I woke up to the headlines this morning about the apparently failed German bond tender yesterday and all the experts predicting doom. In my E-mail box there was around 30 requests for an explanation from readers who had read the news and concluded that it was a major event in the current crisis but didn’t really understand what the implications were. The implications are fairly simple – the bond markets are working out that no EMU government is free of insolvency risk because they all use a foreign currency (the Euro). Germany is better placed to resist the crisis because of the relative strength of its economy but it is not immune from it. Its economy will also deteriorate as the effects of austerity spread out through trade. While the “experts” waxed lyrical about the crisis being confined to profligate EMU states (the PIIGS), it was always clear that the northern strong-hold states were going to be dragged in as the crisis deepened. That is because the problem is the Euro itself and the way the monetary system is designed. All the other emotional stuff about lazy Greeks is a sideshow. Germany is starting to find that out – yesterday, it received its first strong message. The crisis is going right to the top in Europe now.
The news was clear – that the German government’s latest 10-year Bund tender (auction) had failed and according to this Irish Times article (November 23, 2011) – Crisis hits German bond issue – the Euro crisis was finally knocking on heaven’s door.
The Irish Times quoted the head of the Deutsche Finanzagentur, which is the German government finance agency that manages the German debt issuance process as saying that the shortfall in bids for the 10-year bond issue was “mainly due to extremely nervous markets and not a sign of falling investor demand for German debt”.
As we will see:
Germany had hoped to sell €6 billion of debt, but commercial banks bought just €3.644 billion and the debt agency retained a larger-than-usual portion, making it one of its least successful debt sales since the launch of the euro.
The retained amount, roughly 39 per cent of the planned volume, will be sold in the secondary market.
What does this all mean?
1. The cost of funding German deficits has risen (because the secondary bond market sales will be at a greater discount). Even though the yield yesterday was 1.98 (average) which was down on the 2.09 per cent achieved in the October auction, the reality is that this was engineered by the Deutsche Finanzagentur as I will explain.
2. The bond markets are realising that the so-called gold standard of the Euro – the German bund – is only as risk-free as the government that issues it. And it is obvious that the German government is in the same boat as all other EMU member states – it faces insolvency risk because it operates in a foreign currency (the Euro).
Sure enough, the strength of the German economy makes it less of a risk (there is a more robust tax base to plunder) but it is only a matter of degree.
3. We will see more about this in the coming weeks when 3 more auctions are due.
The commentators were interesting. Descriptions such as “This auction is nothing short of a disaster for Germany” and “one shudders concerning the upcoming auctions in other European nations”.
We have been seeing the pressures building for some months now – snaking across the weaker southern EMU states and more recently into larger economies such as Italy and then France.
Now it is going right to the top.
Meanwhile the European Commission president José Manuel Barroso was busily outlining the latest EC plan to salvage Europe from the crisis. Like all other plans it will fail and in the meantime will further erode democracy. I will blog about this plan another day.
Basically it is setting up a centralised surveillance unit to further usurp the fiscal capacity of the member states without at the same time establishing a fully-fledged “federal” fiscal capacity to meet asymmetric aggregate demand shocks (across the region).
The plan would require all member states (17 nations) to send draft budgets to the EC by October 15 each year. The Commission could then reject the plan and force the nation to alter the spending and taxation proposals. There would also be stricter rules under the “Excessive Deficit Procedure” which would seek to enforce the Stability and Growth Pact more closely.
All member states would be forced to set up “independent fiscal councils” which would be involved in the preparation of budgets and official forecasts.
If a nation needed financial assistance there would be federal support it would have to be obedient under these rules.
Short conclusion: it would be a total disaster.
Slightly longer conclusion: if this framework had have been in place in 2007, the outcome now would have been even worse because the initial surge in deficits would probably have been short-circuited. If not, then Europe would be in the same situation as today.
More on this another day.
But back to the German bond issue story.
While I am most familiar with the Australian institutional structure, bond issuance (in primary markets) is organised along similar lines in all countries.
A primary market is the institutional machinery via which the government sells debt to “raise funds”. Remember that the term “funding” is loaded given that sovereign governments do not strictly have to borrow to run deficits. However, in the German case funding has the more traditional connotation given the country uses a foreign currency (the Euro).
A secondary market is where existing financial assets are traded by interested parties. So newly-issued government bonds enter the monetary system via the primary market and are then available for trading in the secondary. The same structure applies to private share issues for example. The company raises funds via the primary issuance process then its shares are traded in secondary markets.
However, new issues can also enter the secondary market via the “back door” and I will explain what that means later.
Clearly secondary market trading has no impact at all on the volume of financial assets in the system and just shuffles the wealth between wealth-holders. In the context of public debt issuance – the transactions in the primary market are vertical (net financial assets are created or destroyed) and the secondary market transactions are all horizontal (no new financial assets are created). Please read my blog – Deficit spending 101 – Part 3 – for more discussion on this point.
Methods of selling government debt into the primary market vary but the two most known methods are tap and tender. A tap system involves the government setting the yield and selling as much debt as is demanded at that yield.
Typically governments would be doing this on a continuous basis and adjusting the yields up or down to meet the market requirements and ensure that there were no discrepancies between net spending and bond sale revenue, apart from small volumes that they “buy” themselves and use, in the words of the Deutsche Finanzagentur to smooth out liquidity when a given asset is “a little stretched”.
The “auction” or “tender” system – is the ultimate neo-liberal development and attempts to take all discretion away from the elected government as to what it would pay on government debt issuance.
In this blog – Will we really pay higher interest rates? – I go into this issue in more detail (although the discussion is Australian-centric) and show that the move from tap to an increased reliance on auctions was was driven by the ideological calls for “fiscal discipline” and the growing influence of the credit rating agencies. Accordingly, all net spending had to be fully placed in the private market $-for-$. A purely voluntary constraint on the government and a waste of time.
Typically, the Treasury determines when a tender will open and the type of debt instrument to be issued. They will usually announce the maturity (how long the bond would exist for), the coupon rate (the interest return on the bond) and the volume (how many bonds) of the assets being put up for auction.
The following diagram is sourced from Deutsche Finanzagentur and shows the process which is followed to determine the parameters and execution of each auction.
As you can see, the German government via the Deutsche Finanzagentur announces the parameters for the issue (maturity, volume and coupon) on the Thursday morning the week before the Wednesday morning auction (in relation to the Bunds). The morning before the auction (Tuesday) the Government invites bids for the issue which must specify the “price” that the buyer is prepared to pay (expressed in terms of the discount to the coupon).
On the auction day (Wednesday), the Deutsche Finanzagentur announces the allocation according to the bids received and what portion they are retaining for “secondary market operations”.
In a general case, once the Government invites bids for the tender, the market then determined the final price of the bonds issued. Imagine a $1000 bond had a coupon of 5 per cent per annum, meaning that you would get $50 dollar per annum until the bond matured at which time you would get $1000 back.
Imagine that the market wanted a yield of 6 per cent to accomodate risk expectations. So for them the bond is unattractive and they would avoid it under the tap system. But under the tender or auction system they would put in a purchase bid lower than the $1000 to ensure they get the 6 per cent return they sought.
The mathematical formulae to compute the desired (lower) price is quite tricky and you can look it up in a finance book.
The general rule for fixed-income bonds is that when the prices rise, the yield falls and vice versa. Thus, the price of a bond can change in the market place according to interest rate fluctuations.
When interest rates rise, the price of previously issued bonds fall because they are less attractive in comparison to the newly issued bonds, which are offering a higher coupon rates (reflecting current interest rates).
When interest rates fall, the price of older bonds increase, becoming more attractive as newly issued bonds offer a lower coupon rate than the older higher coupon rated bonds.
For new bond issues, the Deutsche Finanzagentur currently (2011) recognises 33 institutions which are included in the 2011 Bund Issues Auction Group.
The list in the linked document is ranked in order of the “issue amounts – weighted according to the different maturities and the related interest rate risks – which they took over in 2010”.
So the top 5 were:
Deutsche Bank Aktiengesellschaft
The Royal Bank of Scotland plc Niederlassung Frankfurt
Citigroup Global Markets Limited
UBS Deutschland AG
Goldman Sachs International
In terms of the weightings, it will be of no surprise that a 10-year Bund is weighted 15 while the 6-month Treasury discount paper (Bubills) are weighted 1.
The Deutsche Finanzagentur deals exclusively with this group for primary issues.
We read that the “auctions are carried out via the Deutsche Bundesbank Bund Bidding System (BBS)” and members of the Bond Issuance Auction Group have to bid in units of:
… at least 1 million, or a full multiple thereof, and should state the price, expressed as a percentage of the nominal amount, at which the bidders are prepared to buy the securities offered. In principle, it is possible to enter several bids at different prices and/or to make non-competitive bids. The prices bid must be for a full 0.01 percentage point for Bunds and Bobls …
The Bund uses a multiple price auction procedure. In other words, bids for Bunds … accepted by the German Federal Government are allocated at the price quoted in the respective bid and are not settled at a uniform price. Bids priced above the lowest accepted price are allotted in full, while bids priced below the lowest accepted price receive no allotment. Non-competitive bids are allotted at the weighted average price of the accepted price bids. The Federal Government reserves the right to re-allot the bids at the lowest accepted price as well as the non competitive bids, e.g. to allot them only at a certain percentage rate.
More detailed information about the way the auction is conducted is available from the German Bundesbank (its central bank). We read that bids “should state the price, as a percentage of the par value, at which the bidders are prepared to purchase the Federal securities offered”.
So the German government ranks the bids received in terms of price (and implied yields desired) and a quantity requested in millions of Euros.
The bonds are then issued in highest price bid order until the total auction volume is exhausted or, importantly for the auction yesterday, they exhaust the allowable bids.
So the first bidder with the highest price (lowest yield) gets what they want (as long as it doesn’t exhaust the whole tender, which is not likely). Then the second bidder (higher yield) and so on.
In this way, if demand for the tender is low, the final yields will be higher and vice versa. There are a lot of myths peddled in the financial press about this. Rising yields may indicate a rising sense of risk (mostly from future inflation although sovereign credit ratings will influence this). But they may also indicated a recovering economy where people are more confident investing in commercial paper (for higher returns) and so they demand less of the “lower” “risk” government paper.
Clearly, the paper issued by member governments within the EMU does carry risk whereas paper issued by sovereign governments that issue there own currency can be considered risk free.
Please read my blog – Time to outlaw the credit rating agencies – for a background discussion on the technical matters pertaining to bond issues.
The Deutsche Finanzagentur publishes all the bond auction results – here are the 2011 results to date.
The following table shows the 2011 results for the 10-year Bunds only – given it was this auction yesterday that apparently failed. I edited some of the extraneous information out of the official table to allow the data to fit into the screen and be readable.
If you study the data (and understand it) it is not hard to work out what happened yesterday. First, a clarification. Several readers asked me about the bid-cover ratio which was reported as being 1.1. They asserted that this meant it was a lie to say the bond auction failed and that the German government could have sold more debt (in value terms) than they required (6 billion Euros).
I explain bid/cover ratios in this blog – D for debt bomb; D for drivel ….
The bid-to-cover ratio is typically taken to be the volume (in currency units) of the bids received to the total volumes (in currency units) desired. So if the government wanted to place $20 million of debt and there were bids of $40 million in the markets then the bid-to-cover ratio would be 2.
For sovereign governments clearly the bid ratio is somewhat irrelevant because it could just abandon the auction system whenever it wanted to if the ratio fell to 0.00001.
The ratio is does not provide a clear signal. It certainly signals strength of demand but how strong becomes an emotional/ideological/political matter. Even if you believed that the government was financing its net spending by borrowing, then a bid-to-cover ratio of one would be fine – enough lenders to cover the issue. Some commentators think that 2 is a magic line below which disaster is imminent. There is no basis at all for that.
For reasons that are not explained, the Deutsche Finanzagentur defines the bid/cover ratio differently to the standard practice. It says the bid/cover ratio is calculated as the:
Relation of the demand to the alloted volume.
Note the subtle difference. Usually, it is the ratio of bids to total auction volume. In Germany’s case, the official data is referring to the number of bids to the amount the Government actually issues, which could be (as it was yesterday) well below what it desired to issue.
So the 1.1 for yesterday’s auction refers to the fact that there were nominal bids worth 3,889 million Euros and allotments were equal to 3644.00 million Euros.
The conclusion that the German government “could have” met their auction target if it wanted to is thus false.
If you examine the 2011 results closely, you will see that when the average yield is above the advertised coupon, the “lowest accepted price” is below 100 (meaning the lowest bid received was at a discount to par).
Similarly, when the average yield is below the coupon, the lowest accepted price is above 100 (above par).
You will note (second-last column) that there is an amount retained by the Government for “secondary market operations”. What does that mean?
The Deutsche Finanzagentur provide some insight into their Secondary Market operations.
They say that:
In addition, the German Federal Government Finance Agency supports the market makers’ presence in the secondary market by helping out in case if needed, e.g. in exceptional cases when the liquidity of a given security should become a little stretched. For these purposes the German Finance Agency retains on its own books a certain portion of the nominal amount tendered at the auction of a new or reopened issue.
The following graph shows the amounts retained by the Deutsche Finanzagentur for secondary bond market purposes from 2006 to 2011 (yesterday) (it relates only to the 10-year Bund). The spike at the right of the graph was yesterday. The green line is the average over the entire period 1161.4 million Euros and the average for 2011 is so far 844 million Euros (excluding yesterday’s volume).
By any logic, yesterday’s withdrawal by the Government is an outlier and goes well beyond what they need for “operational” purposes (to ease an asset class that is a “little stretched” for liquidity in the secondary markets).
Finally, it is clear that the nominal bids for yesterday’s auction were 3,889 million Euros while the government was after 6,000 million (less some amount of their secondary market operations tranche (which has averaged before yesterday 844 million Euros).
So the bids were 65 per cent of the volume for auction. If we took out the average secondary market tranche for 2011 then the bids received would climb to 75 per cent of the volume up for auction.
Why then did they only allocate 3,644 millions of the desired volume (some 61 per cent or 71 per cent if you take into account the average secondary market tranche)?
The answer is that they wanted to keep the yield down around the coupon rate of 2 per cent and so had to cut off the bids (the prices that the auction group were prepared to pay) at around par.
Clearly, the remaining bids were trying to push yields up and the Government resisted that market trend.
So to achieve the desired yield they “purchased” 2,356 million Euros-worth of the issue which they will then seek to sell in the secondary market.
I laughed (schadenfreude) when I looked at the data this morning. The German government is manipulating its own rules – by withdrawing much more to sell in secondary markets than it could justify for operational reasons.
They did this to:
1. Keep the official Bund yields low.
2. Bail itself out when the bond markets are not willing to fund it on their terms – or in yesterday’s case – not even fund it on any terms.
While the Germans are preaching to all and sundry about their insistence that the ECB should not be funding government deficits, what the Germans did yesterday is not that far removed from that.
The story has more to go yet though because the Euro crisis is heading right into the core. As the world economy slows again as a result of the deliberate policy choices of governments who seem to want to be vandals rather than govern, the German export machine will contract.
By then the private bond markets will have been attacking France and heading due East.
That is enough for today!