| Fixed income: The internationalisation of the Irish bond market continues |
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| In 1998 overseas investors owned just €7 billion, or 22 per cent of the Irish government bond market. However, international investors tripled their holdings of Irish gilts over the next five years, driven by, amongst other factors, the generous yield pick-up Irish bonds offered over the so-called core eurozone markets such as Germany and France, and held almost €21 billion at the end of 2003, Oliver Mangan writes. |
Domestic financial institutions have reduced considerably their holdings of Irish government bonds since the introduction of the single currency at the start of 1999. At the end of 2003, some €7.5 billion of Irish government bonds were owned domestically, down from €16.5 billion at the end of 1998.
The arrival of the euro at the start of 1999 saw domestic funds move from Irish to eurozone based benchmark indices. Whereas the Irish bond indices had weightings of 80 per cent or more in Irish bonds, the eurozone bond indices have weightings of only 1 per cent or thereabouts in Ireland. Thus, at the start of 1999, many domestic funds were in the position whereby 80 per cent or more of their bond holdings were in just 1 per cent of their new benchmark bond index.
Thus, Irish funds were obliged to diversify their portfoolios, switching from Irish into other government bond markets. A major drawback was that some of the larger eurozone government bond markets were yielding considerably less than Irish government bonds. Ten year German bunds were yielding around 25bps less than equivalent Irish bonds in 1999, meaning that Irish funds had to sacrifice some yield if they switched into such markets.
Another difficulty was persuading international investors to buy the Irish bonds being offloaded by the domestic institutions. Many international funds did not feel obliged to hoold Irish bonds in their portfolios because of the low weighting of Ireland in international bond indices. Instead, they could increase their weightings in larger markets like Spain, which trade broadly in line with Ireland, if they wished to avoid the risk of suffering any loss in yield or performance, because of the absence of Ireland from their portfolios.
International investors, then, had to be encouraged to buy Irish bonds. In the event they became major holders of Irish government paper. Overseas investors tripled their holdings of Irish government bonds from €7 billion at end 1998 to almost €21 billion at end 2003. They now own almost 75 per cent of the Irish market, up from just 22 per cent at the end of 1998.
This internationalisation of the Irish bond market proved to be a remarkably smooth process and its success can be attributed to a number of factors. First, domestic institutions diversified slowly over time, reducing their share of the market by roughly ten per cent per annum during the past five years. This prevented any major dislocation in the market.
Second, the diversification process was aided by the fact that the Irish government was running a large budget surplus for much of the period, in particular in 1999 and 2000. Thus, the authorities had no need to raise funds in the market for much of the period. Instead, the budget surplus financeed repayments of maturing debt, including foreign currency and euro legacy currency debt.
Third, up until the end of 2002, Irish bonds offered a generous yield pick-up over the so-called core eurozone markets such as Germany and France, even though Ireland had an equally high AAA credit rating. Irish ten-year bond yields generally traded in a 20-25bps range over Germany in the 1999-2002 period, making them look quite attractive to international investors.
Fourth, the NTMA instigated a number of significant changes in the market to make Irish bonds more attractive to international investors. In particular, it conducted two major bond switch programmes in 1999 and 2002. Investors were offered the opportunity to switch their holdings of old bonds into new, much larger, jumbo-sized benchmark issues. As a result, the market is now concentrated into five large benchmark stocks ranging from €5 billion to €6 billion in size. These jumbo-sized issues are much more attractive to international investors.
Furthermore, the fact that the bonds are over €5 billion in size means that they are eligible for inclusion for trading in Euro MTS, the major European platform for the electronic trading of benchmark government bonds. This has greatly enhanced the turnover and liquidity of Irish bonds and caused a narrowing of bid-offer spreads, all to the advantage of investors.
Finally, the Irish primary dealer system has matured. There are now five international banks and two domestic institutions, including AIB Capital Markets, which are recognised by the NTMA as primary dealers in Irish government bonds. The domestic market makers, including the Primary Dealer Unit in AIB, also have a long and proven track record in selling Irish government bonds to international investors. They played a key role in recent years in persuading more and more international investors to become involved in the Irish bond market.
The Irish yield spreads over Germany and France have been largely eliminated at this stage, in line with the trend in the rest of the eurozone. This reflects both the sharp tightening of swap spreads in the eurozone and the deterioration in the public finances in Germany and France. However, we expect that international investors will increase their holdings of Irish government bonds even further in the years ahead. The positive outlook for Ireland’s public finances, with particularly favourable trends evident year-to-date, combined with its very low debt/GDP ratio and top credit ratings, as well as the enhanced pricing and liquidity conditions of the Irish market, should ensure that Irish bonds will remain very attractive to international investors, even in the absence of any appreciable yield pick up over the larger eurozone bond markets. |
Oliver Mangan is chief bond economist at AIB Global Treasury.
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| Article appeared in the July 2004 issue.
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