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The Irish Government bond market - 1987-2007 Back  
In 1987, the Irish national debt/GDP ratio stood at a whopping 125 per cent, and the Irish Government was a frequent issuer of bonds aimed at reducing deficits. 20 years on, the scenario couldn't be more different writes Oliver Mangan, with public finances in surplus leading to low bond issuance levels.
Twenty years ago, we wondered who would buy the endless supply of Irish government paper as the national debt spiralled upwards, even though 10 year yields were around 13 per cent at the time. 20 years on and the public finances are in surplus, with little debt issuance and low bond yields. How did we get here?

In retrospect, it is possible to identify 1987 as a turning point for the bond market. The ERM realignment of January of that year marked the beginning of a hard currency regime in the EU. The year 1987 also marked the start of the turnaround in the health of the economy and public finances. The budget deficit declined and then moved into surplus in the late 1990s. All these developments had profound effects on the domestic bond market.
Oliver Mangan

Yield convergence
The Irish pound became a stable member of the ERM from 1987 and Irish interest rates fell sharply relative to their German equivalents. The spread between Irish and German 3-month money rates - which had been as high as 10 per cent in early 1987 - was whittled away to less than 50 basis points by the middle of 1992. Over the same period, the yield spread between Irish and German 10 year bonds declined from some 700 basis points to less than 100 basis points.

This benign picture suffered a temporary, but severe setback, in late 1992/early 1993 when Irish interbank rates and bond yields rose to exceptionally high levels after the UK currency left the ERM and a number of ERM member states devalued their currencies.

Despite the best efforts of the Irish authorities to sustain the value of the currency within the ERM, there eventually was a unilateral 10 per cent devaluation of the Irish pound in January 1993. Interest rates and bond yields fell rapidly in the aftermath of this devaluation.

EMU convergence trades came to the fore in 1996 as it became clear that European politicians were determined to launch a single currency on schedule in 1999. The Irish-German 10 year bond yield spread fell from 150bps in 1996 to less than 50bps by mid-1998.

The Irish pound was selected as one of the currencies to participate in EMU. The convergence of Irish and DM-bloc interbank rates over the closing months of 1998 saw the spread between Irish and German bonds fall further to just 10-20bps by the end of that year.

Eventually, with the new single currency regime gaining in credibility, a large Irish budget surplus and associated marked decline in Irish bond issuance, Irish yields fell to German levels right along the curve in this decade.

Structural changes
There were many structural changes to the bond market in the past two decades. A major change came in 1990, when the government set up the National Treasury Management Agency (NTMA) to take responsibility for the management of the national debt and Exchequer's funding programme.
The main aim of the NTMA was to achieve savings on debt servicing costs. In doing so, the agency engaged itself in fostering the standing and improving the efficiency of the market, in particular boosting liquidity. The NTMA was instrumental in the development of the market, bringing about many important changes including:

• Regular auctions were introduced, replacing sales via a tap mechanism
• A switch from semi-annual to annual coupons stocks
• Settlement through CEDEL and Euroclear for Irish bonds
• The inclusion of Ireland in the main international bond indices
• Large benchmark stocks were built up through concentrating funding in these issues and offering switch terms out of smaller illiquid stocks
• The introduction of a formal market-making system in Irish government bonds, which was launched in December 1995
• A move to electronic trading in this decade as Irish bonds joined the EuroMTS system and with the launch of a domestic system, MTS Ireland

Prior to market making, the Irish bond market operated on an agency only system, whereby stockbrokers were not permitted to deal as principals. Instead they matched buyers and sellers, charging a commission on each transaction.

Under the new market-making system, six recognised primary dealers were appointed. They were obliged to quote firm two-way prices on demand in specified bond issues and in specified minimum sizes.

Initially, the primary system was dominated by the four main domestic stockbroking firms of the time. However, now only one domestic primary dealer remains, while there are eight international primary dealers.

Changing ownership
All these developments enhanced the liquidity of the market, encouraging greater overseas interest in Irish bonds. Non-resident investors have become a major force in the Irish bond market in the past two decades. In the period 1987-92, German investors built up sizeable holdings of Irish government bonds as they offered a very attractive yield spread over German bonds, at a time when the Irish currency was a stable member of the ERM.

The ERM crises of 1992/93 and introduction of 15 per cent ERM fluctuation bands resulted in a considerable weakening of the link between the DM and the Irish pound, causing German investors to scale back their exposure to Irish bonds.

The improving liquidity of the Irish market, though, attracted US and UK investors in their place, including proprietary traders, hedge funds, global capital funds and pension funds. The increasing likelihood of Irish participation in the single currency also attracted flows from other European countries such as Holland, France and Switzerland.

The advent of the single currency saw non-resident purchases of Irish bonds increase as they now formed part of euroland bond indices. By end 1999 non-residents held 30 per cent of the market, up from 22 per cent at the start of the year. The non-resident share continued to rise during 2000 to almost 50 per cent of the market.

Domestic holders, on the other hand, were willing sellers as they moved from Irish to eurozone based benchmark indices. By the end of 2006, overseas investors held over 85 per cent of Irish Government bonds.

So, the Irish bond market has been transformed over the past 20 years. It is now denominated in a different currency, with electronic trading, international primary dealers, overseas investors, infrequent issuance and low yields. We are unlikely to see another such major transformation again in the next two decades.

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