Spreads suggest conditions are still not optimal, however. “Before the pandemic the bid-offer in NZGBs was typically about 2-3 basis points, whereas is it now about 4-5 basis points,” Cox explains. “When we put up a trade nowadays, there can be a large difference between the lowest and highest bidder and dealers are less willing to take positions they don’t want.”

Lower liquidity than before the pandemic is not unique to New Zealand, Cox continues. But the realities of the local market accentuate the challenges. For example, Cox notes: “We trade Australian sovereign bonds, too, and I have noticed a lot more risktaking from dealer desks in Australia. This is partly because we are a lot smaller in Australian dollars compared with our Kiwi book. But the reality is that in Australian market we get electronic pricing back almost instantaneously and it is always very tight. This is not the case when trading NZGBs.”

Less liquidity can mean more volatility – which means the New Zealand market can carry heightened risk and opportunity. Fergus McDonald, head of bonds and currency at Nikko Asset Management in Auckland, says it is typical for the New Zealand market to experience more dramatic price movements than larger markets. “Global investors are not typically mandated to hold NZGBs – it is a tiny portion of global indices,” he comments. “This means that when markets are volatile and big events are
happening, investors go back to basics – which generally means a  neutral bias and not running much risk. New Zealand is a small market and can move more aggressively during risk-on and risk-off events.”

On the other hand, current market conditions include robust and resilient support for the New Zealand sovereign curve. McDonald tells KangaNews: “Syndications have been very well supported, which I think is an indicator that, at the right level, NZGBs are attractive assets. Even though New Zealand appears to be going into an economic slowdown, it is still viewed as a favourable credit globally. I believe there will continue to be significant interest for NZGBs at the right levels.”

Liquidity overall is best described as a work in progress in the New Zealand high-grade sector: on a general upward trend as the size of bond outstandings increases and more investors come in, but still reflective of a small market in global terms. These realities are perhaps particularly noticeable in the sovereign green-bond space (see box).

In the near term, policy intervention and its impact on capital markets is top of mind for participants. The RBNZ’s liquidity policy review (LPR) is the chief concern, but the more recent announcement that the reserve bank is also considering eligibility changes for its exchange settlement accounts also have led some market participants to brace for less constructive issuance conditions ahead.

The LPR outcome is not finalised but there are fears that whatever decision is made could narrow issuance diversity and, by default, liquidity. For example, Cox says there is a fear the review outcome could push bank issuance offshore, which could further reduce the pool of high-quality credit in New Zealand.

In a market with a small domestic high-grade sector – other than the sovereign, New Zealand Local Government Funding Agency (LGFA) and Auckland Council are the only government sector issuers with substantial programmes – a review outcome that makes bank or high-grade Kauri issuance uneconomical could be problematic for the market as a whole. There is even some doubt about the treatment LGFA bonds will get in the forthcoming liquid assets regime.

Market participants have reason to believe this uncertainty is already affecting general market liquidity, while the best-case scenario is only a return to previous norms. McDonald says: “It will either get worse or it will stay the same. It is hard to see how the LPR could be better for liquidity.”

Cox says the impact of the LPR may not be exclusively negative, though at present the path is unclear. “The review is affecting the market enormously,” he confirms. “Everyone is speculating what will be level one or two HQLAs [high-quality liquid assets], as well as what might be allowed in a CLF [committed liquidity facility], what fee it will charge and what haircut it will require. For NZGBs specifically, the review could actually improve liquidity – this asset class will certainly be the main beneficiary. But it is too soon to predict if this will happen.”

The positive story for the New Zealand market is that spreads should continue to be underpinned by the ongoing reality of an imbalance between demand and supply. While market participants are hopeful of a pragmatic, market-sensitive outcome to the LPR, the reality is that local funds under management continue to grow while there is no obvious solution to the shortage of high-quality domestic supply.

Cox suggests KiwiSaver growth is likely to force New Zealand investors to spread their nets wider. “As KiwiSaver grows, there will eventually be crowding-out effects. The New Zealand market is not growing as quickly as KiwiSaver balances. Eventually, KiwiSaver will be pushed more and more offshore.”

McDonald adds: “A lot of New Zealand investors, including ourselves to a limited degree, will look at local issuers borrowing in offshore currencies, or there could be a trend toward New Zealand bond funds buying Australian dollar assets. This would increase the investable universe of funds as well. There are multiple moving parts to this issue.”