Jens Thomsen: Government bond markets in 2009
Speech by Mr Jens Thomsen, Member of the Board of Governors of the National Bank of
Denmark and Chairman of the Economic and Financial Committee, Sub-Committee on EU
Government Bonds and Bills Markets,1 at the European Government Bond Summit,
Brussels, 5 November 2009.
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1. Introduction
I am delighted to be here tonight to offer my view on the development in the financial
markets. A little more than a year ago the financial markets were frozen and there was a
well-founded concern regarding the financial and economic outlook. 2009 has indeed proven
to be challenging in many ways.
In the period after Lehman Brothers collapse the international financial crisis escalated. As a
consequence the spread between uncollateralised and collateralised money-market interest
rates tripled, cf. Chart 1. Most countries launched extensive rescue packages to mitigate the
crisis. The interventions stopped the free fall of the financial system.
Against the backdrop of weaker economic outlook governments introduced fiscal stimulus
and monetary policies have been relaxed substantially. Central banks have reduced the
policy interest rate sharply and provided extensive liquidity to banks and resorted to
unconventional tools to ease monetary policy, which has supported financial stability.
2. Government finances
The global economic prospects were gloomy at the beginning of the year and the financial
crisis has had greater real economic repercussions than expected, which triggered the
adoption of large stimulus packages worldwide. As a result of lower government revenue and
rapidly rising expenses, public finances have deteriorated. In the course of 2009 most
countries have revised their forecast of government deficits to record highs and government
finances are expected to be under extensive pressure in the coming years. Government debt
issuance in the euro zone is expected to be around 925 billion euro in 2009, which is an
increase of around 30 per cent. In 2010, issuance is expected to be even higher.
At the same time the role of DMOs has changed as a result of the financial crisis. The special
status of government securities as risk-free assets has been highlighted, and DMOs played a
key role in connection with the financing of rescue packages.
3. Government bond markets
Primary markets
The primary markets have worked reasonably well in light of the severity of the financial and
economic crisis. The uncertainty in the financial markets, coupled with risk aversion among
investors, led to rising demand for risk-free assets, including government bonds. Even so,
the greater supply of government bonds has in periods caused investors to be more selective
and some DMOs have found it difficult to obtain sufficient demand at auctions and when
issuing syndicated loans. Especially in the latter part of 2008 and the beginning of 2009,
DMOs paid a concession premium in order to attract investors.
In addition, yield spreads to Germany widened considerably in a number of European
countries, cf. Chart 2. This reflected a flight-to-quality, as the German bond market is
considered to be the most liquid in Europe. In addition, investors attributed higher credit risk
premiums due to increasing concerns about fiscal sustainability in view of the rapidly growing
budget. Since mid-2009 the primary markets have improved. DMOs no longer pay
concession premiums and yield spreads between European countries have narrowed. The
market has been able to absorb the considerable higher volume of government debt
issuance better than expected.
Issuance strategies
The challenging issuance climate and uncertainty about future borrowing requirements have
prompted several DMOs to pursue more flexible issuance strategies. This has included
issuance in government securities outside key on-the-run issues, and use of various loan
programmes, including CP and EMTN programmes. DMOs have also introduced new
issuance techniques to secure successful auctions. At the same time, DMOs have an
increased focus on investor relations in order to avoid that investors disregard an issuer on
the basis of incomplete information.
The improvement of the financial markets and lower uncertainty concerning issuance needs
has meant that DMOs to a larger degree are returning to a more predictable issuance
strategy.
Roll-over risk and competition from government guaranteed bonds
In the beginning of the year government deficits and financial rescue packages were
primarily funded by issuing short-term papers such as T-bills and commercial papers. This
raised concern about roll-over risk, especially in the light of expected high government
deficits in the years to come. The concern of roll-over risk eased during the year as the
gradual improvement of the government bond market enabled DMOs to lengthen the
maturity profile of their issuance.
So far debt managers have by and large covered the required record issuance need for 2009
at reasonable costs. The concern in the beginning of the year regarding possible competition
from government guaranteed bonds has proven to be less of an issue than expected. This
can primarily be attributed to the fact that the high liquidity of government securities has a
value for investors. Less liquid issuances of local governments or state agencies have to a
higher degree suffered from private sector issuers with a government guarantee.
In 2010, the government bond market may see increasing competition from other sectors,
including covered bonds and corporate bonds, if the financial market continues to improve
and investors gain risk appetite. This would be a positive sign of health in the financial
system but also raise a concern about the government bond market in view of the record
issuance requirements.
Secondary markets
The secondary market has been more permanently hit by the crisis than primary markets.
After the shock in September 2008, liquidity in the secondary market dried up, resulting in a
significant widening of bid-ask spreads and a dramatic reduction of volumes, cf. Chart 3. The
situation has improved in 2009 with a narrowing of bid-ask spreads, but the secondary
markets have still not normalised. It is important to restore transparency and confidence in
the government bond market. Some countries are successfully bringing more competition in
the secondary market by implementing market making obligations based on relative
performance among primary dealers instead of fixed maximum spreads and minimum
volumes.
Future challenges
Over the summer, the financial markets have been characterised by stronger confidence in
real economic developments, and the extensive political measures have contributed to
increasing the risk appetite of investors. Spreads in the money market have come down from
a high of several hundred basis points to a level below pre-Lehman. Similarly, the spreads
between European issuers have narrowed considerably. These factors indicate a significant
improvement in financial conditions since the historical low in October 2008. The panic mood
has ceased, but the enhanced market stability is to a high degree the result of continued
public support measures. Market conditions have still not normalised and the estimated
government issuance need for 2010 is record high in many countries due to high
redemptions and large budget deficits, cf. Chart 4.
Compared to one year ago, debt managers and banks are however less nervous. The
financial markets have improved and in light of the expectations of the future government
funding requirements turnover in the primary and secondary market should increase. Both
debt managers and bankers have a mutual interest in restoring confidence in the market.