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Annual Report 2016 - 2 -

• The ECB's monetary policy decisions once again shaped the performance of the marketsin 2016, in addition to external factors such as Brexit and the US elections.

• In March, the ECB cut interest rates from 0.05% to 0%, raising the volume of QE fromEUR 60 billion to EUR 80 billion per month. It also increased its purchases of high-quality corporate bonds. In December, the ECB agreed to extend its purchaseprogramme until December 2017, although it would taper it off to EUR 60 million permonth from April.

• In order to encourage the banking sector to lend to the real economy, it penalised thedeposit facility rate, cutting it from -0.3% to -0.4%, and reducing the margin lendingfacility rate from 0.30% to 0.25%.

• Nonetheless, the negative rates did not reduce the excess liquidity held by the ECB,which continued to rise to over EUR 1 billion.

Market performance in 2016



• The demand-side pressure prompting the ECB's purchase programme, along with theexcess liquidity pushed effective interest rates even further down, and also drovecorporate bond risk premiums downwards.

• The 1Y Euribor dipped into negative territory in February, ending the year at -0.082%.

• European sovereign debt yields continued to fall for much of the year, with the German10Y bond yield sliding into negative territory. Exceptionally, 80% of Germany’s bondyields were negative in September. These yields were once again positive in the lastquarter, although some way off the levels at the beginning of the year.

• Institutional investors sought higher returns by investing in US public debt andspeculative-grade corporate bonds.

• Companies have exploited the period of low funding costs to reduce their reliance onbank finance and raise funds on the capital markets.



• The outcome of the British referendum on leaving the EU was announced in June,which increased the volatility of all market indicators.

• The following day, the risk premium of Spanish versus German debt reached a yearlyhigh of 179 bp, subsequently recovering rapidly and even exceeding previous levels.

• The week after, the 3Y Spanish bond yield hit another milestone as it slipped intonegative territory for the first time, following the same pattern as debt with a shorterterm.

• The Spanish economy grew 3.2% in 2016, as in the previous year, building on 13quarters of consecutive growth. The provisional public deficit stood at 4.7% of GDP,while the debt of all public entities reached EUR 1.105 trillion, up 3% year on year, andequivalent to 98.98% of GDP. Inflation ended the year at 1.6%.



• The Treasury had net issuances during the year of EUR 35.043 billion, 27% below the2015 figure and almost EUR 10 billion lower than expected, after covering maturities ofEUR 186.321 billion.

• The average funding cost stood at 0.61% at the end of December compared to 0.84% ayear earlier. Savings on interest payments totalled EUR 2 billion. The average life ofborrowings increased to 6.81 years (+5.6%).

• Aside from its auctions, the Treasury drew down on syndicated bank loans to bring inEUR 22.879 billion, including one notable loan at 50 years.

• The volume of inflation-linked European government bonds and debentures totalledEUR 7.785 billion, with 6.5% of the total expiring in the medium to long term with anew benchmark at five years.



• During the latter half of the year, lending to companies slowed. Various analystsattributed this to the injection of liquidity deriving from eliminating part payments ofcorporation tax on the one hand, and the largest corporations turning to alternativefunding sources on the other. Uncertainty in the domestic and international politicalarenas was also cited as a possible cause.

• New lending to companies fell to October by around a third in the segment of over EUR1 million. In contrast, the volume of loans of less than EUR 250,000 increased by 4.2%,exceeding the former in absolute terms.

• Mortgages rose by approximately 15%, while loan defaults were up 17%. The mortgageloan balance continued to decrease, as in previous years, as repayments andcancellations outstripped new loans.



• The outstanding balance of public and corporate bonds listed on the AIAF rose by 1.2%to EUR 1.38 billion off the back of an increase in state debt, since private sector debtcontinued to fall (-4.4%).

• The treasury positions of entities made up the highest share of this balance at year endof 44.4%.

• The volume of government debt held by non-resident investors remained practicallyunchanged at around EUR 415 billion which, due to net growth thereof, resulted in a 1.6point fall as a percentage of the total. The share of investment in private debt also fell(1.4 points).

• Institutional investors were more active in the primary market, while the share of retailinvestors dropped to just 1% of the total.



• Private fixed income issuances admitted to trading on the AIAF market in 2016 stood atEUR 130 billion (-10.8%) – similar to the figure in 2013.

• Of this amount, 17.5% consisted of promissory note issuances. Short-term issuancesdropped by 17.1% year on year, while medium- and long-term issuances fell by 9.3%.

• Medium- and long-term issuances of financial institutions, including the SAREB, totalledEUR 68.855 billion.

• Bonds and debentures not secured by additional collateral decreased by 33.4%, whilecovered bonds declined by 3.9%. The volume of securitised bonds issued grew by22.2%.



• BME's Fixed Income unit handled trades totalling EUR 347.780 billion, down 44.2%versus the previous year.

• Of this volume, 57.3% involved trading of government debt, and the remainder, privatedebt. By type of transaction, 87.3% were held to maturity, while repos and reverserepos declined by 12.3%.

• Negative interest rates and the lack of new issuances targeting retail investors affectedthe SEND platform for another year, which saw its trading volume drop by 19%compared to 2015.

• Trading volume on the SENAF wholesale public debt platform, where the Treasury'smarket makers are active, rose by 60.6% , with 29.2% more trades being handled.



• The Mercado Alternativo de Renta Fija (MARF) continued to grow, providing access tonew companies seeking to diversify their funding sources. New issuances listed on thismarket during 2016 multiplied by 2.7 in volume terms year on year, to EUR 2.280billion.

• At the end of its third year since it was established, the MARF has handled over EUR3.650 billion of funding through new issuances, and has an outstanding balance of EUR1.608 billion.

• A total of 29 medium-sized enterprises have issued securities individually, with over126 smaller enterprises obtaining finance by grouping notes through securitised bonds.

• A total of EUR 399 million of bonds expiring in the medium to long term, withmaturities of three to 21 years were issued . Companies used 3M to 2Y promissorynotes to raise a total of EUR 1.858 billion, through fifteen issuance programmes with amaximum aggregated outstanding balance of EUR 1.650 billion.


Indicators


Oil

The slump in prices in the previous quarter continued in January, reaching a low of USD26.39 a barrel, subsequently rebounding before the summer. A high was reached inDecember after months of uncertainty.


Gold

Gold prices rose by 20% during the first six months from a low at the beginning of the year.They hit a high on 8 July of USD 1,366.38 an ounce after Brexit. The increase for the year fellto 8.05% during the latter six months.


Euro

The euro reached an annual high against the US dollar the beginning of May of 1,153(+6.2%). The strengthening of the dollar due to US economic growth forecasts saw theexchange rate dropping to 1,052 (-3.13%).


10Y sovereign debt

The Spanish 10Y bond improved its position among European bonds, with the yield hitting1.384% by year-end, having dropped to a low of 0.88% in September. Germany's bond yielddipped into negative territory in June as the British referendum played out.


The spread between Spanish and German 10Y bonds hit an annual high when the result ofthe Brexit referendum was announced, subsequently decreasing to a low of 97 bp inOctober. The year-end result was flat at 116 bp.

Risk premium


Government bond yields

3Y government bond yields continued to be negative during most of the second half of2016. The yield on 5Y bonds dropped by more than 400 basis points.


Market statistics


Private fixed income: Primary market

Private fixed income issuances admitted to trading on the AIAF market in 2016 stood at EUR130.138 billion (-10.8%).


Primary market

Bonds and debentures fell by more than 8 percentage points as a percentage of the totaladmitted to trading, as securitised bonds and covered bonds gained ground.


Promissory note listings

Volumes of promissory notes admitted to trading continued to fall due to the low yields onthis type of paper, making them unattractive for investors.


Promissory note issues

The monthly average of note issues was only EUR 1.898 billion/month, compared to EUR2.288 billion a year earlier. A monthly high of EUR 3.632 billion was posted in June.


Leading issuers of promissory notes

Sabadell was the bank that made the most use of its issuance programmes, with a share ofover 39%. The five leading banks issued upwards of 88% of the total volume.


Private fixed income: Medium- and long-term asset listings

Medium- and long-term asset listings dropped by 9.3%. The greatest fall was of bonds anddebentures not secured by additional collateral (-33.4%).


Bonds, covered bonds and debentures

Spain's bad bank –Sociedad de Gestión de Activos Inmobiliarios Procedentes de laReestructuración Bancaria (SAREB)– arranged four issues accounting for around a third of thetotal assets listed through medium- and long-term plain vanilla issues.

Issuer Volume SAREB 23,466

Santander 11,738

BBVA 7,640

Sabadell 6,417

CaixaBank 5,762

Popular 3,250

Bankia 2,286

Deutsche 2,000

Abertis 1,650

Cajas Rurales Unidas 1,500

Others 6,154

Total 71,863

Source: BME € Millions


Securitisation

Securitised bond issues were up 22.2% year on year to EUR 35.505 billion. Most noteworthygiven its size (EUR 14.2 billion) was CaixaBank's issue in February, secured by home loans.


Maturities

The volume of medium- and long-term asset redemptions fell for the fourth year running.Twenty percent of maturities were concentrated in December.


Securitised bond maturities

The average redemption rate for securitised bond maturities fell by 50% in two years tolevels of 1.50%.


Outstanding balance

The outstanding balance of the AIAF Market at year-end was EUR 1.38 billion (+1.2%).Treasury debt securities rose by over two points in relative terms.


Outstanding balance

The outstanding balance of short-term assets (government bonds and promissory notes)accounted for 7.2% of the total. There were 2,489 issues (ISINs) outstanding at that date.

Short termMedium and

long termShort term

Medium and

long term

Private fixed

income 16,150 494,342

Private fixed

income 333 2,098

Public fixed

income 82,435 744,999

Public fixed

income 12 46

Total 98,585 1,239,341 Total 345 2,144

Source: BME EUR million Source: BME

Number of issues (ISIN)

outstanding Fixed income outstanding balance


Outstanding balance

The volume of private debt securities in circulation at year-end 2016 on the AIAF Markettotalled EUR 510.492 billion, having fallen by 4.4% from the prior year.


Outstanding balance

Covered bonds accounted for over half the balance, although their share fell by 1.5 points.In contrast, the balance of securitised bonds grew in relative terms (3.4 points).


Promissory notes outstanding balance

The outstanding balance of promissory notes increased by 6.2% year on year. Nonetheless,the net monthly balance (issues - redemptions) was negative for much of the year.


Leading promissory note issuers by outstanding balance

The five leading promissory note issuers had a combined outstanding balance of EUR13.732 billion – 85% of the total outstanding balance.


Type of investor in treasury assets

The share of the outstanding balance of treasury debt securities held by non-residentinvestors rose by almost 6 points. Oppositely, the relative position held by retail investorsdecreased by 2.3 percentage points.


Type of private fixed income investor by asset class

The main changes in investor preferences affect promissory notes, where collectiveinvestment institutions and pension funds held greater relative shares, with entities'treasury portfolios accounting for a smaller share.


Outstanding balance of non-resident investors

Non-resident investors held a position of EUR 563.865 billion at the close of the year, withSpanish government bonds and debentures accounting for EUR 328.089 billion of thisamount.


Outstanding balance of CIIs and pension funds

The positions of CIIs and pension funds remained stable year on year, with the reduction ininvestments in private debt being offset by the increase in the position held in public debt.


Secondary market: AIAF private debt

The volume traded in 2016 was EUR 172.962 billion, a third of the volume contracted in theprevious year.


Reverse repurchases of AIAF assets dropped by 84.2%, because the excess liquidity in thesystem due to the ECB's purchases make this type of funding source redundant.



EUR 97.314 billion of covered bonds were traded. The implementation of the ECB's CoveredBonds 3 purchase programme involved a volume of EUR 9.221 billion.



AIAF private debt transactions

Transactions fell because issues are only being placed among a reduced group ofinstitutional investors who intend to hold their portfolios to maturity. Another reasonsmentioned beforehand, is the disappearance of the retail investor market.


Approximately 44% of transactions were for a unit face amount of over EUR 60,000 euros,up 8 points year on year, which is an indication of the presence of institutional investors.

AIAF private debt transactions


SEND: Retail investor platform

Trading activity via the SEND electronic platform totalled EUR 781 million, down 19% from ayear earlier.


SENAF

Trading activity via the multilateral SENAF public debt electronic platform totalled EUR174.816 billion, up 60.6% year on year.


SENAF

A total of 15,808 trades were made, representing an increase of 29%. The average volumewas EUR 11 million per trade, compared to EUR 8.8 million in 2015.


MARF

New issues totalling EUR 2.280 billion were listed on the Mercado Alternativo de Renta Fijain 2016. The outstanding balance grew 56.6% year on year, to EUR 1.612 billion.


AIAF 2000 Indexes

Performance of AIAF 2000 Indices Duration

High Low Last Moderate High Low Last

IG General 5,886.67 5,490.88 5,759.92 5.39 5.58 4.85 5.24

IC Short 4,566.91 4,447.63 4,565.43 1.88 2.03 1.63 1.84

IM Average 5,701.48 5,455.99 5,640.30 3.93 4.07 3.77 3.82

IL Long 7,141.98 6,510.08 6,927.85 6.82 6.92 6.58 6.58

IX Very long 9,255.79 7,914.64 8,637.73 11.72 11.92 11.12 11.29

Contents


AIAF 2000 Indexes

The AIAF 2000 Index climbed 57% over the last five years.


• International: Overall bright outlook, although there are some doubts about therepercussions of the measures taken by Trump's administration. Growth in the USfuelled by more public spending. China will post similar growth to in 2016 (+6%),despite a slowdown in investment. Emerging economies will enjoy growth off theback of a rebound in commodity prices.

• European Union: Growth for the area is expected to hit around 1.5%, althoughthe outcome of Brexit could slash several tenths of a percent off this figure.Inflation has spiked in February to 2% because of higher the oil price. It isexpected to end the year at 1.1% .

• Spain: Spanish economic growth will continue to exceed the European average,standing at around 2.4-2.8%. The CPI rose sharply in early 2017 as a result ofhigher energy prices, although it is expected to fall throughout the year toapproximately 1.8% by year-end.

Market outlook


• Risk premium: At the beginning of 2017, the risk premium rose from 116 to 140basis points in early March, driven by the safehaven effect of German bonds. Inany event, it is expected that the spread versus other European Union countrieswill continue to narrow. It will also be affected by contagion from Italy's riskpremium, although it will remain lower than this.

• Interest rates: It is expected that the Federal Reserve will raise its official rate atleast twice to 1.75%. Low interest rates will persist in Europe, where the currentofficial interest rate of 0.0% is expected to remain flat. European bond yields mayrecover if the ECB tapers off its asset purchase programme.

• Fixed income: Yields on Spanish debt appear to have bottomed out. That said,major changes are not expected during the year until possible withdrawals ofEuropean stimulus measures occur.

Market outlook


• Government debt: The Treasury expects to issue a further EUR 35 billion of publicdebt, net, during 2017 – in line with the prior year – having covered maturities ofaround EUR 185 billion.

• Private debt: Maturities on the AIAF market are expected to total EUR 93 billion,EUR 40 billion of which will concern covered bonds. The nominal balance ofsecuritised bonds will drop by EUR 20 billion.

• SEND: Major changes are not expected, due to the limited returns on offer. Retailinvestors will continue to hold limited positions in both the public and privatefixed income market.

• MARF: During the first two months of 2017, this market handled placementsequivalent to 23% of the total of the previous year. Major increases in issues andthe outstanding balance are expected, as well as of new issuers.

Market outlook

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