Euro rates watch negative net dutch supply in 2016

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16 December 2015

Negative net Dutch supply in 2016 

Gross bond supply will be the lowest since 2008, net supply will even turn negative

Kim Liu



Negative net supply and QE dynamics to support performance versus Bunds

Senior Rates Strategist



The DSTA will lengthen the duration of its debt portfolio from 4.5 to 6.4 years…

Tel: +31 20 343 4669

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… by issuing longer-dated debt and by using less interest rate swaps

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The 2016 funding need will equal almost EUR 80bn, which is 15% lower than in 2015

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But outlook for public finances points to a further decline of the funding need

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Focus will be on money market while it continues to act as a buffer

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Possible downward revision of money market funding poses risk to liquidity of Tbills

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The changes to the funding policy and risk framework could lead to more volatility

Kim.liu@nl.abnamro.com

and cheapening around auctions Dutch State announces significant changes for years ahead in 2016 Outlook Last Friday, the Dutch State Treasury Agency (DSTA) published its 2016 outlook.

Compared to previous years, the 2016 outlook introduces significant changes to its funding policy and to the way how the Dutch State will manage its interest risk exposure.

In this special publication, we discuss these changes and their implications. The full and official publication by the Dutch State can be found here.

New risk framework will lead to higher duration of debt portfolio One of the most important changes affects the new risk framework the DSTA will use for the next 4 years. Under this new framework, the DSTA has decided to lengthen the average maturity of its debt portfolio from 4.5 years to 6.4 years (a range will be used of plus and minus 0.25 years) in 2019. By extending the average maturity, the DSTA will lock in longer funding at low additional borrowing costs and at acceptable risks for the government budget, given historical low yields and a flat sovereign curve.

Lesser reliance on interest rate swaps under current framework The new framework is a formal extension of the amendments made to the current framework in the past few years. Under the original framework, which was developed in 2007, the DSTA swapped almost all outstanding debt back to replicate a constant 7 year centralised benchmark bond. Every new issuance would also be swapped back to a constant 7 year maturity. In the last few years, the DSTA deviated from this policy by not

Insights.abnamro.nl/en

Bloomberg: ABNM

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Euro Rates Watch - Negative net Dutch supply in 2016 - 16 December 2015

swapping back selected longer dated issuance to the 7 year tenor. This resulted in active positions versus its 7 year benchmark.

In the next four years, the DSTA will lengthen its funding profile by issuing longer dated bonds and by not automatically swapping back all new issuances. By using swaps less frequently, the DSTA can continue to decrease counterparty risks by further unwinding swaps with financial counterparties with whom the swaps were executed initially. Another advantage of having a lesser reliance on using swaps, is the removal of the interference of the current derivatives portfolio on the funding policy. In 2015, the DSTA held EUR 20bn as cash collateral, which reduced and decreased its room for manoeuvre in the issuance of money market instruments. The decision to reduce its reliance on swaps also fits legislative developments. With the implementation of the accounting framework ESA 2010 (European System of Accounts) in September 2014, which replaced ESA 95, it is no longer allowed to use swaps to manage the interest rate risks to the EMU balance.

As such, the DSTA will therefore discontinue to use swaps as an predefined part of its risk framework but more as a fine tuning instrument to adjust the duration of its portfolio to its intended target and to manage short term interest rate risks.

2016 issuance will be around EUR 80bn, which is almost 15% lower than in 2015 Another important change is the significant lower 2016 funding requirement. The DSTA is expecting a funding need of EUR 78.8bn (see table below), which is down from EUR 92.1bn in 2015. The lower borrowing requirement is mainly caused by a smaller amount of bond redemptions in 2016. The reduction equates to a decrease of almost 15% compared to 2016. As a result, the 2016 funding need will be the lowest since 2008 and it is around EUR 40bn higher than the average funding need in the period 2003 - 2007.

Dutch State 2016 Outlook (in EUR bn) Funding need

Borrowing plan

Capital market redemptions 2016

28.2

Bond issuance

25 – 30

Money market balance 2015

22.4

Money market borrowing

48.8 – 53.8

Cash collateral balance 2015*

20.6

Of which, money market issuance

28.2 – 33.2

Projected cash deficit 2016

7.6

Of which, cash collateral*

20.6

Total

78.8

Total

78.8

Source: DSTA * Cash collateral balance is assumed to remain unchanged

Euro Rates Watch - Negative net Dutch supply in 2016 - 16 December 2015

Dutch 2016 funding need is lowest since 2008 In EUR bn

120 90 60 30

Bond issuance

2016

2015

2014

2013

2012

2011

2010

2009

2008

2007

2006

2005

2004

0

2003

3

Money market issuance

Source: ABN AMRO Group Economics, DSTA

‌ but could drop even further Additionally, the DSTA has already signalled that the 2016 borrowing need, can be revised further downwards as the impact of a number of possible events are sizeable and difficult to incorporate in their current cash projections. These three developments can be summarised as follows.

Firstly, the DSTA points to a possible improvement in the government balance if the Dutch economy continues to gradually recover. Secondly, future proceeds from privatisations of government owned entities are not included in the official forecasts. These privatisations include the additional sale of ABN AMRO and the sale of ASR. Thirdly, the cash collateral amount is assumed to remain unchanged in the official forecasts. The DSTA still has a large receiving derivatives portfolio, and as rates fell in 2015, their counterparties posted cash as collateral. As stated before, the large cash inflow resulted in cheap funding for the State but also interfered with it borrowing activity as an increase of the collateral reduces the issuance of money market instruments. In 2015, the DSTA has started to unwound long dated swaps, which reduced the derivatives portfolio. However, since the derivatives portfolio is still very substantial and volatility in rates could remain elevated, the cash posted as collateral can continue to affect the DSTA’s 2016 funding policy.

Composition of 2016 funding plan shows higher degree of flexibility As uncertainty is high, the DSTA has decided to build in more flexibility in its funding plan.

For example, the DSTA has decided to publish ranges instead of point estimates which was common practise until now. In addition, given the developments which are described above and which are difficult to predict, the estimated amount for money market borrowing is substantial in both absolute as a percentage of total funding. By setting the issuance at a high level, it can absorb sizeable (positive) changes in the cash deficit.

To illustrate, the borrowing range for money market instruments, which is set at EUR 48.8 - 53.8bn, is almost comparable to the amount issued in the year 2011, in which the DSTA was still in crisis mode. In addition, the scheduled issuance of money market instruments equates to around 65% of the total funding need, this is the second highest level for the period 2000 – 2015 (see graph).

Euro Rates Watch - Negative net Dutch supply in 2016 - 16 December 2015

2016 funding is tilted to money market issuance In %

100% 80%

60% 40%

20%

Bond issuance

2016

2015

2014

2013

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

0%

Money Market Issuance

Source: ABN AMRO Group Economics, DSTA

2016 net bond supply is on the decline and could even turn negative As a consequence, the remaining funding need forms the basis for the available bond issuance in 2016. The projected 2016 bond issuance is also given in a range, which is set at EUR 25 – 30bn. If we take the mid-level of the target range, we observe that while the expected money market issuance is almost equal to crisis levels, the 2016 gross bond issuance is the lowest since 2008. One of the reasons why the DSTA will need to fund less in 2016 is a lower amount due for redemptions (EUR 28bn). However, if we take into account this relatively low redemption amount, we calculate that net bond supply can still become negative. This would mean that while the ECB continues with its QE programme, the DSTA is actually decreasing its outstanding amount of bonds.

Net bond supply could turn negative in 2016 In EUR bn

40 30 20

10 0 -10 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

4

Net Bond Supply Source: ABN AMRO Group Economics, DSTA

The DSTA has also broken with its tradition to issue every year a new 3 year benchmark as it aims to increase the average duration of the debt portfolio. Instead it plans to issue new 5 and 10 year benchmark bonds. The remaining bond issuance will be raised by the reopening of longer dated off-the-run bonds (see table for full schedule).

Euro Rates Watch - Negative net Dutch supply in 2016 - 16 December 2015

Scheduled bond issuance 2016 Bonds

In EUR bn

New 5 year DSL

7.5 – 10

New 10 year DSL

15

Reopenings of longer dated

2.5 - 5

off the run DSLs

25 - 30

Total bond issuance Source: DSTA

Negative net supply is supportive of credit spread compression versus Bunds The most important takeaway of the information published by the DSTA is the high likelihood of negative net supply of DSLs in 2016. Even if net bond supply is slightly positive, this should still be supportive of further spread narrowing versus Bunds, giving ongoing ECB PSPP purchases and a gradual recovery of the Dutch and euro area economy. Currently, Dutch sovereign bonds with a maturity of 5 year trade at a pickup of around 5bps versus their German counterparts. Given the relative lack of supply in 2016 in the short end of the curve and the preference of the Dutch central bank for relatively short dated assets, we think that the likelihood of credit spread widening in this area is limited. However, further performance is also limited given the tight levels.

Contrary to the relatively expensive 5 year part of the curve, we do see value and arguments for further tightening vs Bunds in the 10 year part of the curve. In this part, the credit spread trades around 15 bps. As the QE programme is extended to at least March 2017 and as the eligible pool of German assets is increased by the recent addition of regional bonds (see graph), we think that these ingredients are supportive of 10 year DSLs versus Bunds.

Addition of regional bonds decreases German scarcity In % of eligible assets per country

40

30 20

10

QE Plus without regional bonds Source: ABN AMRO Group Economics, ECB

SUPRA

SP

PT

NL

IT

FR

FI

DE

BE

0

AT

5

QE Plus with regional bonds

6

Euro Rates Watch - Negative net Dutch supply in 2016 - 16 December 2015

Recent decisions could lead to more volatility and cheapening around auctions‌ Another possible implication of the new funding and risk policy is more volatility around auctions. Volatility by itself could increase in the run up to auctions as liquidity has decreased in both the secondary government bond and in the futures market. This means that the market could need more room in the form of cheapening of the bond to digest the primary issuance.

The level of volatility is also dependent on the amount of delta which is coming into the market and to which extent the DSTA will decide to deploy swaps. In principle, swaps are meant to adjust interest rate exposure but debt management offices can also use these instruments around auctions to support the market. If the DSTA decides to not to use swaps to support the market, it could need to lower its selling price more often than has been the case in 2015 (the DSTA uses an auction technique in which the DMO sets the price at which banks can purchase the bond).

Furthermore, we calculate that the DSTA will need to raise on average EUR 1.75bn nominal per auction. We assume bond issuance to total 27.5bn and that the 2 DDAs will raise a combined amount of EUR 10bn. As it has been common practise for the DSTA to not issue in the Summer months and in December we divide the remaining amount available for auctions by 10 and assume therefore that the DSTA will hold 1 bond auction per month. We observe that the average amount to be raised per auction is less than in 2016, which totalled around EUR 2.1bn. But next year, the DSTA will less likely use swaps around auctions which will leave the market more vulnerable. In addition, the duration of the bonds which are going to be issued in 2016 is longer, which results in a higher delta amount and which offsets the lower nominal issue amounts. An example of what could be in store in 2016 are the several reopenings of the DSL January 2047 in 2015. The long end can serve as a proxy as in these auctions the DSTA did not swap back the issuance, and as the long end is less liquid than shorter areas on the curve. The DSTA reopened the DSL January 2047 three times, while the amounts issued varied between EUR 1 and 1.5bn. These auctions were accompanied by higher volatility and cheapening than the auctions in the shorter end of the curve. ‌and downside risks to issuance of DTCs Finally, the risks for the issuance of money market instruments is clearly tilted to the downside. Developments for 2015 are largely positive and could point towards an improvement of the cash balance. If this comes true, the money market issuance will be lowered and DTC auctions could be cancelled as has been the case in 2015. While money market issuance for 2015 is intentionally scheduled upwards and from a historical perspective high, it remains to be seen if the buffer is large enough to succeed in a liquid DTC market. This depends on the gradual recovery of Dutch public finances, the amount due from privatisations and the development of the cash collateral.

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Euro Rates Watch - Negative net Dutch supply in 2016 - 16 December 2015

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