Germany’s technically uncovered 10-year bund auction has stirred much debate.
To us, the mystery is the inconsistency. How do you reconcile low auction demand, with supposedly high demand for haven assets like bunds and the low or “special” repo rates in the German bond collateral market.
And why, given the market is supposedly so ‘special’, is there little or no demand for stocklending operations from Germany’s Finanzagentur?
Is it, as we considered, because the Bundesbank was specifically targeting that rate through its own (separate) operations, meaning the rate reflected the short covering stress in the market rather than real long-only demand?
Or is it because the use of German bond collateral, somewhat counterintuitively, is going down. Bunds are becoming so scarce due to the flight to quality, that everyone is desperately looking for other types of collateral? People want to hold bunds, but only outright. It’s the virtue of the asset therefore which is leading to market dysfunctions, making it more tricky for dealers to operate in the market more generally?
The ‘specialness’ may be asymmetric.
How does that reconcile with a technically uncovered auction? Well, the fact that the Finanzagentur retains a certain portion is quite normal. It’s just that the sum it retained on Wednesday was larger than usual. This is in no way to be confused with debt monetisation, however.
Pimco’s Lorenzo Pagani explains this well here on the Economist’s Free Exchange blog:
The Finanzagentur issued only 3.9bln cash. They gave 3.9bln bunds to the market and kept 2.1bln bonds on their books. In the future they can sell this retention amount into the secondary market, raising cash. You may have read that the Bundesbank bought the unfilled part of the auction; this is not correct. The Bundesbank is not financing Germany; it just operates as an agency for Finanzagentur. It is worth repeating that Finanzagentur always retains part of the bonds, so this part of the process is normal. Today the retention was larger than usual. This is probably due to low liquidity across market, lower incentive to place certain minimum size bids by dealers, and richness of bunds in general.
We think that’s exactly it. Dealers are finding it tougher than usual to operate in the market because of the drop in liquidity — the result of a drop in the use of German bunds as collateral, a contracted lending pool and the wider market’s general preference to sit on bonds outright.
Since dealers can’t operate as fluidly they are presumably less willing to commit to large auction exposures. As Pagani also explains:
Also, the requirement to be a dealer in Germany means making sure of a minimum allocation across auctions that is relatively low (0.05%), while in other countries this requirement is higher (3% for example in Italy). Germany doesn’t grant greenshoe options to its dealers. Other countries do. A Greenshoe option gives the dealer the right to buy the bonds for a few day after the auction at the same price of the auction. Overall this means that demand for German auctions will tend to be lower—all else equal—than for other countries’ auctions. Since 2008, Germany has seen uncovered auctions 1 out of 5 times. Today’s retention amount was large, 39% of the 6bln target.
Thus, it may be market mechanics (reflected by a tougher environment for bond dealers) which are leading to the low auction turnout, rather than any real drop in demand for bunds.
Interestingly, there is one European Treasury which may have figured out the importance of such mechanics and the dangers of over-relying on conventional dealer processes. The UK’s Debt Management Office has been using syndicated offerings as a supplemental auction process for a while now, and is likely to continue to use them going forward, particularly for longer-dated bonds that are more difficult to sell.
One of the key features of syndication is the ability to sell directly to end investors (via the competitive book of demand built by the lead mangers).
According to the DMO:
Syndications involve the appointment of a syndicate of banks whose salesmen market bonds directly to investors. The DMO re-introduced syndications in June 2009 and has held 17 offers to-date. It has plans to raise £32.1 billion via syndications in 2011-12 and has raised £24.7 billion to date.
Could the larger retention by the Finanzagentur be more reflective of this sort of trend rather than anything else?
* We previously stated the DMO was using private placements, when we meant syndicated offerings.
Related links:
The bund that broke the Bundesbank – FT Alphaville
A loser’s nightmare in Europe’s debt auctions? – FT Alphaville
Bunds get Junckered, and other repo dysfunctions - FT Alphaville