With the UK possibly standing on shaky ground when it comes to its Moody’s-imposed AAA sovereign rating, it’s to be expected that some UK gilt holders could be getting jittery.
A reasonable alternative for someone operating within the GBP-denominated repo market with a need to hedge against widening GBP-Libor spreads and/or sovereign risk might then be GBP-denominated paper issued by a AAA-rated supranational like the European Investment Bank.
To wit, we present the successful issuance last week of the EIB’s first ever SONIA (Sterling Overnight Index Average) -linked GBP Benchmark note.
As RBC Capital Markets, who syndicated the deal, noted in a press release on Friday, the £300m issue featured some particularly innovative characteristics – among them the fact it was linked to the Sonia rate — the first ever Supranational sterling-FRN issue to be structured this way:
* Linked GBP Benchmark from EIB
* First SONIA-linked Sterling FRN ever issued by an SSA borrower
* Driven by structural UK demand for repo eligible assets with natural hedge
* Adds a new dimension to investor appetite for repo-eligible borrowers
In the press release, Bertrand de Mazieres, Director General of Finance at the EIB explained it thus:
“This issue was a timely response to new market needs for liquidity and collateral management solutions. EIB is well positioned to such address investor needs, as it can satisfy demand for top quality, repo-eligible, liquid and suitably designed products.”
RBC’s director of bond syndication Andy Sweeney, meanwhile, added the following:
Andy Sweeney, Director, Bond Syndication at RBC Capital Markets said: “This was a deal that could only be done by a select few borrowers. Given EIB’s reputation for having a proactive approach to investor needs, we felt that they were the correct borrower to open this market. The reception from UK investors has been excellent and we feel that EIB has opened up a strategic new funding opportunity both for themselves and for other borrowers. ”
Which, of course, is partly connected to the FSA’s (recently delayed) plan to impose stricter capital-buffer requirements on banks following the credit crisis. These, among other things, would require banks to keep a certain percentage of assets in government bonds.
While that’s good news for UK gilts and other sovereign issues it isn’t exactly an enticing prospect for institutions when sovereign-risk sensitivities are running high.
So, what is a bank operating in the UK repo market, which doesn’t want to sit on potentially decaying sovereign debt, to do?
Ideally, encourage a supranational — the next safest thing — to issue exactly the type of debt it might need to fulfil the requirements instead.
With last week’s EIB Sonia-issue, investors sort of did just that — the issue being highly demanded, according to RBC, precisely because the EIB remains one of the few borrowers the Bank of England will accept for repo collateral, and whose bonds will qualify for capital buffer requirements.
What’s more the issue also helps to provide holders with exposure to UK base rates without the use of derivatives. That’s because, according to RBC, it is a natural hedge for “liability management purposes on bank balance sheets”.
Or as far as we can tell, investors want products linked to Sonia rather than Libor because the rates are likely to react more slowly to the removal of central bank liquidity than interbank rates — where a mountain of refinancing in the next three years could see spreads widen significantly away from UK base rates.
Much of this has to do with Libor being set via indicative bids and offers from participating panel banks, and Sonia being set by the average of loans actually transacted overnight. In other words, Libor reflects the rate banks could borrow at, while Sonia more accurately reflects the rate already borrowed at.
If you consider that some banks might not have access to the interbank market at all during a credit crisis, but still get to contribute quotes to Libor, you see how the potential problem unfolds. In that scenario, Sonia arguably becomes a better indicator of the actual lending rate achieved by institutions still capable of operating in the market.
Here, at least, is how the Sonia curve has performed versus the Libor curve in the past:
And how the two benchmark indices performed over the crisis:
Hence, if you need collateral for repo-ing, but are scared of being left exposed to higher rates on the repurchase side, seeking out more Sonia-linked instruments may make sense– especially since these can also be hedged much more effectively in the money markets than Libor products.
Meanwhile, it’s interesting to note that Barclays Capital has already observed a disconnect appearing between Sonia and Libor rates, despite no change in BoE rate policy:
In the UK, there is little expectation for any change in the policy stance from the BOE at this week’s meeting. UK data has improved, but market sentiment towards the overall economic prospects remains weak. We have seen some indications that money market conditions are tightening from the Sonia market and this could be exacerbated by any upward move in rate expectations that remain low.
Related links:
FSA finalises liquidity bondage - FT Alphaville
Back to bondage – FT Alphaville
The FSA and bondage – FT Alphaville
The great European SSA recovery. Save Spain? – FT Alphaville