As persistent debt and deleveraging challenges impede a more robust global economic recovery, major central banks have had to apply greater doses of unconventional monetary policy (QE) to suppress the level and volatility of interest rates.
These potentially inflationary central bank asset purchases together with multiple sovereign ratings downgrades have led more fixed income investors to search beyond a shrinking universe of AAA assets for high-quality investments offering “safe spread” (incremental yield over U.S. Treasuries but with the potential for minimal additional credit risk).
Issuers in the global Supranational/Sovereign/Agency and Provincial (SSA) market have been major beneficiaries of this crowding-in effect to high-quality fixed income assets. Debt from these issuers periodically offers value for PIMCO clients, and we regularly evaluate U.S.-dollar-denominated securities in this sector versus competing products such as U.S. agencies or comparable debt issued in different currencies.
A developing landscape
Twin financial crises in the U.S. and Europe have challenged borrowers and savers alike – the deleveraging and austerity exercised by those with unsustainable debt has been painful and recessionary, with the outcome for some large sovereign debtors still undetermined.
Meanwhile on the global lender side, in addition to having to upgrade investment playbooks with sovereign credit risk capabilities, fixed income managers have grappled with a shrinking risk-free investment universe.
Debt formerly perceived as “riskless” and having U.S. Treasuries as the cornerstone had included other G-10 sovereigns, agencies, and supranational organizations. Yields and spreads in the sector were then sent into disarray by successive sovereign downgrades, distortive central bank asset purchases with associated seniority uncertainty, regional bailout fund machinations, and Greek debt restructuring.
Dual debt crises rattle AAA/AA universe
A look back at the U.S. experience illustrates the uncertainty and complexity of this changing landscape. Investors began to question the underlying safety of AAA and AA assets across sectors, particularly in debt which had not carried an explicit government guarantee such as agencies. As a result of the 2007–2008 mortgage crisis and failure of Lehman Brothers, the primary government-sponsored enterprises (GSEs) Fannie Mae (FNMA) and Freddie Mac (FHLMC) were forced into conservatorship. These agencies reduced loan portfolios and subsequently pursued smaller debenture issuance. Meanwhile, U.S. Treasury issuance expanded amid political dispute over deficit reduction, eventually leading to S&P’s downgrade of the U.S.’s credit rating to AA+.
More recently, and a continent away, the European debt crisis erupted, sparking a new series of ratings downgrades, rising market volatility and capital flight. Many asset managers who had held passive allocations to fixed income assets for reserve diversification purposes began to direct funds away from peripheral sovereign debt into core fixed income AAA and AA alternatives, with much of these destined for U.S. dollar assets.
Filling the gap: agencies wane, foreign issuers gain
As investor demand for liquid high-quality fixed income assets grew amid this turmoil, the global SSA market expanded, almost tripling in size from 2005 to 2012 (see Figure 1). Much of the growth has come since 2008 as SSAs expanded balance sheets, taking advantage of low interest rates, allowing issuance in the sector to supplement the loss of other formerly high-quality assets.
The SSA market now embodies traits of both government bonds and investment grade credit, occupying a corner of the spread sector typically favored by buy-and-hold-oriented central banks, as well as reserve and sovereign wealth fund (SWF) managers. Yields on SSA debt inhabit the range between core sovereign debt and investment grade credit, and valuation at any given point can be viewed as either government or corporate surrogates (much like agencies).
As shown in Figure 1, the total amount of debt outstanding in the U.S.-dollar-denominated SSA sector has increased to $650 billion as of 1 May 2012, an amount equivalent to 75% of the outstanding market value of U.S. agencies. U.S.-dollar-denominated SSAs (frequently classified as high-quality “Yankees”) account for roughly 35% of global SSA market issuance.
The U.S. dollar SSA market in particular includes names (see Figure 2) that may be familiar to many, such as European agencies (European Investment Bank, KFW), sovereigns and sub-sovereigns (e.g., Canadian provincials), all of which compete with FNMA and FHLMC for end investor capital.
SSA investor considerations
SSA issuers adhere to conservative lending standards (see details in sidebar), and the demand for such high-quality paper makes these investments generally trade at lower yields than competing spread product but still above sovereign debt from the respective country. Once SSA investors become comfortable with the underlying credit quality of any given sovereign issuer, they typically view familiar names as yield enhancers to lower-yielding core sovereign debt.
SSA investors often are indifferent to duration and liability-matching sensitivities and manage without fixed income benchmarks. On the other side of the equation, typically upward-sloping yield and spread curves make shorter-dated borrowing by SSA issuers less expensive. These mutually congruent dynamics skew the average life of the sector toward shorter maturities, generally to a maximum of 10 years, fostering a symbiotic relationship.
Another important characteristic of sovereign USD issuance and agency debt is the ability of investors with captive currency allocations (e.g., restricted to USD) to access country credit risk in U.S. dollar-denominated instruments (e.g., a Scandinavian country issuing in dollars). This is especially important for investors looking for an alternative to credit default swaps (CDS), which may be an eligible means of expressing a positive credit view.
Returns and spreads
From an annual return standpoint, SSA securities’ duration-adjusted returns (shown in Figure 3a as Government-related) have ranged between those of Treasuries and corporate bonds in all years since 2008. Over the last four years, in periods where corporates outperformed Treasuries, SSAs have also outperformed Treasuries, but by a smaller margin. Conversely, when Treasuries have outperformed corporates, SSAs also posted higher returns than their corporate counterparts.
However, Figure 3b shows that while the annualized return of the government-related sector over the last seven years has been lower than the Aggregate Index and comparable to Treasury returns, the volatility of the sector has been less than both.
Additionally, Figure 4 shows five-year constant maturity spreads versus U.S. Treasuries, showing ranges of various issuer spreads versus U.S. Treasuries and how SSA spreads infrequently trade below those of Treasuries. In past periods, concerns about U.S. credit quality and the overall strength of the European economy and debt ratios (e.g., EU guarantee for EIB is joint and several), along with issuer scarcity, allowed yields on EIB debt to fall below yields on U.S. Treasuries.
From a value perspective, it also is evident in Figure 4 that SSA issuer spreads generally tend to trade in tandem, especially during flight-to-quality periods like 2008-2009. One notable exception is the trajectory of spreads for Italy in U.S. dollars, which widened to almost 700 basis points in late 2011 and have yet to recouple with other SSA issuer spreads since the advent of the European debt crisis.
The SSA market is an important sector with a dedicated investor base, and (in U.S. dollars specifically) can offer high-quality investment alternatives with yield pickup to U.S. Treasuries and agencies. SSA spreads periodically offer value for PIMCO clients, and we frequently evaluate U.S.-dollar-denominated securities in this sector against competing products such as agency debentures and debt issued in different currencies.
Will changes in the ownership of U.S. GSEs and reduced issuance generate more demand for the SSA and covered bond market?
As the reduced rate of agency issuance exceeds the incremental rate of decline in U.S. dollar reserves, we believe allocations will continually find their way back into high-quality SSA debt. We expect that the gradual pace of reserve reallocation ensures that the SSA market will retain broad investor interest, especially among reserve managers and central banks with fixed U.S. dollar allocations.
What will the effect of QE3 be on the SSA market? Local creditworthiness considerations aside, we believe the SSA market should benefit much like other issuers of spread product have as investors follow “portfolio channeling” patterns and shift exposures into higher-yielding assets out of Treasuries (“portfolio channeling” is a term used by some Fed officials for an ancillary effect of QE, enticing investors to move out the credit spectrum). Also, as central banks provide reflationary impetus in the form of low base rates, cheap financing, and direct asset purchase and credit easing, a continuous recycling of G-10 currency purchases by reserve managers may sustain demand for SSA product. Given that the Fed has announced it will purchase $40 billion of mortgage-backed securities per month in QE3, other comparable asset classes also may benefit at the expense of Treasuries. Less supply and differentiation among GSE debentures should add a scarcity premium for SSA debt.
We believe that SSA spreads and returns are likely to follow patterns similar to those observed in the past but are not expected to trade at yields lower than those of U.S. Treasuries – mainly due to liquidity, issuer size and idiosyncratic issuer differentiation related to credit concerns.
When the SSA market offers value for our clients, PIMCO will utilize this market as another tool to complement investor portfolios.
Understanding SSA Issuers
SSAs issue debt on a regular basis to fund regional projects and development programs, but must adhere to relatively conservative capital requirements, balance sheet constraints and lending standards written into their charters. These guidelines limit the type and amount of direct lending possible, with recourse on many public sector borrowers (many of whom have taxing power) to mitigate ultimate exposure.
These borrowers attempt to maintain benchmark issues denominated in the major reserve currencies to maintain the necessary liquidity to retain end investor interest. A similar symbiotic relationship to that of official investors and the U.S. Treasury is in play in the SSA market, as foreign issuers benefit from the ability to borrow cheaply in USD, while global investors continually need to recycle dollar funds. This dynamic perpetuates current reserve allocations among central banks/SWF.