks made up just 18%, 14% and 13% of total demand respectively. Philip Read, director of the €2.05bn pension scheme for Metal Box, the UK manufacturer, says: “It is very positive that any government wants to issue very long dated indexlinked bonds but there needs to be a lot more of it. There is no magic in a 50 year note, however. We have liabilities that go out 80 years and so having a 50 year note helps with that but it is not the be all and end all. What we need is a range of index-linked deals that stretch out as far as is necessary.” The pension fund community in the Netherlands endorses this. Forthcoming changes to Dutch pension solvency requirements, entitled FTK, that are scheduled to come into effect at the beginning of next year, will force pension fund investors to mark their liabilities to market ahead of fixed rate usage. This shift to fair value accounting will sharply increase the volatility of their liabilities and it is widely expected that investors will beef up their exposure to very long-dated paper and become forced sellers of equities and shorter-dated deals in order to reduce volatility. “The 30 year state-swap spread, which is already at historically tights, could narrow even further as a result of the new supervisory framework for pension funds and insurers that will be introduced in 2006,” says Bert Heemskerk, chairman of the executive board at Rabobank Nederland.“The rationale being that we expect the FTK to lead to a massive interest in receiving fixed ultra long swap Arnaud Mares, Head of Portfolio Strategy, at the UK’s Debt Management Office rates, which will push in spreads versus ultra long bonds.” Indeed, Harvinder Sian, an analyst at ABN Amro, believes that more than €120bn worth of Dutch pension and insurance assets will flow into long-bonds as a result of the new requirements and investors’ need to match liabilities. “Dutch pension funds should be big buyers of duration this year on regulatory factors,”he says.“Pension funds will want to hedge the risk in their long-term liabilities to avoid the most onerous regulation elements and we expect around €bn120-€150bn in [long-dated] buying.” But even though investors in the Netherlands are expected to be large consumers of very long-dated debt – and interestingly, demand from the Benelux region made up seven per cent of AFT’s €19.5bn order book – the Dutch government is unlikely to issue a 50 year bond any time soon. The borrower did, however, issue its first 30 year bond in seven years at the end of April after instructing ABN Amro, Fortis and CSFB to investigate the potential market demand for the note. The Dutch State Treasury Agency had intended to issue a 10 year deal but found enough interest to price a €5.2bn 2037 deal that paid four basis points over German bunds and was 40% sold to pension and asset managers. Erik Wilders, head of the Dutch State Treasury Agency, says: “There is obviously demand in the market for very long-dated bonds and the research from ABN Amro, Fortis and CSFB found that there was indeed room for us to come to the market with a 30 year deal. But issuing a 50 year bond is simply not an option for us right now,” he adds. “You need a huge amount of outstanding debt to successfully launch such a deal and, at the moment, we do not have that. Our goal is to issue debt as cheaply as possible at a given level of risk.” But it is precisely this attitude that makes many buyers worry that 50 year bonds are a much better bet for issuers than investors.“While moves to increase the availability of very long-dated assets are to be welcomed, we expect these deals to be a sideshow for most investors,”says Jeremy Toner, fixed income portfolio manager at Investec Asset Management. “Although governments are showing an astute understanding of timing by issuing very long-dated instruments when inflation and interest rates are particularly low, investors face the risk of capital losses unless the bonds are priced with the potential for higher future inflation. Previous experience with very long dated bonds has been unhappy for investors. For example, the undated UK war bonds issued prior to WW1 and reissued at 3.5% in 1932 (another period of very low inflation and interest rates) have experienced significant capital losses to date.” Denis Gould, head of UK fixed income at AXA Investment Managers, agrees: “There is clearly demand for ultra long maturities, especially from liability driven investors but we think the current craze for 50 years may wane. In government bonds, 50 year issues have the benefit of higher convexity, which is worth something, but investors receive next to no extra yield for moving out to a rather isolated point on the curve where liquidity could be JULY/AUGUST 2005 • FTSE GLOBAL MARKETS
poor. Worse, if many other countries follow France’s lead, demand could quite quickly become exhausted.” Jon Little, chief executive officer at Mellon Global Investments is equally as critical. “There was definitely a herd mentality going on with the French deal and I would not be surprised if after few years some of those investors that bought into the bond begin to wonder what they got themselves into. The pricing left a lot to be desired.” But this does not worry Benoit Coeuré, deputy chief executive officer at AFT. The borrower’s February deal attracted demand from at least 10 different countries including Italy, Germany, the UK, Japan, the US, Sweden and France, while its eventual size beat expectations by around 100 per cent. Indeed, the issuer plans to increase the size of that deal to somewhere between €10bn and €15bn and then has ambitions to launch an inflationlinked 50 year note once this has been achieved. “We were definitely surprised by the amount of investor demand there was for our deal,”says Coeuré.“We expected and were committed to issuing a deal of somewhere between €3bn and €4bn but eventually brought a deal to market that was twice as big as we thought. What we learnt is that demand is very deep and that there is more than enough room for other issuers to come to the market. In fact the more that come the better and that does not just mean sovereigns. We would also like to see more non-sovereign issuers, such as utilities, bringing 50 year deals as this will add more depth and liquidity to the sector.” Arnaud Mares, head of portfolio strategy at the UK’s DMO, also rubbishes Gould’s suggestion that the appearance of too many government 50 year bonds will dilute and ultimately extinguish investor demand. He believes that there is more than enough space for other ultra long issues and is unconcerned by the fact that there has been a spate of 50 year deals in a relatively short space of time. “It was never an issue for us what the other governments were doing and whether or not we were the first into the market,”says Mares.“It is not a race. We know that there is significant demand out there from the pension fund community but demand is not restricted just to pension funds. ultra long bonds have a high convexity and this makes them appealing to other sections of the market, such as hedge funds and the trading desks of banks.” But whether or not the demand for 50 year deals dries up over the next couple of years, right now investor interest in such bonds remains strong. Continued moves from the various European regulators to increase protection for pensioners and reduce their exposure to market risk is increasing the need for fixed income products – particularly long-dated instruments as countries move to fair-value liability accounting. At the same time, national treasury agencies throughout Europe have been eyeing the opportunity to issue very long-term debt at a time when both interest rates and inflation are at relative lows. This demand and supply match-up looks set to mark the arrival of many more ultra long bonds over the next 12 months, despite investors’fear FTSE GLOBAL MARKETS • JULY/AUGUST 2005 Benoit Coeuré, deputy chief executive officer at AFT of rising interest and inflation rates. “Nominal 50 year deals are not as attractive as inflation-linked bonds but you can be sure that investors will jump into any deal if other investors are doing so,” says Read at Metal Box.“People do not like to be left on the sidelines and European sovereigns will not have a problem finding demand.” “Interest in these deals will not wane,”adds Emeric Challier, global CIO for European fixed income at Fortis Investments “If governments become too active in issuing 50 year bonds we may see a fall in demand but this will only happen over the longer-term. Right now we are just at the beginning.” Emeric Challier, global CIO for European fixed income at Fortis Investments 59
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