The decline in the value of the dollar this year has again raised questions about how dominant the currency will remain in foreign exchange reserves, and to what extent the US Treasury and supranational, sovereign and agency borrowers in dollars will continue to benefit from demand from such accounts.
"In our recent dollar benchmarks we saw a very strong take-up from central banks," says Eila Kreivi, head of funding for America and Asia Pacific at the European Investment Bank in Luxembourg, "but the major holders of dollar paper have in recent weeks raised concerns about the currencys fall. It is possible that this will to some extent detract demand from the traditional investor base in favour of other currencies, particularly with yield differentials being smaller than in the past.
"But it is difficult to say to what extent this will really happen because there have been noises about diversification for several years, and so far hard evidence has not emerged."
Indeed, research by UniCredit in mid-November suggested that demand for dollar assets from some quarters has only strengthened. "Oil exporters have been the only foreign buyer of US Treasuries during the last year," concluded Harm Bandholz, an economics and commodity analyst at UniCredit in New York.
"Our chart of the week [see chart on this page] reveals that oil-exporting countries have been continuing to channel the bulk of their petrodollars via London to the US," he explained, having previously argued that oil exporters did not recycle petrodollars on their own account, but used the financial infrastructure in London.
"With rising oil prices, net purchases of US Treasuries made by the UK soared to $205bn during the last 12 months. What makes this number even more impressive is the fact that during the same period, net purchases of US Treasuries by all foreign countries added up to $208bn."
Not surprisingly, some of this demand for dollar assets has spilled over into the dollar SSA market.
"Oil-based countries have been larger buyers of benchmark issuance," says one SSA syndicate official in London. "As the price of oil has kept rising, they have more and more money coming in, and the dollar is still their reserve currency, in spite of its dramatic fall."
Asia sells, Europe buys
But Bandholz at UniCredit warns that this demand will not necessarily persist, since OPEC members have been discussing the possibility of switching oil price denomination and hence, their new reserve accumulation from the dollar to a currency basket.
Any such move would be all the more painful for the US, he argues, given the way many Asian countries, such as China and Japan, have, he says, already been selling US Treasuries.
"An eventual shift of the oil exporters out of the US dollar would not only weaken the greenback, it would also be a drag on US Treasuries," Bandholz says. "Against this background, it is plausible that Treasury Secretary [Hank] Paulson does not get tired in reiterating the US governments belief in a strong US dollar."
But Kreivi at the EIB says that Treasury holders will be just as wary about a fall in demand for Treasuries. "If you are a very large holder of US dollar paper, be it corporate, agency or Treasury, starting to sell a major part of those holdings will make the situation even worse, so it remains to be seen to what extent that occurs," she says.
Furthermore, there has been another leg propping up demand for the dollar this year: Europe.
"There was a continued increase in demand for dollar assets from Europe, compared to Asia, for example," says Nick Dent, head of rates syndicate at Merrill Lynch in London. "Average dollar allocations probably dropped by more than 10%, while European demand picked up by a bit more."
The picture is sometimes confused by lead managers statistical grouping of Europe with the Middle East, including its oil-exporting countries, and Africa, when they give distribution breakdowns for bond issues.
But Dent says the trend is undeniably there. "Europe has increasingly been in play," he adds, "with pension funds, asset managers and central banks all active."
Ed Mizuhara, head of frequent borrower syndicate at Credit Suisse in London, agrees. "Investors from Europe are coming into dollar books because the currency looks cheap," he says. "We have therefore seen greater distribution of dollar benchmarks to Europe than in recent memory."
Buyers tempted out to 10 years
Until recently, issuers wanting to raise more than $1bn of 10 year dollars often found it difficult to do so, because that part of the yield curve relied more than any other on US investors.
But lately that has changed. For example, in 2006 the EIB launched $2bn and then $3bn 10 year globals, and this year it followed these with a brace of $3bn issues at the long end of the curve.
One reason for this has been the growth in non-US demand for the maturity. "We have had a lot more 10 year transactions this year," says one SSA syndicate manager in London, "largely as a result of central banks moving along the curve. This is partly because the traditional buyers are seeking higher yields in the underperforming US currency.
"And as more central banks reserves grow and they get more involved in the dollar SSA market, they gradually extend along the curve, eventually out to 10 years."
Triple-A issuers have also gradually succeeded in penetrating the US investor base, having several years ago begun seeking to position themselves as less volatile alternatives to the US government-sponsored enterprises, especially Fannie Mae and Freddie Mac.
"If you speak to US investors, EIB, KfW and the like are winning the battle," says one head of frequent issuer syndicate in London. "EIB has consistently come 1bp-3bp inside Fannie and Freddie with all its dollar globals this year. They have at the same time achieved average US placement of around 25%."
One might imagine that the non-US SSAs cause was only furthered by the volatility this summer, caused by problems in the US mortgage market.
Although Fannie and Freddie are not involved in subprime mortgage lending, Freddie Macs $2bn loss in the third quarter of 2007, which knocked its share price down by 30% in one day in November, showed that the GSEs are not immune from the deterioration in the US housing market.
However, it is not necessarily entirely clear that non-US SSAs have benefited in relative terms from the crunch.
"One question we are faced with is what impact the substantial spread volatility of the GSEs will have on us," says the EIBs Kreivi. "They have been anywhere from Libor flat to Libor minus 20bp or even tighter in the last three months, and their Libor curve has gone from being very flat to very steep at the long end we now look fairly expensive compared to the GSEs.
"Whether or not this will mean that investors, especially in the US, will shift in any major way towards the more stable names like ours remains to be seen. It has not been very noticeable during past crises and may even hit our penetration in the US because we look more expensive."
Some syndicate officials agree with Kreivi. "It doesnt really tend to benefit non-US SSAs to have the GSEs trading so cheap because US investors will always ask how much they are having to pay up to get a European triple-A," says one. "This outweighs any concerns they might have about the GSEs or the volatility of their paper.
"The only way that I can see there being a change in this is if questions start to be raised about the long term existence of the GSEs. Even then, that is only likely to affect the long end of the curve and it is only likely to happen if there is actually a rating action that affects GSE debt."
But other bankers say that increasingly the comparison is a non-issue. "There is a certain degree of segmentation between the GSEs and other SSAs," says one. "Accounts are much more focused on the relative value of EIB versus EIB, KfW versus KfW, etc, than either against GSEs. That is particularly true given the shrinkage in benchmark issuance from the agencies."
Poor GSEs boost covered bonds
This last point has helped another class of borrower seeking to penetrate the US investor base: covered bond issuers.
At the start of the year they went, all guns blazing, into the US domestic market and came back with some impressive results.
After years of struggling to make any inroads into the US investor base with its covered bonds, the UKs HBOS was able to sell some three quarters of a $3bn 10 year covered bond in the States in February.
This built on a $2bn five year issue it had launched in November to strong US demand, which itself followed a $1bn five year Pfandbrief deal for German mortgage bank Hypothekenbank in Essen earlier in the month that was more than half taken by US investors.
Then, in March, Depfa ACS Bank, the covered bond issuing arm of the Irish-registered, German-listed public sector bank, sold 88% of a $1.25bn 30 year asset covered security in the US.
US bankers said the deals success was helped by the tight levels at which US agencies were trading, partly due to the lack of supply from GSEs and proposals to submit them to tighter legislation and regulation, which had stimulated renewed foreign demand for their paper.
"The combination of these factors has pushed agency valuations 15bp-20bp tighter than where they were a couple of years ago," said Jeanmarie Genirs, head of syndicate, liquid products, at Deutsche Bank, which was joint lead on both HBOSs deals. "US investors have really gotten disintermediated from the GSE product. They are simply having difficulty achieving their yield targets.
"Well, now we can offer them a triple-A credit with dual recourse to a high quality pool of assets and a highly rated bank, that they get paid for as well."
But whereas SSAs have weathered the volatile second half of 2007 well, covered bond issuers have found US investors less welcoming than in the first half of the year.
Leaving aside the fact that one issuer that followed the pioneers into the US market was the ill-fated Northern Rock, US accounts have been unimpressed by the liquidity of covered bonds, which issuers had trumpeted.
Market participants believe that the dollar market for covered bonds will reopen, but not necessarily at the same speed for all.
Spreads for mortgage and public sector-backed paper could bifurcate again, after the distinction appeared to become blurred in the dollar market. Dexia Municipal Agency, for example, the French public sector bank, was forced to cheapen a $1bn 10 year Eurobond by 2bp because of relative value considerations versus HBOSs mortgage backed blowout.
"The differential between mortgage and public sector covered bonds has not been examined in much detail in the dollar market, but tghere will be a shake-up in how things stand," says one syndicate manager in London. "The differential will re-emerge. US accounts have enough problems with their own mortgage market and wont be interested in getting exposure to those of Spain or the UK."
Julia Hoggett, head of capital markets at Depfa in Dublin, recently roadshowed in the US and says the response was encouraging. "One of the things investors were positive about was the public sector element," she says. "The opportunity to find a product that was neither ABS nor GSE, but offered a spread to agencies, and with a clean set of exposures to public sector markets that they couldnt necessarily buy otherwise, was pretty well received."There will be a lot more work to do, but the covered bond market, particularly the public sector component, does not seem to be struggling to the extent that has been suggested by some people."