New Zealand's high-grade sector close up

What we are seeing is a correction in a gradual upward trend as opposed to a long-term turning point, which isn’t a particularly daring call when you look at a chart over 100 years and observe that Treasuries are still emerging from historic low yields.

The outlook for the New Zealand economy appears to be more in sync with global peers, particularly when you think back to recent years when we had idiosyncratic boosts such as the Christchurch rebuild and rapid growth in net inward migration which drove domestic demand.

With leading indicators pointing to a softer growth outlook it’s easy to side with the view that the risk of inflation getting ahead of us, and thus the requirement for rate increases any time soon, is even more unlikely now than it has been in recent times. In saying this, I’m not convinced of the need for cuts if the economy is growing close enough to potential. Inflation looks to be low, stable and sticky and I don’t see additional monetary-policy stimulus shifting this any time soon.

When we look at New Zealand Treasury forecasts for the official cash rate, we have pushed back the potential for the first hike into 2020. Although some analysts are calling for the next move to be a cut, our team doesn’t see the evidence for this and still expects a hike.

New Zealand fundamentals certainly support low interest rates: inflation is low, growth is ‘okay’ and not threatening inflation, and we have a central bank that is very happy to let the currency do some of the work. I wouldn’t say this is a turning point as such – I think we are still kicking along the bottom of interest-rate settings.

I have been expecting interest rates to rise every year for the past five and global equity markets to slow for the past three – and they haven’t. It seems like all asset markets are moving into a new era of low interest rates and we have slightly higher valuations in other asset classes as a result.

Investors continue to be attracted to New Zealand’s strong fiscal outlook, the good institutional backdrop and steady but contained bond supply. Having said this, we can’t deny the fact that the proportion of offshore holdings of New Zealand government bonds (NZGBs) continued to decline last year and is now at the lower end of the range of the past decade, at roughly 50 per cent.

There are idiosyncrasies in specific bonds. We saw offshore holdings of shorter-dated bonds – the 2019, which is the line we are repurchasing, and the 2021 – decreasing. However, offshore holdings have increased in each of the on-the-run bonds – the 2025s, 2029s, 2037s and the 2040 inflation-linked bond we have been issuing into over the past year.

Our investor base has been predominantly bank balance sheets so far. But we expect the depth and breadth of our investor base to grow over time. We have seen some interest from KiwiSaver accounts and a lot of them have already carried out credit work.

Mark Butcher made some comments at this roundtable last year around how important it is for local funds in particular to have liquid lines across the curve. This is something we will work on through taps as our bonds roll down the curve.

Investor feedback is they have appetite for Auckland Council debt. The fact that they have visibility of the pipeline is helpful, although they are conscious that delivery can sometimes be an issue.

This is higher than in previous years, largely because the last remaining councils are joining the LGFA. Our market share is now around 85 per cent of all council borrowing. Councils have also been able to deliver capex closer to their plans than has been the case historically, necessitating a higher level of borrowing and refinancing existing debt.

Given the additional supply of LGFA bonds, our spreads did not compress as much to NZGBs towards the back end of the curve last year. We also issued a 2033 maturity.

We expect slightly higher-than-normal annual issuance volume to continue and we’re working on the projections now. There are still some unknowns – including around how much infrastructure will be funded directly from councils’ own balance sheets. But taking longer-term council borrowing plans into account, our annual issuance is likely to be close to NZ$1.4-1.6 billion.

Our short-dated lending to councils and our short-term bills issuance are at record levels. We have lent more than NZ$500 million to councils in the front end of the curve and short-term bills on issue are also close to NZ$500 million. We are pleased with how the market has handled the increase in short-term issuance as well as the additional long-term bond supply.

It is worth mentioning that the additional borrowing includes the whole sector – not just across the ‘golden triangle’ of Auckland, Waikato and the Bay of Plenty regions.

We are probably the only issuer other than the sovereign that regularly tenders bonds – every 5-6 weeks. We are relatively flexible in our issuance strategy and will issue in the part of the curve where there is demand.

But our view is that tender issuance is becoming harder. We try to offer three or four maturities at each tender but some of the recent tender results have been inconsistent. We might not get enough bids in an individual maturity in some tenders and our bid-offer ratios are broadly lower, too. This probably shows that breadth of demand is lower and overall demand is less consistent than in previous years.

Some recent tenders have printed at prevailing secondary mid-levels and in others we might be 2-5 basis points wider. We will try to be accommodative and not truncate results – we would rather reward banks for participating in tenders, so if there is a slightly longer tail we tend to accept that tail on a tranche to reward participation.

It has certainly been harder over the past year from an issuer perspective. But the previous five years were a very conducive borrowing environment. Market conditions go through cycles and right now the environment is slightly more difficult, so we may need to start considering alternative mechanisms.

The other consideration is that we are a funding conduit for councils that want to minimise their borrowing costs. They aren’t compelled to borrow through the LGFA. If we were to start issuing more expensive foreign-currency bonds and tried to pass these costs through to our borrowers, they would issue in the domestic market in their own names.

The bulk of our funding was issued via tender but we did complete one syndication in March. We had delayed this from late 2017, partly to allow investors to receive full information including the first half-year economic update from the new government.

We also changed our issuance strategy by offering a shorter-dated bond, as mentioned earlier, off the back of feedback from our banks and in response to investor demand.

One interesting point is that offshore investors increased their holdings of LGFA bonds in 2018 – though admittedly only by around NZ$200 million year-on-year. Nevertheless, as an overall percentage their holdings shrank because they didn’t keep pace with our level of issuance.

Our strategy is to find investors that have existing New Zealand dollar investments and convince them to switch into LGFA bonds. We generally find that our investors don’t come into the LGFA curve first – they will be holding some NZGBs or other New Zealand dollar bonds before making the switch.

In 2018, we provided investors with a new research piece called the New Zealand Government Securities Funding Strategy. The purpose of this is to be as transparent as possible around our funding strategy, so even those investors we can’t meet face-to-face can have the information they need about us.

This is consistent with what we saw through our bond syndications. Our first syndication, which was our debut dual-tranche deal, admittedly was in the ‘right’ part of the curve. We targeted the maturities where we’d expect to see most demand. We were very happy with how this transaction played out, including achieving around 12 per cent offshore participation.

When we returned to market for the curve extension in October, we got the sense that investor interest for New Zealand dollar product in general had waned somewhat. We didn’t see a material increase in new investor names and there was only a marginal uptick in offshore-investor interest. I think we would have seen more if conditions had remained the same or strengthened.

Offshore demand for Kauri transactions didn’t appear to be as robust in the second half of 2018 as it was in the first, and our experience in the market was consistent with this.

The LGFA’s level of offshore holdings, at around 40 per cent, is a good example of where Housing NZ might ultimately like to be. This will depend on the eventual funding need but at the very least we hope offshore demand will continue to rise.

There are buyers and sellers. Not every offshore investor that was there at the end of 2018 had been there since the end of 2017. We saw some holders exit, partly for currency reasons or spread to US Treasuries – these were predominantly from North America. We saw others that continued to add to their holdings, putting money to work as they received proceeds from other New Zealand dollar maturities and coupons.

For the last four or five years the story has consistently been either that existing investors keep adding to their holdings or we build our investor base. Last year was a little different, in the sense that we didn’t get a whole lot of new investors coming in while some exited. The net effect was an increased nominal volume of holdings but not an increase in percentage terms.

As part of their long-term plans the councils forecast an average interest cost for the next 10 years, and most have been forecasting a reduction in this cost. A couple of years ago the assumed cost of borrowing was around 5 per cent, but now most councils are forecasting a borrowing cost at least 50 basis points lower.

We think the timing helped. The global backdrop was relatively stable in March and investors had enough information about the new government so were able to get comfortable around fiscal responsibility and strategy. They also took comfort from the new government’s reiteration of its commitment to maintain a minimum level of NZGBs on issue, equivalent to 20 per cent of GDP.

On the asset side, many of the investments we make can qualify as green. We have assets like water and public transport with considerable environmental impact. We chose electric trains for the first deal as these assets fit the criteria and can be ringfenced. We thought this approach would be prudent as this was our first green-bond issue. We chose to seek independent verification from EY and certification from Climate Bonds Initiative.

We went to market in June 2018. The feedback was tremendous and investors were very supportive. As a result, we got the transaction away at a tighter price than our secondary levels at the time. We also saw some new investors to Auckland Council bonds coming into the book.

The message we heard loud and clear from the domestic market was that there is insufficient green product to meet investor demand. At least part of what we wanted to achieve was to develop the market by supplying some product and generating interest in green bonds.

We know the cost of green-bond issuance, but the financial benefits remain uncertain. Given LGFA is already a funding conduit, we would have to add a second layer of certification – and cost – onto our loans to council borrowers. I also don’t see much evidence to date of an issuer being able to lengthen duration via green bonds. Finally, it is unlikely the pricing we could achieve would be a significant improvement on our current cost of borrowing.

LGFA will move quickly into the green space if we see a compelling reason to do so. It is a financial decision about delivering the best outcome for our council borrowers. For now, we don’t feel a green bond will deliver this.

I think green bonds haven’t taken off in New Zealand because we are a small capital market lacking significant scale. There are not many issuers, very few have sizeable funding programmes and we don’t have notable sector diversity.

Most corporate issuers in New Zealand that could issue green bonds are already issuing at relatively low funding cost so there are few economic incentives for issuers.

We have provided advice to the government on the merits of green bonds as part of the core Crown funding portfolio. We have split this into two issues: the pure economics of debt issuance as measured against our traditional mandate of funding the government at low cost over the long term with due consideration for risk, and the wider benefits green-bond issuance can provide.

Against the traditional mandate there are several factors that require careful consideration, including the additional costs of issuance – for example the cost of setup and monitoring. Investor diversification and the impacts on liquidity of existing NZGBs are also of interest. The differential isn’t enough, purely from a pricing perspective, to convince us either way.

Having said this, there is a real question about whether government issuance of green bonds would provide environmental and signalling benefits and crowd private-sector capital into environmental projects. This judgement will be made by the government, but it is one we will continue to assess and provide advice on. At this stage, though, green bonds do not form part of our issuance strategy.

But it is hard not to take notice when we see New South Wales Treasury Corporation’s A$1.8 billion (US$1.3 billion) green bond and Auckland Council’s entry to the New Zealand green-bond market, so we are having another look at this now.

Housing NZ has recently developed an environment strategy which aims to reduce the impact of our operations, our build programme and our assets on the natural environment. It’s an interesting area for us to be exploring.

Electric trains are a great example of an asset that could have been financed by other means than green bonds. I don’t think the availability of green bonds provides financing that wasn’t already available – these were likely already in Auckland Council’s long-term plan and would have been funded one way or another. They just happened to be suitable for a green label.

The challenge we have is that, much as they like the concept, investors in New Zealand still have a price point where they are comfortable. We landed at a level where we were comfortable with diversification and price.