New Zealand still at the tip of the global market spear
New Zealand is one of the first countries to re-enter a rate hiking cycle as the world slowly emerges from the pandemic, due to rising inflation and an increasingly tight labour market. Local high-grade issuers are used to being at the forefront of market changes – a leadership position they also hold in the sovereign-sector sustainability space – and say they remain confident on market conditions despite some challenges.
DEMAND AND DURATION
Davison What is issuers’ read on funding conditions in the New Zealand dollar market at the start of 2022?
MARTIN The key issue is that our tender supply is much lower since we reduced our bond programme forecasts in December: we now have a NZ$200 million (US$133.3 million) weekly tender run rate as opposed to NZ$500 million at the end of last year.
On the demand side, things are looking reasonably attractive on a relative value, outright yield and hedged basis. We are seeing decent numbers from our offshore holdings data: nonresident holdings of NZGBs [New Zealand government bonds] at the end of December were around 58 per cent, which means NZ$52 billion of our bonds is held offshore – the highest volume ever.
We have only had three lots of weekly tenders since the start of the year but the cover ratios have been not far from long-run average, at around three times The exception is the 2051 long bond, which has had a cover ratio of closer to two since we started tendering into it late last year.
Davison How important a factor is outright yield, particularly in the context of the expectation of a significantly higher cash rate in New Zealand in the medium term?
MARTIN What matters is when market participants get comfortable that what is priced into the yield is at least as much as their own OCR [official cash rate] expectations. The market is now pricing the OCR to be heading toward 3 per cent by the middle of next year, which is perhaps giving participants some comfort.
BUTCHER Yields are trending higher around the world but have risen more aggressively still in New Zealand, particularly in the front end. This has been a tailwind for offshore investor engagement and involvement in the Kiwi market. The cash rate has only just started to go up but the market is pricing seven further hikes over the course of this year, which means yields have already reached a point where New Zealand is attractive from a relative and outright perspective.
As global yields move higher, one would always expect investors to start looking for attractive places to invest. New Zealand was relatively expensive for a while throughout 2018-20, so we cheapened up at the same time as yields popped globally in 2021. If offshore investors were not active in New Zealand under these circumstances, we would have a major problem.
I am not quite as positive when it comes to underlying market sentiment. There is good support for tenors out to 10 years but it is still sticky beyond that point. We experienced strong offshore buying for the front-to-mid part of the curve throughout 2021.
Since last August, we have tendered 11 out of our 12 maturities as we have tested the sweet spot for issuance. We had a couple of good tenders in December and February but the term of these was just more than four years. When we tried to issue longer-dated bonds, in September and November, we really struggled even with small amounts.
This makes some sense. If investors believe the interest rate cycle has further to run in New Zealand and globally, why would they want to buy long-duration bonds?
BLIGH I agree a lot of tightening has already been priced into the market and that we have seen this sentiment in outright valuation. Investors are considering their views on inflation and its effect on monetary policy, and on the curve continuing to push higher – specifically whether it reflects what is expected and known.
My suspicion is that the market will experience a continuation of themes from last year, particularly from the last quarter. This means conditions, in our view, are initially going to be challenging and data dependent.
We are also seeking to manage our duration – but, as Mark Butcher says, why would investors go long if there is a view rates have further to run? We are looking for conducive issuance windows and want to take opportunities when we can. We are still an emerging issuer in this regard: we are continuing to build our nominal bond curve where we can including offering volume that is appealing from a liquidity perspective.
At the moment, the feedback we are getting is that value resides in the middle of the curve – it is certainly not long. Testing this will be interesting, given it is where ideally we would like to be. Ultimately, we will have to issue something outside our tenders in the balance of this financial year. We will be looking at the market from right now through to June to meet that requirement.
“A lot of tightening has already been priced into the market and we have seen this sentiment in outright valuation. Investors are considering their views on inflation and its effect on monetary policy, and on the curve continuing to push higher – specifically whether it reflects what is expected and known.”
JOHN With rates going higher, it seems there is more interest in the front end of the curve. When we issued domestically last year it was in the mid-to-front area. We also had an offshore benchmark issue in the longer end of the curve, for €500 million (US$572.6 million). We were trying to de-risk our position, given the uncertain times we are in.
We have substantial maturities in this first quarter and into April – more than NZ$1.2 billion of refinancing – so we did quite a bit of pre-funding at the end of last year. We are now sitting on cash and we do not need to rush into the market for the time being.
I also agree there seems to be some uncertainty in the market. But as we proceed through the year we should get a clearer picture of where rates are heading locally and globally. For the time being, I concur with the view that investors have no reason to lock into the long end.
Taking everything together, we have no major urgency to get any new issuance done in the first quarter of 2022 as the bulk of our funding will come into the second half of the year. We expect market conditions to have settled to some extent and there should be more certainty by then. We can also borrow through LGFA [New Zealand Local Government Funding Agency] in the short term and look at where the market is later in the year.
BUTCHER We may be coming across as a bit too pessimistic in some of the comments made so far. I’m sure we could all go out and issue a good amount of two-, three- and four-year bonds. The degree of difficulty comes from going further out along the curve.
New Zealand is a small, open economy and the RBNZ is one of the first central banks to commence tightening. Investors now get yield from being in New Zealand – but there will always be volatility along the way as well.
Davison In an environment like this, where there is ample liquidity in the short-to-mid curve but conditions are more challenging further out, do borrowers just have to issue shorter and try to extend duration later on, or do client or internal asset-liability management requirements dictate a certain amount of 10-year-plus issuance that has to be completed regardless of curve pricing?
BLIGH As an infrastructure builder we are always driven to go long, but in some regards we have to meet the market – particularly as we are an emerging issuer. If the market is prepared to provide the volume we require we have to be willing to meet its requirements. Over the past few years the ultra-low rate environment provided a great opportunity to go long and all issuers sought to extend their curves. Things moved very quickly in the last quarter of last year.
The capital losses in investor portfolios were swift and quite severe. We are now seeing central banks moving in unison, to some degree normalising rates to where they were before the pandemic. There will be opportunities but as a programmatic issuer it is about the balance of achieving our financing requirement and meeting the market at pricing that works for issuer and investor across all tenors.
MARTIN We are quite structured in the way we approach the market and try to accommodate a variety of investors’ demands. At most times, we issue into short, medium and long bonds and do not generally turn off the tap just because the pricing is not quite in our favour at any particular point in time. We may tweak, at the margin, toward the longer or shorter end but offering presence in the market to different investor types is important to us.
Specifically on the 2051 bond, although tender demand has been less strong it is worth noting that it is still fairly recently syndicated. The original syndication was NZ$3 billion and we have a general policy of trying to build up volume and liquidity in new bonds. We will likely continue to issue into this new line for a while.
COVID-19 exit strategy
New Zealand’s pandemic experience has been close to unique and its ability to keep the virus at bay for much of the period has assisted its positive economic position. As the world creeps toward a new normal so expectations are becoming – somewhat – easier to forecast.
MARTIN I am prepared to say we have passed peak uncertainty but it would be a stretch to say conditions are back to a normal level of predictability.
To put this in context, our half-year forecast published in mid-December included information from well before we started to consider the impact of Omicron on the New Zealand economy. The next opportunity to publish revised forecasts will be for the budget, which normally comes in May.
One thing I would point out is that at the half-year update our bond programme, even though we dialled it back, still allowed for quite a big liquidity buffer in the near term, relative to what we have calculated is an appropriate enduring level of around NZ$15 billion (US$10 billion). This gives us scope in the short term to absorb any downside fiscal impacts.
I am prepared to say we have passed peak uncertainty, but it would be a stretch to say conditions are back to a normal level of predictability. To put this in context, our half-year forecast published in mid-December included information from well before we started to consider the impact of omicron on the New Zealand economy.
Davison It is a noticeably down year for New Zealand dollar high-grade maturities, with no New Zealand government bond (NZGB) redemptions and a much smaller than usual maturity profile in the Kauri market. All else being equal, will this have a widening influence on yield as there is still a fair amount of new issuance to be done by local borrowers?
MARTIN We have no maturities this fiscal year so our net issuance is quite high, at about NZ$18 billion, after accounting for some indicative buybacks of the 2023 maturity. However, this is still quite a bit lower than last year – the peak COVID-19 year – when it was NZ$33 billion. In future years, when we get back into maturities, our net issuance drops to less than NZ$5 billion.
This fiscal year, which runs to the end of June, we are well ahead of our issuance run rate. We have a NZ$20 billion gross issuance task and have done almost NZ$16 billion at early February. So we are not concerned.
BUTCHER I don’t think there will be a yield impact per se but we think there might be a fall in turnover. We have an upcoming NZ$1.6 billion maturity in April so have thought about market dynamics. We have gone back and looked at the impact on our bonds when there is no LGFA maturity in a particular year – specifically 2016 and 2018. There was a noticeable reduction in secondary market activity in those years. In other words, we discovered that having maturities does generate additional secondary market activity.
The other thing we note about NZGB maturities is the duration lengthening in the index and cash being reinvested in the month in which the maturity happens. LGFA has benefited from these factors in the form of a pick-up in activity in these months.
The market will not have this support in 2021. However, I still believe the market has in general become broader and deeper over the past few years.
Davison High issuance from local government-sector entities last year was of course supported up to June by the Reserve Bank of New Zealand (RBNZ) large-scale asset purchase (LSAP) programme. When this came to an end, did issuers experience anything like a ‘taper tantrum’ – and what do they expect from further tightening or even the RBNZ attempting to reduce the size of its balance sheet?
MARTIN The feedback we have had from investors is that the cessation of the LSAP programme went fairly smoothly. I think this is because, at the point in time when the programme ended, the domestic economic indicators were so strong that to investors it almost seemed incongruous for the RBNZ to continue buying bonds.
BUTCHER The RBNZ started buying LGFA bonds in April 2020 and stopped in February 2021, so we have been out of LSAP for a year now. The RBNZ bought LGFA bonds as part of its goal to stabilise the wider debt market in New Zealand, which is why it stepped back relatively quickly when this support was no longer needed.
The RBNZ is holding between NZ$33 million and NZ$260 million in nine of our 12 bonds lines, so we are comfortable in our ability to refinance them. If anything, it was good that the RBNZ stopped buying LGFA bonds early as the refinancing of these holdings can be easily managed by us.
Davison Is the market expecting the RBNZ actively to sell down holdings or simply to let them mature over time?
MARTIN Speaking to investors we hear varying views. The RBNZ has reiterated that it is a priority to maintain the smooth functioning of financial markets and we have restated the importance of collaboration between the reserve bank and New Zealand Debt Management (NZDM) to ensure the efficient functioning of the NZGB market.
There has been media commentary from the reserve bank to the effect that, if it decided to undertake sales, it would most likely be through NZDM as opposed to in the secondary market. However, the RBNZ has indicated that it will provide further details early this year.
Davison It has been a big few months in sustainable debt for New Zealand high-grade issuers, specifically NZDM and LGFA making significant commitments in the space. What update can NZDM provide on the process of developing a sustainable issuance programme?
MARTIN The minister of finance initially announced the intention, in November, to issue a first sovereign green bond for New Zealand, and it followed that NZDM would be the team doing the work. By Christmas, we announced the appointment of our joint structuring advisers.
Subsequent to this, we have been working with the advisers, Treasury and the wider public sector to progress the work to build a durable framework – with the intention of issuing a first bond this year. We are aiming to have the green-bond framework detail published by the middle of this year and for a first syndicated transaction by late this year.
Davison NZDM has said in the past that if it becomes active in this space it wants to do so as a leader rather than just following global trends. The green, social and sustainability (GSS) bond product, and the sustainable debt market more generally, is constantly evolving and investor expectations are increasing. What does a leadership position potentially entail in this context?
MARTIN We are still early in developing the framework. Because we are not the first mover in the sovereign space we have the advantage of being able to speak to peers and build on global best practice. Equally, we want to make sure what we do represents New Zealand and has a New Zealand-specific element to it.
My core belief has always been that we need to consider these products from two sides: the pure debt management perspective and the environmental or social outcome. The debt management aspects like pricing, investor diversification and liquidity are obviously important. But it is on the other side where we are thinking about the wider benefits.
What this means is that we are thinking about what can genuinely improve outcomes – how we set up the framework so it contributes to robust environmental outcomes that are well reported on and do not just tick a box for some portfolios.
Davison The LGFA has also made announcements in the GSS space. What is it hoping to achieve, and how is it dealing with the additional challenges of representing many underlying councils rather than just borrowing for its own balance sheet?
BUTCHER We do not have a definitive timeline for issuance of GSS bonds – we are in the gathering assets phase now. The assets are loans to councils for eligible projects. Our use of proceeds is loans to councils, and once we have sufficient council loan assets we will consider issuing GSS bonds to help the market develop.
We launched our GSS lending programme in late 2021 and have had two councils borrow so far. A challenge we have is that councils do not borrow the complete cost of a project on day one so we must be patient with asset accumulation. We have taken the view that we will not issue a bond with a GSS label and then say we will use the proceeds in the future on a best endeavours basis. We would rather have the assets first and then issue the bonds as this is more transparent and truer to label.
Another challenge we have is that councils do not always identify each of the projects they are financing. What they tend to do instead is take a consolidated approach to their borrowing activities.
We are encouraging councils to change their behaviour and undertake sustainable borrowing from us. We are offering a 5 basis point discount on their borrowing, so we are already giving them a ‘greemium’ to encourage take up.
Finally, our core objective at LGFA is to provide low-cost financing for the sector, which we have done through our issuance strategy of matching government bond maturities and offering a liquid, fungible yield curve for investors. Any GSS bond issuance needs to align with these objectives.
Demand and rates outlook
The market expects the Reserve Bank of New Zealand (RBNZ) to maintain an aggressive tightening path through 2022 and into 2023. While higher yield should support global demand for New Zealand bonds, issuers say the headline cash rate is far from the most important factor.
MARTIN We have seen the proportion of our offshore holdings and the outright dollar volume of them pick up, which is always encouraging and represents good investor diversity for us.
In the past two years, when we have been running more frequent and larger syndications, we have also seen some genuine new investor names. The 2051 bond was an example of this.
One could argue that if the RBNZ undershoots on its OCR [official cash rate] delivery, in theory yields could decline and our bonds rally to the benefit of holders. Investors have told us they also have their eyes on the RBNZ’s LSAP [large-scale asset purchase] programme, specifically on how the next steps are going to be communicated and what they might mean for New Zealand government bond supply.
We have seen new investors and old ones returning after having exited when New Zealand yield went below us treasuries in previous cycles. They are coming back in, as the spread pickup has become attractive.
Davison If LGFA is offering councils a greenium will it be obliged to look for the same when it comes to issue its own GSS bonds?
BUTCHER It would be nice if investors decided to pay up for GSS bonds but it is also about LGFA making a wider contribution to the environment and society through trying to encourage our council borrowers to adapt. I am unsure if a 5 basis point discount on a 15 basis point base lending margin will be financially significant enough to make councils prioritise eligible projects over ineligible ones when it comes to capex delivery choices. But every basis point helps.
This means our GSS loan assets will also have to come from councils embracing some of the nonfinancial benefits associated with financing projects through our programme as well as the modest financial benefit.
Davison What does the potential arrival of NZDM and LGFA mean for New Zealand issuers that are already active in the GSS space?
JOHN I think it is great news that NZDM and LGFA are seeking to issue GSS bonds. We always hear investors say there are not enough green and social assets so hopefully this will help generate the assets needed. I think anything we as a collective can do to get investors interested in green and social products in New Zealand is a good thing.
The other point is that the four of us – the main local high-grade issuers – all looking at GSS products further opens the way for corporate borrowers to move in the same direction. It gives the sense that GSS products are going to be mainstream rather than on the periphery.
We have NZ$32 billion of capital investment over the next 10 years, according to our long-term plan. A large part of it should be in sustainable products and projects, so there are plenty of assets to come through the pipeline.
BLIGH The entry of LGFA and NZDM is a fantastic outcome, given the size of their programmes and their respective investor bases. We believe the key investor priority is liquidity, but after that it is product offering. Being able to offer a different product in a different format widens the appeal.
Given the green format provides greater optics, more issuance may help reduce the barriers for accounts that do not yet have a New Zealand dollar mandate. If they are looking at the likes of NZDM issuing in GSS format, we can piggyback on to that by offering sovereign-equivalent credit risk with extra yield. It is also positive to hear discussions about NZGBs being included in the world bond index.
Davison How are Auckland Council and Kāinga Ora – Homes and Communities tracking on the GSS asset side?
JOHN The challenge is from a practical and operational sense: being able to collect the data. So far, we have focused on the low-hanging fruit such as electric trains, cycleways, green buildings and water assets. The hard part is trying to identify, monitor and report on the other assets we are investing in and their contribution toward adapting to or mitigating climate change.
BLIGH The market is really moving beyond financial outcomes, because corporate and government strategy is increasingly focused on social and environmental outcomes. But it involves a shift in thinking, which is tricky. Issuers need buy-in from a corporate strategy perspective, starting from the top down.
There has to be clear, robust reporting. It is one thing to have a framework and policy that sets parameters but it takes an investment of time to make all the connections. This is critical if financing is to achieve an outcome or impact under use of proceeds.
The criteria are even stricter for sustainably-linked product. The sooner there is buy-in further up in an organisation or agency the better – then it becomes part of the DNA and becomes easier to manifest.
We have used GSS issuance as it naturally aligns with our outcomes as a government agency. We are continuing to show a leadership lens on this – we are not going to sit on a use-of-proceeds product just because it is what we have used to far. On the other hand, we have to know we have the systems in place to support the reporting involved in moving to a sustainability-linked structure.
“At most times, we issue into short, medium and long bonds and do not generally turn off the tap just because the pricing is not quite in our favour at any particular point in time. We may tweak, at the margin, toward the longer or shorter end but offering presence in the market to different investor types is important.”
Davison Are investors aligned with what Kāinga Ora is providing? How has the investor side evolved over time?
BLIGH It remains a developing space. With our offshore engagement, investors are more focused on our ESG credentials and the questions are a little more nuanced and detailed. They want to know, with some precision, what our carbon footprint is. Domestically, the enquiries are more anecdotal – although they are becoming more focused.
It comes back to the element of how transparent we are able to be with our reporting. We have really worked on this over the past couple of years. We have the collateral to provide detail in conversations about GSS, so it becomes less of a barrier. This will evolve – it must evolve – because it is what the market is demanding from issuers.
JOHN We produce a lot of material about what we are doing in the climate space. We developed Te Taruke-a-Tawhiri: Auckland’s Climate Plan in the past year, we adopted TCFD [Task-force on Climate-related Financial Disclosures] reporting and we have produced our third green-bond annual report. It is an evolving space.
We are finding that investors now have typically invested a lot more resource into their sustainability teams so they are skilled to do the analysis and drill down into the details. We cannot just have a broad-brush approach and we must be quite specific at times when it comes to discussing our sustainability outcomes and approach.
When we issued our first green bond, four years ago, I do not think there were mandates for sustainable debt investment in New Zealand. Now, most fund managers will have mandates and responsible investment policies. The space has evolved substantially.
The challenge all issuers face is that the regulations, taxonomies and standards are changing as well. However, everyone in the space realises there is a lot more water to flow under this bridge so they are typically quite accommodating and understanding as we progress in the area of sustainable and green financing.
BLIGH It is important to be authentic. No-one is going to be fooled by issuance in a format that does not agree with corporate strategy and the direction the issuer is going.
BUTCHER We have seen a pick-up in investor engagement though it is only modest. I think this is because investors understand that local-government sector activities mainly fall within GSS groupings anyway and Auckland Council has done a good job on highlighting sustainability within the sector. Investors also understand the challenges we are overcoming in issuing GSS bonds.
The bottom line is that we have not seen investors turned off LGFA because we do not have a GSS bond product to offer them. This is fine, but we are committed to making the journey as quickly as we can subject to the constraints we are facing even so.
MARTIN We encountered a growing number of investors asking if the New Zealand sovereign was going to issue in GSS format well before we announced anything. Separately, we have also had many investors asking us about environmental- or policy-related factors, as part of our generic conversations.
Another thing I have seen, though it is not widespread yet, is investors with quite specific criteria that issuers need to meet. Even if a sovereign generally appears to be well-rated on GSS metrics, if there is a specific policy the government has not signed up to it can find itself inadvertently excluded from portfolios.
Davison Is the critical sustainability question for sovereign borrowers when national sustainability strategy will start influencing cost of funds across the curve? In this context, is NZDM working on the assumption that, in time, sovereigns will end up paying more for funds if they are not hitting a standard of investor expectation?
MARTIN It may be impossible ever to prove this given the multitude of influences on funding costs. However, the direction seems to be that conversations on sustainability will infiltrate all investor engagements with sovereign issuers and not just in relation to labelled product.
HIGH-GRADE ISSUERS YEARBOOK 2022
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