More retail and institutional money every day
The niche currency Eurobond market endured a battering in 2006 when investors in two staples of the previous year — the Turkish lira and Icelandic króna — were reminded why coupons in those markets are so high. But as Matthew Attwood discovers, investors, existing bondholders and new money accounts are back and as enthusiastic as ever.
The two big stories of 2005 in local currency markets were the opening of the Turkish lira and Icelandic króna Eurobond sectors, in January and August.
Investors flocked to the new markets in search of currency diversification and yield, but some critics said the growth — especially in króna issuance — was unsustainable. Between March and the summer, it seemed as though they were about to be proved right.
"The big theme of 2006 in the local currency market sector was correlation between markets," says David Fry, global head of local currency markets Eurobonds at ABN Amro in London.
"The volatility in Icelandic krónur in March was echoed in July and August in Turkish liras, and as less sophisticated investors became nervous there was some withdrawal of exposure."
Yet the demise of the carry trade — a familiar refrain in recent years — was not at hand, the markets have repriced after robust central bank intervention, and customers are behind the sector again.
"There is more money every day from both retail and institutional accounts anxious to pick up higher yields and diversify their holdings," says Fry.
"They see a pick up over traditional emerging market investments, such as Russian credits in US dollars, and are moving over to the local currency markets we cover."
Trouble was first felt in Iceland in February, when Fitch, concerned about the country's current account deficit, revised its outlook on Iceland's ratings to negative.
On February 21, the króna suffered its biggest 24 hour drop for almost five years — 4.5% — amid a sell-off of Icelandic assets. Other markets, including Turkey, were affected, but they soon rallied.
Having started the year at Ikr63.5 against the US dollar, the króna embarked on a depreciating trend that continued throughout March and April — in the last week of April it reached lows of Ikr79 against the dollar.
The Icelandic central bank responded to inflationary pressures by adopting a tightening regime, which began at the end of April when rates were increased by 75bp to 11.5% from 10.75%. It continued to intervene throughout the year, and rates now stand at 14%.
While many investors were concerned by Fitch's decision, króna Eurobond issuance continued as the currency began to depreciate.
Rentenbank announced a Ikr2bn two year transaction on March 15, even as the future of the market was beginning to be questioned.
"Despite the uncertainty about krónur, investors in our network still see opportunities," said a spokesman for lead manager Fortis Bank at the time. "If the currency depreciates, they can reinvest in krónur in two years, and the 8% coupon on this deal is attractive compared to yields available in other markets."
Up and up
Paul Eustace, head of syndicate at TD Securities in London, recognises that strategic approach: "Existing investors in the market who have found themselves offside on the currency when their holdings mature often look to reinvest the maturing proceeds.
"Also, throughout 2006, we have seen new money looking to come into the market in order to benefit from the cheaper currency and higher coupon levels."
Each time rates went up in 2006 — they did so in April, May, July, August and September — issuers came to the market to offer investors an opportunity to benefit from the new economic conditions.
Rabobank was one such borrower, announcing a Ikr5bn one year transaction in July when rates had reached 12.25%.
"The pressure in Iceland has eased since June, following the latest 75bp interest rate hike, and this is the first new issue to take advantage of the new landscape," a syndicate official at Royal Bank of Canada Capital Markets, which led the deal, told EuroWeek at the time.
"It compares well to outstanding trades, which typically have a coupon of 8% or 9%."
While there is a risk that investors involved with deals that are issued in immediate response to rate tightening could lose out when rates go up again, as happened throughout 2006, coupons are still higher than other markets and they still stand to gain from appreciation in the currency.
"Institutional accounts in mainland Europe, especially funds in Germany and Switzerland, are happy to invest in this market," says Eustace. "With US Treasuries at 4.5%, markets like Icelandic króna, with compelling yield opportunities and potential currency appreciation, will always be attractive."
Redemptions and new money appetite for the improved yield environment kept issuance steady throughout the summer and into autumn. Although the króna came under renewed pressure at the end of November, it has recouped around two-thirds of the losses it incurred earlier in the year.
Positive reports on Iceland from Moody's and the OECD in the summer have improved sentiment, and the shape of the yield curve indicates the market's view on the country.
"Issuance is concentrated at the short end — one to three years. As the high interest rates we see at the moment are expected to come down, this has led to an increasingly inverted yield curve," says Eustace.
Investors will be looking ahead to the next round of Eurobond maturities — the largest spike is due in September this year, when Ikr74bn will redeem — and hope that no further crises will interrupt the króna's recovery.
Local currency market investors had another shock in the middle of the year, when the influences that provided them with high coupons in Turkish liras conspired to create instability.
"Volatility caused by growing inflation coupled with EU accession concerns caused a major sell-off in the Turkish lira that led to significant rate rises back in May and June," says Eustace.
Rates went from 13.25% to 15% at the end of May, but this intervention was not sufficient to reverse the effects of inflation, so the central bank increased them by another 225bp at an emergency meeting in late June.
While some investors who had rushed for the new current coupon level after the year's first rate rise regretted their haste, others were enthusiastic about the prospect of 20% coupons. Kommunalbanken was the first issuer to achieve this level, with a TL50m two year transaction announced in October, led by TD Securities.
The opportunity to get returns like that has kept investors active ever since, says Eustace.
"Investors have returned to the market, attracted by coupons in the area of 20% versus the 12%-15% coupons available last year. Deals from issuers like Depfa Bank boasted a 20% coupon and proved especially attractive to new money able to take on the currency risk.
"The rate environment is expected to improve, so issuance is concentrated on the short end to capture coupons," he adds.
Coupons of 20% might be keeping issuance levels up, but the volatility is preventing the market's development in other directions, although market participants are still hopeful that it will mature in time.
"At the moment, volatility is such that investors do not always want to take on extra credit risk, but there is no reason to suppose that this will always be a triple-A arena," says Eustace.
"When Turkey's international and macroeconomic standing improve, the buyside will be willing to look at new credits."
There is also insufficient yield differentials between middle rated corporate borrowers and sovereign, supranational and agency issuers to justify their entry in an arena where yields are at 20%. Investors simply have no need to go further down the credit spectrum for additional returns.
ABN Amro's David Fry agrees. "While higher yielding markets are a question, mainly, of currency risk, asset quality and ratings are more of a concern in lower yielding sectors such as Norwegian kroner and Australian dollars."
The lira sector will continue to be one to watch in 2007, but local currency market participants are looking at new additions to the canon.
"2005 and 2006 have been great years for Turkish liras and Icelandic krónur," says Eustace. "Maybe next year it could be Romania or Brazil, both markets where we are seeing growing demand."
David Fry, whose team has steadily added to the markets it covers over the year, concurs.
"This year, we will see investors getting on board with new markets that do not have extensive government bond curves. They want further exposure in Romania as well as Kazakhstan and Asian currencies, and for some, Eurobonds will be the only opportunity.
"Brazil, Russia, India and China will be the stories of 2007. Investors are looking for vehicles to participate in those markets and the banks are working to provide them. I expect to see the Russian rouble, which becomes eligible for clearing on the Euroclear and Clearstream systems in January, to have a fully developed yield curve from a triple-A to double-B sector by the end of the year."
"The Romanian leu deals we led in 2006 have sold very well, and we would have done more if there had been more liquidity in the swap market," says Eustace.
"The high coupon markets used to be Australian and New Zealand dollars; now it is Icelandic krónur and Turkish liras. Things change and investors move on, but there is still plenty going on in Australian dollars, for example, just with a completely different investor base than before."
An indication of the non-core market's health is the establishment of ABN Amro's local currency markets syndicate, headed by former TD Securities man David Fry.
"The local currency market sector is becoming an increasingly competitive arena, and although the increased competition is not ideal, it is flattering that other banks are emulating our approach," says Eustace.