OECD Sovereign Borrowing Outlook 2019

Chapter 2. Understanding investor demand for government securities

The investor base for government securities has evolved significantly over time. Today, a wide range of individual and institutional investors buy and sell government bonds and bills with different motivations. In addition, new technologies in finance have had substantial implications for primary and secondary government debt markets. This chapter looks at the evolving structure of the investor base in addition to the role of investor base information in public debt management.

Sovereign issuers have a strong interest in observing and assessing the investor base in terms of changing needs and behaviours. This is critical to enable debt managers to draw up more informed issuance strategies and to adjust investor relations and communication practice. Against the backdrop of ever-changing conditions in the investor landscape, sovereign debt managers strive to enhance the information on the investor base, as well as engage with them on a continuous basis to understand their prevailing concerns/interests. Accordingly, they adapt how they communicate, what they sell, and the way they sell through innovation and re-organization.

2.1. Introduction

The changing profile of the investor base is having a major impact on the functioning of sovereign debt markets. Today, sovereign debt management offices function in a more demanding and more volatile investor landscape. This new environment requires closer monitoring of market, a diligent communication strategy with investors and greater transparency of debt management in terms of debt statistics, long-term strategies and short-term funding plans.

Against this backdrop, this chapter discusses relevance of the investor base for sovereign debt management, access to the investor base information, current and potential changes in investor base as well as implications of these developments for issuance and communication strategies.

Key findings

• The primary objective of sovereign debt management, which is financing government borrowing needs at the lowest cost, taking into account risk, can only be achieved by encouraging the development of a liquid and efficient government securities markets, and diversifying the investor base.

• Decisions on the composition of debt issuance methods are informed by an assessment of investor demand for debt instruments by maturity and type. Issuance methods (e.g. syndications, auctions or direct sales) are also adapted based on target investor base.

• The last decade was a period of significant shifts in the investor base as well as investor behaviour, partly due to quantitative easing programmes and regulatory changes. Widespread adoption of new financial technologies are also having an influence on the trading behaviour.

• A majority of OECD countries receive broad information on foreign non-bank investor categories, under which foreign investors with significantly different investment mandates are reported together. In order to make informed decisions on issuance plans, sovereign issuers need more granular and timely investor base data, particularly concerning the subsectors of foreign investors.

• Continued funding challenges in the post-crisis environment have led to a situation where a broad and diverse investor base is more essential than before to support liquidity, depth and stability in government securities markets.

• For countries with a concentrated investor base, the challenge is to diversify the investor base in order to be prepared for a potential structural change in the ownership of government securities. For countries with limited government funding needs, the challenge is to address investors’ concerns over long-term viability of government securities markets.

• Against this investor landscape, sovereign issuers would benefit from frequent and consistent dialog with investors. Investor relation programmes should cover potential investors as well as existing investor base. In addition, there is a need for re-engaging with their traditional investor base, such as pension funds and insurance companies, and putting emphasis on geographical diversification.

2.2. Relevance of investor base for sovereign debt management

Throughout the centuries, the use of government securities has grown exponentially, with both issuers and investors using these securities for various reasons. The early examples of government debt indicate that governments issued bonds only for financing budget deficits (particularly for funding wars) and to a limited number of local investors.1 In modern financial markets, government securities have a wider set of roles and a broadened investor base.

They serve as a saving instrument for individuals and institutional investors, an investment instrument for central banks, a risk management instrument for companies, a collateral to secure to financial transactions, and a benchmark for pricing of other debt instruments. For example, pension funds and insurance companies invest in long-term government bonds to meet their future liabilities. Central banks use government bonds for quantitative monetary policy purposes along with reserve management. Another phenomenon observed in recent years is the increasing number of investors committed to integration of environmental, social, and governance (ESG) factors, catalysing allocation of capital to green bond markets.

Investors' preferences for specific bonds have influence on issuance and communication strategies. For example, the trend of growing ESG-sensitive investors has encouraged sovereign issuers to consider issuing green bonds and adjust their communication strategies. Similarly, demand of pension funds for long-dated indexed and fixed securities is an important factor prompting issuance choices. According to the preferred-habitat view proposed by John Culbertson (1957) and Franco Modigliani and Richard Sutch (1966), there are investors with preferences for specific maturities, and the interest rate for a given maturity is influenced by the demand of the corresponding investors and the supply of bonds with that maturity. That said, a higher demand of pension funds would be expected to raise prices of long-term bonds and thus lower long-term interest rates.

In addition to changes in investor base, new technologies in finance have had substantial implications for primary and secondary government debt markets in the last few decades.2 For example, new electronic systems in primary markets play an important role by making it easier for retail investors as well as institutions to bid directly in auctions. In the secondary markets, automated trading systems have improved order entry speed at a lower cost and helped market makers to maintain tight yield spreads and consistent prices for closely related assets, which in turn supports market liquidity. However, algorithms-based trading may also cause less heterogeneous behaviour, leading to greater volatility. In this regard, investor data is important to be able to assess the influence of one single investor or a group of investors or the dependence on those investors in government securities markets.

If the investor base is diverse and includes different types of investors from different geographic regions, the behaviour of any subset will have a diminished effect. Credit rating agencies also consider a broad and diversified investor base as a credit supportive feature (Moody’s, 2018). For instance, when foreign investor demand reverses, provided that banking sector is able to absorb additional buying of securities, negative impact of a sell-off would be limited. Similarly, domestic institutional investors can act as a buffer absorbing part of the excess of supply of medium-long term paper when foreign investors sell off. Therefore, a stable and diversified investor base can facilitate the absorption of volatile capital flows and mitigate the pressure on refinancing in times of stress. Nevertheless, it should be noted that there is no generally accepted definition of a diversified investor base.

From the issuers’ perspective, a reliable and broadly diversified investor base is critical as it supports liquidity, depth and stability in government securities markets. Today, government debt is not only issued for financing deficits, but also to meet investors’ needs for a risk-free asset and as part of a broader strategy to develop local bond markets.3 Indeed, since the 1990s it has been widely recognized that the primary objective of sovereign debt management, financing government borrowing needs at the lowest cost, taking into account risk, can only be achieved by encouraging the development of a liquid and efficient government securities markets, diversifying the investor base, and meeting the principles of openness, transparency and predictability. Against this backdrop, sovereign debt managers have adapted what they sell, and the way they sell to the ever-changing conditions in government securities market through innovation and re-organization. Clearly, understanding the changes in investor demand for government securities is a key element of this progression. Changes in investor demand have an influence on a wide range of sovereign debt management issues from issuance strategy to transparency and communication practices.

An issuance strategy can include different maturity and interest-rate combinations of existing instruments as well as new financing instruments. When setting issuance strategies, sovereign issuers consider investor demand for a wide range of funding instruments (e.g various types of loans, bonds, bills and commercial papers). The 2018 survey of the OECD Working Party on Debt Management (WPDM) on primary market developments mirrors this situation. Specifically, when setting issuance strategies, 33 out of 34 participant countries take investor base information into account from a small extent to a very large extent. The survey shows that investor base information is important for sovereign debt managers to implement more informed issuance strategies.

Figure 2.1. Influence of the investor base knowledge on issuance strategy

Source: 2018 Survey on primary market developments by the OECD Working Party on Debt Management.

In order to diversify the investor base, sovereign issuers focus on attracting investors with different mandates and investment horizons through issuance strategies and investor relations policies. In most cases, maturity composition of the debt issuance is determined in consideration of market needs and trends. In terms of maturity choices, overall central banks prefer short-dated securities for reserve management purposes, while institutional investors such as insurance companies and pension funds invest in long-term bonds to match the maturity of their liabilities. For example, sustained strong demand from pension funds for long-term assets is one of the driving factors of long maturity bond issuance in the UK.4 Similarly, life insurance companies in Japan are the major investors for super long-term Japanese government bonds (JGBs).5

Investors demand transparency and clarity in debt management operations and plans. When investors understand better how and why decisions about changes in funding and debt management are made, uncertainty may be reduced, leading, in turn, to lower borrowing costs. On the subject of providing clarity to the market about future debt policies, sovereign issuers in favour of transparency and predictability in general since the long-run benefits of predictability outweigh the disadvantages (e.g. losing flexibility).

Accessing investor base information is a prerequisite for monitoring the investor base, information-based strategy-making, as well as for building and maintaining relations with current and potential investors. With this in mind, the next part of this chapter discusses debt management offices’ (DMOs) access to quantitative and qualitative information on investor profile and preferences.

2.3. Access to investor base information

A majority of OECD area issuers have regular access to investor base information (Figure 2.2). Usually, the data is more granular for domestic investor groups than for foreign investors. Typically, holdings of primary dealers, domestic pension funds and insurance companies and national central banks are regularly collected, and other local financial institution holdings are calculated as a residual. On the other hand, non-resident investors are often broken down into three sub-sectors: central banks, banks and non-bank financial institutions. It means that the foreign non-bank category is composed of a wide range of investor groups including hedge funds, asset managers, insurance companies and pension funds from different regions. Clearly, each of these investor groups has significantly different investment mandates, which in turn lead to different trading behaviours.

Figure 2.2. DMOs access to investor base information

Source: 2018 Survey on primary market developments by the OECD Working Party on Debt Management.

Given the fact that the structure of the domestic and foreign investor base is an important element for the types of products offered by the issuer, many DMOs point to lack of detailed information. Specifically, 16 out of 34 respondents to the 2018 survey on primary market developments highlighted a need for more granular data on the investor base (Figure 2.2). During its 2018 annual meeting, members of the OECD Working Party on Debt Management (WPDM) elaborated on the availability of investor base information and the need for more granular data, particularly concerning the foreign investors category. Sovereign debt managers highlighted that more detailed information on the investor base would be desirable for answering a set of key questions including the following: i) is there a strong concentration or strong diversification of investor base?; ii) whom to sell a new security?; iii) whom to visit on road-shows?; iv) to what extent is the sovereign vulnerable to sudden investor outflows?; and v) how to structure the issuance plan for the upcoming year?. It was also stressed that the aim is not to act like a regulator, but purely to allow informed issuance strategies and to assess longer-term trends.

For domestic investor base, registry information is the primary source of information with intermediaries (e.g. Primary dealers) providing a secondary source of information. It is a common practice amongst the OECD countries that primary dealers are often obliged to report on their trading activities, as well as on their observation of investor demand. In terms of coverage and period of such reporting, country experiences vary across the OECD area. In many countries, primary dealers prepare monthly reports on their activities, in addition to ad hoc research or surveys requested by the DMOs. Primary dealers in euro area report to DMOs within Harmonized Reporting Format (HRF). In a few cases (e.g. Ireland and the United Kingdom), DMOs receive primary dealers’ position at the end of each business day, which reveals the relevant information such as PDs’ appetite for different bonds, and for how long PDs keep bonds on their books following each auction.

The geographical diversification of the investor base over the last few decades led to an important shift in the holders of government securities from local CSD (central securities depository) to international CSDs. Sovereign debt managers often cite the IMF, ECB and BIS as the primary data source for foreign investor holdings.6 It should be noted that efforts to collect consistent and timely investor data by international institutions have increased in recent years. For example, the ECB introduced ‘Security Holdings Statistics’ in 2014, in response to the need for granular information on holdings of individual securities. In addition, the IMF’s sovereign investor datasets for advanced economies and emerging markets are regarded as welcome developments. Despite the recent progress, sovereign issuers highlight incomplete coverage of holdings, delays in publishing and granularity of categories as the main shortcomings of existing data.

2.4. Current and potential changes in investor base

The survey results show that a large majority of DMOs have been observing structural changes in the investor base composition in recent years. Major trends draw on issuers’ observations on investor demand across the OECD area presented in Table 2.1, as follows:

• More changes observed in domestic investors demand: The number of countries observing changes in domestic investor demand higher than those with changes in foreign investor demand.

• Greater role of central banks and institutional investors: In terms of central banks and institutional investors, the number of countries observing stronger demand from foreign and domestic markets is more than double those observing lower demand.

• Higher demand from national central banks coincides with lower demand from domestic banks: Many countries that reported higher demand from national central bank also observed lower demand from domestic banks.

Table 2.1. Observations of sovereign issuers on demand changes (by investor groups)

▲higher demand ▼lower demand ⇆ no change	Domestic investor demand				Foreign investor demand
	Banks	Central Banks	Institutional investors	Others	Banks	Central Banks	Institutional investors	Others
Australia	▲	⇆	▲	⇆	⇆	⇆	▲	⇆
Austria	▼	▲	▲	▲	▼	▼	▲	⇆
Belgium	▼	▲	▼	▼	▼	▼	▲	⇆
Canada	▲	▼	▲	⇆	⇆	⇆	▲	⇆
Chile	▲	⇆	▼	⇆	(▲) from foreign investors as a whole
Czech Republic	▲	⇆	▲	⇆	(▼) from foreign investors as a whole
Finland	⇆	▲	▼	⇆	▲	▲	⇆	⇆
France	⇆	▼	▲	⇆	⇆	▲	⇆	⇆
Germany	▼	▲	▲	⇆	▲	▲	▼	⇆
Greece	⇆	⇆	⇆	⇆	▲	▼	▲	⇆
Hungary	▲	⇆	⇆	▲	(▼) from foreign investors as a whole
Iceland	▼		⇆		(⇆) from foreign investors as a whole
Israel	⇆	⇆	▲	▲	⇆	⇆	⇆	⇆
Italy	▼	▲	⇆	▼	▼	⇆	⇆
Japan	▼	▲	⇆	⇆	(▲) from foreign investors as a whole
Latvia	⇆	▲	▼	⇆	⇆	▲	▲	▼
Lithuania	▼	▲	⇆	▼	▼	▲	▼	⇆
Mexico	▲	⇆	▲	▲	▼	⇆	▼	▼
Netherlands	⇆	▲	⇆	⇆	(▼) from foreign investors as a whole
New Zealand	▲	⇆	▲	⇆	⇆	▲	▼	⇆
Norway	▲		▼					▲
Poland	▲			▲	▼	▲	▲	⇆
Portugal	▲	▼	▼	▲	▲	▲	▲	▼
Slovak Republic	▼	▲	⇆		▲	▲	▲	⇆
Slovenia	▲	▲	⇆	⇆	▲	▲	⇆	⇆
Spain	▼	▲	⇆	▼	⇆	▲	▲	▼
Sweden	(▼) from domestic investors as a whole				(▼) from foreign investors as a whole
Switzerland	⇆	⇆	(▼) pension funds (▲) insurance (▲) investment funds	⇆			▲	⇆
Turkey	⇆	⇆	▼	⇆	▼	⇆	▼	▼
United Kingdom	⇆	⇆	▲	⇆	(▼) from foreign investors as a whole
United States	⇆	▼	▲	⇆	(⇆) from foreign investors as a whole

Source: 2018 Survey on primary market developments by the OECD Working Party on Debt Management.

Country responses to the survey indicate that recent changes in investor demand are largely attributable to low yields on government securities, monetary policy actions and post-crisis regulatory changes (Annex A). In addition, developments concerning sovereign credit ratings and cross-currency basis swaps between different markets are noted by a few countries as other factors affecting investor base changes. These developments have different implications for different investment groups. For example, central banks give priority to safety, liquidity and stable long-term holdings and are expected to be less sensitive to interest rate developments. Asset allocations of pension funds and life insurance companies, driven by features of their liability, are sensitive to changes in regulatory frameworks and demographic patterns. Hedge funds, on the other hand, have more freedom to pursue various investment strategies (e.g. relative-value arbitrage). The changing profile of the investor base is having a major impact on the functioning of sovereign debt markets. Moreover, the structure of the domestic and foreign investor base will determine, to a greater extent, the types of products offered by the issuer. Against this backdrop, impacts of various developments on major investor groups are elaborated in the following sections.

Greater role of domestic central banks in government bond markets

In several OECD countries, central bank demand for government securities has substantially increased as an operational consequence of the quantitative easing policy launched by major central banks. Today, government securities holdings of the ECB, BoE, BoJ and the Fed add up to USD 11 trillion (Figure 2.3). As a result, central banks in several countries have become one of the key domestic investors (40 % in Japan, above 20% in Austria, France, Germany and the UK).

Figure 2.3. Government security holdings of selected central banks

Note: Values have been aggregated by using fixed exchange rates, as of 1st December 2009.

Source: ECB, central banks of Japan, United Kingdom and the United States.

Moreover, with the greater role of central banks in government bond markets, maintaining a diversified investor base has become more difficult than before. This huge demand coming from (domestic) central banks is raising questions about its impact on other major holders of government securities. In some cases, including France, Italy, the United Kingdom and the United States, supply of government debt has also increased in the post crisis period. In such cases, absolute holdings of existing investor groups did not have to change significantly. In contrast, countries with diminishing or limited borrowing needs have faced a challenge. For example, in Germany, the ECB has increased its share from 0 to close to 30%, while the amount of outstanding government bonds has changed only very slightly. For the countries with declining borrowing requirements, sustained central bank bond buying programmes result in “crowding out” other investor-groups – mainly foreign investors.

In some cases, higher demand from national central banks coincides with lower demand from domestic banks. In Japan, the share of banks decreased from over 40% in 2008 to 17% in 2018, while BoJ holdings moved from 8% to over 40% over the same period. In addition, the share of households in total debt declined from 4.4% in 2008 to 1.2% in 2018.

Against this background of substantial participation of central banks in government securities market, it can be argued that a shift from unconventional monetary policy may have important implications for investor bases in major OECD countries. In cases where balance sheet normalisation occurs in countries with a concentrated investor base, re-engaging with the traditional investor base is becoming more relevant.

Figure 2.4. Evolution of holdings of government debt: domestic banks versus national central banks

Note: Coverage of debt is general government. For French, German and Italian government debt the central bank is the ECB, for Japanese government debt the central bank is the BoJ, for the UK government debt the central bank is the BoE and for the US government debt the central bank is the Fed.

Source: Arslanalp and Tsuda (2014, updated)

Given that government needs for new debt is substantial, sovereign DMOs should benefit from re-engaging with their traditional investor base, such as pension funds and insurance companies, and putting more emphasis on regional diversification. With rising yields, a higher demand from ‘real money investors’ and foreign investors in search of high-quality assets with positive yields could be anticipated. In particular, the move away from sub-zero yields will be welcomed by the investors with self-imposed investment constraints regarding nominal positive returns. This chapter looks at the evolving structure of the investor base, in addition to the role of investor base information in public debt management.

Changes in foreign investor demand: Tracking the details

The 2018 survey on primary market developments carried out by the OECD WPDM reveals that approximately 60% of government debt is held domestically, with substantial differences across countries (Figure 2.4). Government bonds are held predominantly by domestic investors in some countries (e.g. Israel, Japan, Korea, Iceland and Chile). In contrast, foreign investors are the main holders of debt in another group of countries (e.g. Lithuania, Latvia and Germany). It should be noted that euro area countries have very high percentages of ownership within the euro area.

Figure 2.5. Percentage of bonds held domestically vs. offshore

Note: Where it is known, ECB’s holdings from the PSPP is considered as domestic. OECD average is the median average.

Source: 2018 Survey on liquidity in secondary government bond markets by the OECD Working Party on Debt Management.

In terms of trading behaviour, domestic investors are typically very stable holders of own sovereign debt, as foreign investors are more sensitive to various risk factors (e.g. political and macroeconomic risks). For example, in Canada a sell-off by non-resident investors occurred mainly due to NAFTA negotiations and monetary policy normalisation. However, the overall impact on the market remained limited, since almost 70% of total debt is held by domestic investors (mostly pension funds, domestic banks and insurance companies).

The portion of bonds held by domestic banks is around 20% in some countries (e.g. Australia, Denmark and Italy). Domestic banks are typically stable holders of own sovereign debt with home-biased behaviour. However, an excessively large “home-bias” with a high level of government debt level increases the interdependence between the sovereign and local banks, which undermines domestic financial stability. Rating agencies incorporate this fact into their methodology when analysing sovereign risks. For example, Standard&Poors sees a risk factor if “a large share (typically more than 20%) of the resident banking sector’s balance sheet is exposed to the government sector via loans, government securities, or other claims on the government or its closely held agencies, indicating a limited capacity of the national banking sector to lend more to the government, without possibly crowding out private sector borrowing”.

Foreign investors are of great importance for developing or maintaining liquid local bond markets. In relatively small markets, high demand from non-residents may also have an impact on prices. Peiris (2010) studied 10 emerging markets and found that a 10% increase in the share of non-residents is associated with a 60 basis points lowering of government bond yields. One challenge is understanding the direction of the causality. For example, one might suspect that enhanced macroeconomic fundamentals along with expectations regarding a credit rating upgrade of a country might attract inflows of foreign investors and official reserve managers. Nevertheless, especially when foreigners are a very large share of the total investor base, proper attention needs to be paid to type of foreign investors and the associated risks (e.g. likelihood of a sudden investor outflow). In this regard, rating agencies also consider the share of non-resident as an assessment criterion. For example, Standard&Poors sees a risk factor if non-residents hold consistently more than 60% of government marketable debt.

There are several factors driving non-resident demand for government bonds, including upsurge in the official reserves, flight-to-quality phenomenon, and cross-currency movements. Official reserves held by monetary authorities increased fivefold over the period 2000–2010, reached USD 9.3 trillion in 2010 and gradually increased to USD 11.4 trillion in September 2018 (IMF, COFER database). Central bankers, having traditionally conservative investment strategies with prudential, monetary control and liquidity management purposes, invest in reserve currency bonds. In terms of currency composition, the concentration of foreign reserve holdings in USD assets remains significant. Over the recent decades, while the share of USD holdings declined gradually, the shares of other currency holdings including euro, Chinese renminbi and pounds sterling have increased.7 Research suggests that concerns regarding the fundamental weakness of a currency and rating downgrades prompted key changes to the asset allocation of reserve managers (Morahan and Mulder, 2013).

In the post-crisis environment, demand by non-residents for safe assets picked up despite low yields, reflecting a flight-to-quality phenomenon. Most notably, U.S. Treasuries benefit from flight-to-quality and flight-to-liquidity episodes and attract substantial foreign flows during episodes of increased market turbulence and investor risk aversion. For example, according to Securities Industry and Financial Markets Association (SIFMA) data, share of foreign and international investors group in the US Treasuries, surged from around 40% in 2007 to 44% in 2012. In recent years, the ratio has gradually declined to 36% in 2018.

Non-resident investors are not homogeneous and different investor types may have different effects on the underlying market. According to research based on the historical relationship between changes in investor holdings of sovereign debt and sovereign bond yields, the most variable investor type is foreign non-banks, followed by foreign banks, foreign central banks, domestic non-banks, domestic banks, and the domestic central bank (Arslanalp and Tsuda, 2012). However, investor base studies should be assessed with caution due to insufficient granularity of investor groups. As discussed in a previous section, the ‘foreign non-banks’ heading covers a wide range of investment strategies such as hedge funds, asset managers, insurance and pension funds. Understanding the various data-sets related to foreign participation in government securities markets is important for conducting accurate analysis and interpretation of the data.

In some advanced economies, while overall holdings of foreign investors have not changed significantly, types of foreign investors have changed in the post-crisis period. During the 2018 annual meeting of the OECD Working Party on Debt management, several debt managers provided anecdotal evidence of increased foreign investors’ activity largely driven by hedge funds in local government securities markets, in particular the T-bill market. For example, foreign investors’ share in T-bill markets reached 60% in Japan and 64% in Italy in 2018. Widening cross-currency swaps and quantitative easing environment might be among the factors that explain increased activities of foreign investors, including hedge funds. Ireland, a small issuer that was recently upgraded to investment grade, is highly dependent on foreign investors. Anecdotes indicate that increasing hedge funds activities in Ireland has improved market liquidity in bond markets. However, the lack of more granular investor base data is limiting the analytical test of impact of changes in types of foreign investors demand for different segments of government bond markets. Currently, the majority of the sovereign debt managers, mainly rely on anecdotes, require more granular investor base data in order to better monitor investors’ behaviour and make better assessments. That said, data availability issues create a natural barrier for further analysis.

Factors affecting demand from pension funds and insurance companies

During the last two decades, most OECD countries experienced a dramatic increase in institutional investors. Figure 2.6 illustrates the trend in total assets managed by institutional investors such as pension funds and insurance companies in the OECD area.

Figure 2.6. Assets under management by traditional investors in the OECD

Note: All OECD area, excluding Australia, Lithuania, and Mexico.

Source: OECD National Accounts.

Institutional investors, particularly pension funds and insurance companies are buy-and-hold, stable investors given their investment strategy. Pension funds and life insurance companies, reflecting the length of their financial liabilities, tend to have long-term investment horizons and prefer high quality long-dated indexed and fixed debt. Thus, typical investors for long-term bonds in government securities markets are pension funds and life insurance companies. Figure 2.7 shows that ‘debt securities’ account for over 40% of total assets of institutional investors. It should be noted that ‘debt securities’ include debt issued by general government as well as financial corporations and non-financial corporations.

More specifically, the share of government debt holdings of domestic pension funds and insurance companies reach substantial levels in some countries. For example, in the United Kingdom, domestic pension funds have dominated the gilt markets since the mid-1990s (currently around 30%). In the US, pension funds, the second largest investor group of US Treasuries following the foreign and international investors, hold about 15% total marketable debt. Similarly, domestic insurance companies in France held around 19% of government debt as of 2018.

Figure 2.7. Asset allocation by traditional institutional investors in OECD countries

Note: Other includes the following financial assets; Insurance pension and standardised guarantees, Financial derivatives and employee stock options, and Other accounts receivable.

Source: OECD National Accounts.

Changes in pension systems, regulatory frameworks and demographic profiles are the main factors that determine the growth of pension funds as well as their investment strategy. For example, changes in pensions systems from defined benefits to defined contributions have an impact on portfolio investment strategies. In the United Kingdom, where the existing stock of pensions is predominantly based on a defined benefit (DB) system, demand for long-dated bonds is strong, as it is for inflation-linked bonds – since the liabilities are also linked to changes in inflation. On the contrary, in the United States, a rapid shift to defined contribution retirement plans suggests limited demand for ultra-long bonds.

Regulations (e.g. rules concerning underfunded pension plans and early retirement) also have an impact on asset allocation of pension funds. In the United Kingdom, the Pensions Act of 2004 instituted fines for underfunded pension plans, providing strong incentives to buy more long-term government bonds. Greenwood and Vayanos (2009) shows that long-term government bond yields decreased following regulatory changes that induce pension funds to hold longer-term assets.

Demographic patterns, largely driven by fertility and mortality rates, have consequences for the growth of pension funds and insurance companies, which in turn affect their demand for government securities. Developments in insurance contracts significantly affect the companies' investment and the amount of interest-rate risk that they bear. The maturity of liabilities is affected by a range of factors such as the composition of insurance products, the mortality rate, and the surrender rate. For example, life insurance companies in Japan are major investors in super long-term Japanese government bonds (Debt Management Report MoF of Japan, 2018). 8 In Japan, empirical studies suggest that the average life expectancy has been on an uptrend, which in turn contributed to the lengthening of the maturity of overall liabilities. In this regard, future demographic changes may shorten the maturity of liabilities, and therefore demand for super-long-term JGBs from life insurance companies is likely to change accordingly (Bank of Japan review, 213).

Lastly, the prolonged low interest-rate environment in several OECD countries poses a significant challenge for pension funds and insurance companies, which promise a minimum return to their customers.9 Some of institutional investors have restrictions on buying government bonds with negative yields. In markets where government securities have negative yields, pension funds and other institutional investors become less active or invest more in the long-end of the yield curve. In Japan, life insurance companies replaced shorter-term bonds with super long-term bonds with positive yields. In Germany, life assurance companies selling many insurance contracts with guaranteed yields of 3 to 4 per cent, have gradually reduced their purchases of new issuances of German government securities to diversify into other issuers or asset classes since the 2010s. Against this backdrop, one should expect conventional investors such as pension funds and insurance companies to demand more government securities when the yields rise.

Given the direct impact of credit ratings on institutional investors’ portfolios, along with bank capital requirements and pension fund investment restrictions, a downgrade can generate a portfolio shift, which can significantly affect bond yields. An OECD survey of investment regulation of pension funds revealed that a majority of the respondent countries indicate credit rating restrictions cornering investments in debt securities. Sovereign credit quality in the OECD area stands at high levels and provides high quality liquid bonds, albeit a considerable deterioration has been experienced during the last decade (Box 2.1).

2.5. Implications of changes in investor demand for issuance strategies

The diversification of funding sources reduces the reliance on any one group of investors and reduces the risk that unfavourable conditions in one market segment becomes costly to the government (OECD, 2002). While, investor base of a government debt portfolio is predominantly a result of markets forces, using a variety of instruments (nominal bonds, real return bonds, Treasury bills, foreign-currency instruments and retail products) and a range of maturities can be used for building a broad investor base as well as reaching out to new investor groups. In particular, countries with substantial borrowing requirements (e.g. the US) need to increase attractiveness of government securities to foreign and domestic investor groups. Issuing a new product or adjusting an existing product might generate additional demand from available domestic and international savings pools.

Box 2.1. Trends in credit quality of sovereign bonds

From an investor’s perspective, the credibility of a government’s macroeconomic framework; the integrity of state institutions; the political environment and the country’s economic growth prospects are the main determinants of bond valuations. In practice, these elements are allegedly captured in sovereign credit ratings.

Credit ratings of many countries have steadily shifted down since the GFC, albeit a recent improvement. To better quantify and assess the credit quality of sovereign bond issuance, an index covering 10-year bond issuance by OECD governments over the period 2008-2018 has been constructed. The results reveal a clear deterioration in sovereign bond credit quality in the OECD area for the designated time period. The trend is clearly driven by the G7 and euro area country groupings which can be explained by the sustained rise in borrowing needs in most of these countries.

 

Figure 2.8. Evolution of sovereign debt credit quality, credit ratings weighted by amounts issued, 2008-2018

Figure 2.9. Distribution of sovereign bond issuance among rating categories, as a percentage of total, 2008-2018

Notes: Weighted average (by amounts issued) and based on the maximum issuance rating from three rating agencies: Fitch, Moody’s and Standard and Poor’s. Influenced by the methodology used in the “corporate bond quality index” (OECD, 2017), each issuance is assigned a value ranging from 1 for the lowest credit quality rating and 19 for the highest.

Source: Refinitiv and author calculations. See Annex 1.A1 of the 2018 SBO for the methodology.

The distribution of sovereign bond issuance among rating categories indicates two significant shifts during the past decade: The first move was from ‘Prime’ category to ‘High grade’ category during the initial years of the GFC, the second was from ‘High grade’ down to ‘Upper medium grade’ category. Overall, the share of A-rated bonds in total 10-year bond issuance in the OECD area has decreased gradually from above 95% in 2008 to 90% in 2017. Since 2017, upper medium category further increased in expense to lower medium grade category, largely due to recent upgrades in sovereign ratings in some euro area countries (i.e. credit rating of Greece, Iceland, Portugal and Spain have been upgraded in recent years).

Source: OECD Sovereign Borrowing Outlook 2018 (updated)

The structure of the domestic and foreign investor base largely determines the types of products offered by the issuer. For instance, an issuer may not be able to sell longer-term – in particular ultra-long term – maturities in the market, in the absence of continued and substantial demand for that particular maturity. On the other hand, observing a robust and viable investor demand for a new instrument encourages issuers. Given the strong investor demand for floating-rate and inflation-linked securities, these instruments have become part of regular issuance choices over the past few decades. In countries where high and volatile inflation rates prevailed for a prolonged period, local investors, particularly insurance companies and pension funds, tend to give greater priority to protecting the future real value of savings. This generates a strong appetite for inflation-linked securities (OECD, 2017). In fact, an increasing number of EMs (e.g. Chile, Mexico and Turkey) have introduced inflation-linked bonds to eliminate the risk of inflation uncertainty over the total return on investment. Another example comes from the UK, where strong demand from the pension funds for the long-dated Gilts have impact of debt strategies. As discussed in Chapter 1, a high presence of pension funds is the main reason explaining the high weighted average maturity of outstanding debt in the UK (i.e. the weighted average maturity of outstanding debt was 17.5 years in 2018 in the UK, the highest in the OECD area). Similarly, as environmentally conscious investing is growing quite rapidly today, sovereign green bond issuance, though still at an embryonic stage, has risen steadily in recent years.

In addition, sovereign issuers consider investors feedback when designing securities to attract various types of investors. Several OECD countries have a retail-targeted debt instrument (e.g. France, Italy, Spain and Turkey). Also, they tailor products to investor needs within an appropriate risk management framework. For example, investor base and preference have an influence on a reference index choice of inflation-indexed debt. France and Italy issue bonds, which are linked to the national consumer price index excluding tobacco, as well as bonds that are linked to the Eurozone harmonised index of consumer prices excluding tobacco (HICP ex-tobacco). Another example is the floating rate notes (FRNs) issued by the United States Treasury in 2014. The Treasury introduced the FRNs in a way to offer investors a hedge against rising rates by offering an interest rate tied to the most recent 13-week T-bill auction, while extending the maturity of debt.

Auction systems and bidding procedures are, in some cases, adapted to allow involvement of wider investor groups. For example, direct bidding may be a useful system to broaden investor base, as it reduces or eliminates intermediary costs (SBO, 2013). In the United States, direct bidding to the Treasury auction is made possible for individuals as well as other investor groups through the Treasury Automated Auction Processing Systems (TAAPS). Similarly, some countries facilitate bond-purchasing process via online applications. This is the case in Austria, where an online retail saving product (i.e. bundesschatz.at) launched by the Austrian Treasury in 2002, offers a secure and free of charge alternative to savings accounts.

2.6. Considerations of investor relations and communication practices

Two-way communication between sovereign issuers and investors is essential to establish and maintain an efficient government securities market at all times. The continued funding challenges discussed in Chapter 1 have recently led to a situation where a broad and diverse investor base is more essential than before. This means that it is more important to take into account the preferences of both foreign and domestic investors when making changes to issuance procedures and introducing new instruments. In this regard, most countries mention that they give a higher priority to maintaining good investor relationships not only with current investors but also with potential investors.

Investor relations (IR), a strategic communication function, has become a standard part of work programmes of sovereign debt management offices across the OECD countries since the 1990s. Sovereign issuers have adjusted their IR practices according to evolving market conditions, particularly in response to changes in investor bases and their preferences (Box 2.2).

Box 2.2. Investor relation practices in the OECD area

The investor relation (IR) activities facilitate two-way communication between investors and issuers on a wide range of issues from a government funding needs and strategies to macroeconomic targets. In the OECD area, objectives of IR activities include the following themes:

• to develop and maintain a wide and diversified investor base;

• to reduce uncertainty and promote transparency;

• to provide investors with the information they need on a timely basis including changes in debt management strategies;

• to ensure awareness of fiscal, economic and debt management policies and developments;

• to promote awareness of government securities and facilitate access;

• to gauge investor appetite, grasp investment trends and obtain feedback on investor needs.

In terms of the IR strategy, target key investor groups include insurance companies, pension funds, institutional asset managers and primary market distributors. Interaction with primary dealers is considered as one of the most useful activities related to communicating debt management information and for receiving input into the decision making process.

In the majority of the OECD countries, the IR activities are executed as an integrated function of debt offices, and some OECD countries (e.g. Australia, Mexico and Turkey) have an investor relations office with a discrete group dedicated to IR activities (Dooner, M. and D. McAlister 2013).

When providing information to stakeholders, they adapt information based on the stakeholder and tailor presentations depending on how well-informed the stakeholder is. In terms of communication methods, DMOs organize regular and ad-hoc face-to-face meetings with investors as well as overseas roadshows. Technological advances changed the communication methods, as issuers can communicate directly and is less costly with a larger investment community through social media, video conferences and web-based communications. DMOs attach great importance to dissemination of information that all current and potential buyers of government securities are provided simultaneously with the same information, and that dealers and investors are treated fairly and equally.

In the aftermath of the global financial crisis, sovereign issuers fortified their investor relation activities due to an increased need for on-going co-operation with domestic and international investors (Dooner M. and D. McAlister, 2013). For instance, some countries made their first ever roadshows to Asian countries in order to diversify their investment base. Some countries established an investor relations office with a discrete group dedicated to IR activities. This is the case, for example in Australia, where a dedicated IR unit was established in 2009 with the purpose of stimulating immediate demand from investors in the face of rapidly growing issuance programs.10 The Ministry of Finance of Japan established the Office of Debt Management and JGB Investor Relations at the Debt Management Policy Division of the Financial Bureau in July 2014.

In recent years, environmental, social, and governance (ESG) factors have become increasingly relevant for a number of institutional investors. This has implications for sovereign creditworthiness and ultimately for bond prices. In this respect, credit rating agencies have taken steps to incorporate ESG factors into country risk assessments. This, in turn, encourages sovereign issuers to integrate ESG approaches in their communication strategy. The Finnish State Treasury, for example, presented the government’s initiatives and actions to promote sustainable development in its annual debt management report.

For countries with highly concentrated debt holdings composition, the challenge is to diversify the investor base in order to be prepared for a potential structural change in the ownership of government securities. In this regard, there is a need for re-engaging with their traditional investor base, such as pension funds and insurance companies, and put emphasis on regional diversification.

In cases, where monetary policy normalisation coincides with rising or high borrowing requirements, the need to expand the investor base is more crucial. Issuing a new product or adjusting an existing product can be considered for generating additional demand from untapped savings pools. In this regard, consultation with market participants is key to assess investor appetite for a new instrument, or to design an appealing product for a specific group of investor.

As discussed in Chapter 1, some of the OECD countries have been experiencing shrinking budget deficits or budget surpluses in recent years, which leads to a concomitant decline in government financing needs. In that case, the challenge for sovereign issuers is to maintain a liquid market for government securities with a limited security offering. DMOs, facing such a situation, focus on issuing a limited number of benchmark bonds along the yield curve. Sovereign debt managers, in consultation with investors, may consider various policy options associated with their primary and secondary market activities to promote secondary market liquidity. These include, but not limited to, the use of buy-back and switch operations to enhance the volume of benchmark bonds, modifications in primary dealership systems and security lending facilities to help market participants to continuously quote prices and avoid delivery failures.

Declining stocks of government securities might raise concerns about the benchmark status of government bonds. Then, it is necessary to address investors’ concerns about maintenance of government debt supply and provide clarity about a government’s commitment for a liquid and efficient government securities market. In New Zealand, where strong and persistent fiscal position led such concerns, the New Zealand DMO assessed that the investors need to be reassured about a minimum level of borrowing amounts irrespective of fiscal outlook. In response, based on the DMO’s proposal the government committed to “maintain levels of New Zealand government bonds on issue at not less than 20 per cent of GDP over time” regardless of the fiscal outcome in 2017.

References

Arslanalp S. and Takahiro Tsuda (2016), “Sovereign Investor Base Dataset for Emerging Markets”, the Monetary and Capital Markets Department of the International Monetary Fund, Washington D.C. www.imf.org/external/pubs/ft/wp/2014/Data/wp1439.zip.

Arslanalp S. and T. Tsuda (2014), "Tracking Global Demand for Advanced Economy Sovereign Debt" IMF Economic Review, Volume 62, Number 3, Washington DC. www.imf.org/external/pubs/ft/wp/2012/wp12284.pdf

Bank of Japan (2013), “Japanese Life Insurance Companies' Balance-Sheet Structure and Japanese Government Bond Investment”, Bank of Japan Review, February 2013. www.boj.or.jp/en/research/wps_rev/rev_2013/data/rev13e02.pdf

Beltran, Daniel O., Maxwell Kretchmer, Jaime Marquez, and Charles P. Thomas, 2013, “Foreign Holdings of U.S. Treasuries and U.S. Treasury Yields,” Journal of International Money and Finance, 32, pp. 1120-1143. www.federalreserve.gov/pubs/ifdp/2012/1041/ifdp1041.pdf

Culbertson J. M. (1957), “The Term Structure of Interest Rates”, The Quarterly Journal of Economics, Vol. 71, No. 4, November 1957, pp. 485-517, The MIT Press. www.jstor.org/stable/1885708

Dooner, M. and D. McAlister (2013), “Investor Relations and Communications: An Overview of Leading Practices in the OECD Area”, OECD Working Papers on Sovereign Borrowing and Public Debt Management, No. 6, OECD Publishing, Paris. https://doi.org/10.1787/5k4dhnwfxtq6-en.

ECB (2015), “Who holds what? New Information on securities holding” ECB Economic Bulletin Issue 2 / 2015. https://personal.lse.ac.uk/vayanos/Papers/PPGBM_AER10.pdf

Greenwood R. and D. Vayanos, 2009, “Price Pressure in the Government Bond Market,” The American Economic Review, Vol. 100, No. 2, (May 2010), pp. 585-590. https://personal.lse.ac.uk/vayanos/Papers/PPGBM_AER10.pdf

Greenwood R. and A. Vissing-Jorgensen (2018), “The Impact of Pensions and Insurance on Global Yield Curves” June, 2018. http://faculty.haas.berkeley.edu/vissing/greenwood_vissingjorgensen.pdf

HM Treasury (2018), “Debt Management Report 2018-19”, March 2018. https://dmo.gov.uk/media/15381/drmr1819.pdf

Ministry of Finance of Japan (2018), “Debt management Report 2018”. www.mof.go.jp/english/jgbs/publication/debt_management_report/2018/esaimu2018.pdf

Modigliani, F. and Sutch, R. (1966), “Innovations in Interest-Rate Policy” American Economic Review, 56, 178-197. www.jstor.org/stable/1821281?seq=1#metadata_info_tab_contents

Moody’s (2018), “Sovereign Bond Ratings - Rating Methodology”. www.moodys.com/research/Moodys-updates-its-methodology-for-rating-sovereign-bonds--PR_392072

Morahan A. and C. Mulder (2013), “Survey of reserve managers: Lessons from the crisis”, the Monetary and Capital Markets Department of the International Monetary Fund, Washington D.C Working Paper WP/13/99. www.imf.org/external/pubs/ft/wp/2013/wp1399.pdf

Peiris, S. (2010), “Foreign Participation in Emerging Market Local Currency Bond Markets”, IMF Working Paper No. 10/88. www.imf.org/external/pubs/ft/wp/2010/wp1088.pdf

S&P Global Ratings (2017), ‘Sovereign Rating Methodology’, December 18, 2017. www.spratings.com/documents/20184/4432051/Sovereign+Rating+Methodology/5f8c852c-108d-46d2-add1-4c20c3304725

OECD (2013), OECD Sovereign Borrowing Outlook 2013, OECD Publishing, Paris. http://dx.doi.org/10.1787/sov_b_outlk-2013-en

OECD (2016), OECD Pensions Outlook 2016, OECD Publishing, Paris. http://dx.doi.org/10.1787/pens_outlook-2016-en.

OECD (2017), OECD Sovereign Borrowing Outlook 2017, OECD Publishing, Paris. http://dx.doi.org/10.1787/sov_b_outlk-2017-en

OECD (2018a), OECD Sovereign Borrowing Outlook 2018, OECD Publishing, Paris. http://dx.doi.org/10.1787/sov_b_outlk-2018-en

OECD (2018b), OECD Pension Funds in Figures June 2018, OECD Publishing, Paris. www.oecd.org/daf/fin/private-pensions/Pension-Funds-in-Figures-2018.pdf

OECD (2018c), “Annual Survey of Investment Regulation of Pension Funds”, OECD Publishing, Paris. www.oecd.org/daf/fin/private-pensions/2018-Survey-Investment-Regulation-Pension-Funds.pdf.

Warnock, F. E., and V. C. Warnock, 2009, “International capital flows and US interest rates,” Journal of International Money and Finance, 28(6), 903-919. https://faculty.darden.virginia.edu/warnockf/papers/WarnockWarnock_Flows_and_Rates_JIMF.pdf

Notes

← 1.  Early examples of government bonds were used to fund military operations and other expenditure in times of wars. For example, the Bank of England issued the first government bond in 17^th century to raise money to fund a war against France. Following that, governments in other European countries, Canada and the US sold bonds for war financing.

← 2.  The widespread adoption of new technologies in finance, such as the proliferation of electronic trading venues, high-frequency trading and robo-advisors, has changed traditional registration, clearing, settlement, payments, reporting and monitoring operations, as well as investment management services (OECD 2018a).

← 3.  Today, there are examples of governments (e.g. New Zealand and Singapore) with strong fiscal fundamentals, which do not use debt to finance their expenditure, instead, bonds and Treasury bills (T-bills) are issued to support investors in need of safe assets.

← 4.  The size of pension fund assets has reached 105.5% of GDP in the UK in 2017 (OECD 2018b). As of September 2017, the three largest investor groups in the UK Gilt markets were insurance companies and pension funds (31%), overseas investors (28%), and the Bank of England’s Asset Purchase Facility (25%) (HM Treasury, 2018).

← 5.  As of September 2018, life and non-life insurance companies hold 20% of outstanding Japanese Government bonds (Ministry of Finance of Japan, 2018).

← 6.  The IMF’s Currency Composition of Official Foreign Exchange Reserves (COFER) and Coordinated Portfolio Investment Survey (CPIS), ECB’s Securities Holdings Statistics (SHS), and Bank for International Settlements (BIS) International Banking Statistics are among the datasets provide investor base information.

← 7.  The IMF Currency Composition of Official Foreign Exchange Reserves (COFER) database indicates a gradual change in the currency composition of foreign reserves since 2000, with the share of USD holdings, at a global level, at its peak with 71.1% in 2000. Since then, the share of USD holdings has declined, standing at 62% in September 2018. The share of euro holdings increased from 18.3% to 20.5% within the same period.

← 8.  This is because the share of new policyholders has been declining in accordance with the decrease in the number of young people, while the share of the existing policyholders has been increasing.

← 9.  Prolonged low interest rates and falling inflation rates pose serious challenges to insurance and pension systems and, in particular, to defined benefit pension funds and life insurance companies offering long-term financial promises (OECD, 2016).

← 10.  Australia had maintained budget surpluses for several years prior to the Global Financial Crisis. Following the events of 2008, the Australian Office of Financial Management went from issuing bonds in order to maintain a certain level of market liquidity aimed at supporting the futures contracts, to a regime of significantly larger funding programs aimed at funding the budget deficit. In this regard, investor relation activities included active engagement with new and existing institutional investors where they were introduced to, educated on and updated about topics such as the Australian economy, the Government’s fiscal and debt positions as wells as the issuance strategy.