As regulatory-driven investment forces a more passive investor base into the bund market, the Eurosystem will become the single biggest holder of bunds by the end of this year, predicts HSBC. Bert Lourenco points out in his July 12 research piece titled “Bunds-hostage to the ECB” that as long as QE persists and trading volumes and yields fall, signs of stress in the bund market will likely worsen.

Demand for bunds from German pension sector to persist

Lourenco believes that following the 2008 crisis, monetary policy has continued to push down on all forms of premia, and although bond returns have been very healthy, the ability for smaller or leveraged investors to participate in the markets has been impaired, effectively changing the markets’ structure towards a buy and hold focus. Highlighting the unique nature of the bund market, the analyst points out that unlike in the case of other issuers, Germany’s fiscal surplus suggests there will be fewer bunds available for German pools of savings and the broader set of investors that use bunds for duration management purposes. The analyst notes that from a domestic perspective, 15% of bunds are owned by German pension funds:

German pension funds

Citing EIOPA’s Financial Stability Report from May 2015, Lourenco points out that the German insurance industry is having the biggest duration mismatch within all EU nations as liabilities average 20 years, while assets only average 10 years. Hence, the HSBC analyst argues that demand for bunds from the German pension and insurance sector is likely to remain strong, but a consequence is that these bonds may be held to maturity due to the investment purpose.

Though Bundesbank highlights that the single biggest private sector owners of bunds are German banks, the HSBC analyst believes this trend will change as the ECB perseveres with its PSPP. Lourenco points out that the Basel capital requirements as part of the Capital Requirements Directive (CRD) also accentuated German banks’ accumulation of bunds to increase rapidly from 2013-15 due to a doubling of HQLA retention requirements:

Bund purchases by banks Bunds, Eurosystem, HSBC

Bunds’ benchmark status could be challenged

The HSBC analyst believes the overwhelming pressure to hold bunds under passive investors’ mandates should act as a drain on market turnover rates, as they are far less active in the secondary markets. The analyst argues that Germany’s negative net issuance and aggressive Bundesbank purchases are set to continue until at least March 2017. He believes that conducting QE, while reducing bond supply, by aiming for persistent fiscal surpluses is not consistent with a well-functioning market.

Lourenco believes that with less market turnover, bund market liquidity will continue to deteriorate, leading to bigger gap risks for market participants trying to manage and hedge their duration exposure. He adds that these developments will call into question the viability of using bunds as a benchmark market. The HSBC analyst believes France’s bond market, which is almost twice the size of the bund market, may be a better alternative as it has active futures contracts at the five-year and 10-year maturity points, well-established nominal and linker curves, and a transparent issuance program from the AFT.

The HSBC analyst notes that the key attributes of benchmark markets are efficiency, liquidity, depth, and ease of execution, including hedging. He believes that as these characteristics of the bund market are disappearing quickly as QE progresses and in the absence of supply, OATs may be a better alternative.