Monday, December 3, 2007

Bond market illiquidity hits eurozone

From the FT this morning:

A severe bout of illiquidity has hit eurozone government bonds, threatening to impair the ability of some governments and other borrowers to meet their funding needs in coming months, according to market specialists.

The development is striking because it underlines the degree to which problems in the US subprime mortgage market is spilling over into seemingly unrelated sectors, including traditionally safe government bond markets in the single currency region.

In recent weeks, risk premiums on eurozone government bonds, except those of Germany – which is the largest and most liquid market in the region – have been rising.

“European government bond markets are facing challenges they haven’t done for decades,” said Steven Major, head of fixed-income strategy at HSBC. “We are seeing a repricing of risk and a level of illiquidity we haven’t seen for a long time.”

Tensions in the secondary markets are also being fuelled by the “turn of the year” effect, which make banks increasingly reluctant to lend to each other in maturities extending beyond the end of any given year.

But analysts say the year-end effect should have dissipated by now if markets were behaving more normally. “People have generally been complacent because they thought that risk aversion might have gone away by now but risk premiums are only getting higher and so is risk aversion,” said Mr Major.

The situation could become problematic for governments in the eurozone, as well as a swathe of other issuers from the region, including supra-national and quasi-government agencies, which have traditionally tended to issue a large proportion of their debt at the start of the calendar year – unlike in the US and the UK.

“There is a massive surge in funding in January and if things do not get back to a reasonable sense of normality by then, there could be some difficulties raising funds,” said Ciaran O’Hagan, strategist at Société Générale. He estimates that eurozone governments alone could issue a gross €570bn ($885bn, £405bn) next year, with more than €70bn likely to come in January.

One European sovereign debt management official said: “It will be very difficult in the new year to conduct all the new issue activities, especially for corporates but for some sovereigns as well. There are so many standing in line and waiting.”

Some analysts say the huge proportion of the year’s redemptions, which also come early in the year, will help absorb new supply.

“I doubt that governments will have trouble raising money,” said Marc Ostwald, strategist at Insinger de Beaufort. “But they may be fretting about a potential sharp upward adjustment in the yields they need to pay to sell their debt.”

Indeed, even in the US Treasury market, the spread between buy and sell prices for securities issued by the Treasury before the current quarter has become a lot wider than normal. “Traders and banks are in risk-reduction mode,” said Tom di Galoma, head of Treasury trading at Jefferies.

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