Swap spreads widen but rates still near rock bottom
The deep-frozen international yen bond market began to thaw in 2006, as the Bank of Japan raised rates and yields began to show signs of life. Issuance grew by 50%, led by triple-A European agencies and US companies. A few Japanese government bodies ventured overseas too. Samurai issuance, however, was hit by the loss of US borrowers because of concerns about US withholding tax. Jo Richards reports.
The Euroyen and global yen bond markets staged a modest revival in 2006 after a quiet few years, as arbitrage opportunities for Libor-based borrowers improved and rising interest rates caused some reweighting of portfolios.
The volume of international yen bond issuance rose from ¥1.74tr in 2005 to ¥2.65tr ($22bn) in 2006 as market conditions improved markedly, especially for top tier borrowers.
Not only did the revitalised Japanese economy attract more investment in yen, but the dismantling of the Bank of Japan's quantitative easing policy and a 25bp rise in interest rates in March 2006 created arbitrage opportunities that had not been available for many a year. This, combined with a reduction of the basis swap from yen into dollars and euros, brought triple-A issuers back into a market that had been virtually closed to them.
However, some market practitioners are still cautious. "We do not expect to see a full scale revival of the international yen markets until yen interest rates are more closely on a par with dollar or euro rates," says Brian Lawson, co-head of international syndicate at Nomura International in London. "The full restoration of the offshore yen markets to the levels enjoyed in the late 1990s may be a few years, not months away and will be constrained by the fact that most major accounts can now buy JGBs, which was not the case in the past."
Paul Morganti, head of debt capital markets at Mitsubishi UFJ Securities International in London, is in the more optimistic camp. "Last year we saw a big breakout in the JGB/yen swap spread, which had been compressed for a number of years," he says. "Higher absolute interest rates aligned with wider swap spreads, a normalised basis market and a solid outlook for the yen are the reasons we are positive about the re-emergence of the global yen sector."
Demand set to continue
On the issuer side, KfW, which raised ¥200bn in the global yen market last year, takes a hopeful stance. "The signs in 2006, especially at the end of the year, are a clear indicator that there will be continuing demand," says Horst Seissinger, head of capital markets at KfW in Frankfurt. "Yen is not a core currency for us so our issuance depends on the swap markets and on the market environment. If both are positive for issuance, we would like to continue with our global progamme in yen."
KfW's hopes are no doubt shared by the European Investment Bank, Spain's Instituto de Crédito Oficial, Bank Nederlandse Gemeenten, GE Capital and Pfizer, which all issued in yen in 2006. At the same time, improved funding opportunities brought the Development Bank of Japan (DBJ) and Japan Finance Corp for Municipal Enterprises (JFM) back into the international arena.
In the early part of the year, a revival of demand for long dated product prompted the first 20 year issues in yen since 2003 and the first by non-Japanese issuers since 1997, as investors sought to profit from curve-flattening trades.
The EIB launched a ¥50bn ($431m) transaction in January led by Nomura and KfW a ¥50bn deal in February with Morgan Stanley. In October KfW's issue was increased to ¥75bn with UBS as sole manager.
A final ¥50bn 20 year bond was issued by DBJ in June, via Citigroup and UBS. It was the borrower's first global bond since June 2004.
JFM was tempted back into the global yen market in April after a three year absence, to take advantage of a surge in demand driven by 10 year yields approaching 2%, which is a trigger point for many investors.
At ¥120bn, JFM's deal was the largest straight issue in the yen market in 2006 and the first 10 year benchmark to be launched for almost two years. The transaction was led by Deutsche Bank, Merrill Lynch and Nomura.
Highlights on the corporate front were globals from triple-A issuers Pfizer and GE Capital.
The Pfizer transaction, issued in February, was the US drug company's first yen issue and its first in a foreign currency since May 2001. It comprised a five year tranche of ¥60bn and a 10 year tranche of ¥55bn. Mitsubishi UFJ led both tranches with Goldman Sachs on the five year and Nikko Citigroup on the 10 year. Despite its global format, the deal was sold mainly in Japan.
"The company achieved big size and the fact that both tranches were increased gave a strong message about how well the issue went," says Chris Lees, director of syndicate at Nikko Citigroup in London. "The market sold off just before execution, which created demand for yen assets. Swap spreads had also widened by 5bp-6bp. As a result we were able to achieve appealing headline spreads to JGBs at the same time as offering attractive levels versus swaps from the issuer's perspective."
In November, GECC took advantage of a resurgence of non-Japanese buying to price a ¥65bn five year global bond. Lead managers Daiwa Securities SMBC and Mitsubishi UFJ identified demand for a five year offering a yield pick-up over public sector paper.
Increased from ¥50bn, the deal was priced at 27.3bp over JGBs. Fifty-four percent of the issue was bought by European accounts and 22% by non-Japan Asia. The issue was increased to ¥100bn by a ¥35bn tap in December, lead managed by UBS.
Short end populated with FRNs
Short end demand, present for much of the year, was exploited by a proliferation of floating rate issues from mid-year on as investors sought exposure to currency appreciation, while protecting themselves from future rate rises.
The trend was initiated in July by UK bank Alliance & Leicester, which raised ¥50bn in a three year deal led by Daiwa SMBC Europe.
"Large yen FRNs are extremely rare and to our knowledge this was the largest yen FRN for a bank name since 2003," says Steve Apted, co-head of syndicate at Daiwa SMBC in London. "The underlying market conditions for a yen FRN deal were very strong. Interest rates were rising in Japan and investors were on the hunt for liquid, defensive instruments."
While the Alliance & Leicester deal was sold mainly to European accounts, US investors were the driving force behind five year FRNs issued by KfW and the EIB in August and September respectively. KfW raised ¥75bn and EIB ¥50bn, with a tap of ¥25bn in October.
KfW's transaction was the first JGB surrogate in global FRN format for 12 years. According to Merrill Lynch, sole lead on both the KfW and EIB issues, two-thirds of the bonds were sold to US accounts and 100% to real money accounts.
The only opportunity for investors to gain exposure to sovereign debt came from Instituto de Crédito Oficial, which is guaranteed by the Kingdom of Spain and rated Aaa/AAA/AAA. The ¥50bn three year transaction, launched in September by Daiwa SMBC, was ICO's debut in the yen market.
Antonio Cordero, financial markets manager at ICO in Madrid, said he was persuaded to issue in yen after seeing the increased appetite for yen product from fund managers and central banks in Europe and Asia.
Samurais — down but not out
Unlike in the previous two years, the Samurai market played a junior role to its Euroyen and global counterparts in 2006, as US borrowers held back from issuing because of concerns about withholding tax. Samurai issuance fell to ¥515.5bn ($4.4bn), compared with ¥1.8tr in 2005 and ¥1.46tr in 2004.
The Samurai market was closed to US issuers from April to October pending resolution of withholding tax issues that arose in relation to the introduction of the new Japanese Book Entry Transfer System (BETS), which created fears that the US tax authorities would cease to define Samurais issued by US firms as bearer bonds. That would make them subject to US withholding tax.
As a consequence, the big users of the Samurai market in previous years, such as Citigroup, Bear Stearns, Bank of America and GE Capital, stayed away, pending clarification on the withholding tax issue.
Some relief came in October, when the US Internal Revenue Service released new guidance, saying that existing Samurais would be grandfathered when they are transferred to BETS and would continue to be treated as bearer bonds for taxation purposes. The grandfathering was also extended to new Samurai issues that settled before the end of 2006.
There are two potential avenues for US issuers in the Samurai market in 2007. The IRS guidance clarified that future bonds giving investors the option to convert to bearer format would be considered as bearer bonds for US tax purposes.
Alternatively, for the next two years, and before the classification is phased out, issuers would be able to launch Samurais as Foreign Targeted Registered Notes (FTRNs) requiring more limited certification than standard registered bonds, in order to have coupons paid gross.
US issuers accounted for over two-thirds of Samurai issuance in 2005 but last year they either had to issue Euroyen bonds, and be limited to marketing to 49 investors in Japan, or to issue Euroyen notes with Uridashi documentation, which enables a public offering in Japan.
GECC, for example, which issued ¥185bn in the Samurai market in 2005, was forced to take the latter route when raising ¥60bn in June. The deal, led by Mitsubishi UFJ and Mizuho, comprised three tranches, a five year fixed, a five year floater and a 10 year fixed.
Julian Kerslake, head of syndicate at Mizuho in London, says the offering process mimicked as closely as possible the Samurai process. "GECC opted to use the Euroyen format as an interim solution while matters were being resolved by the relevant authorities," he says. "To maximise distribution in Japan, in addition to offering the bonds in Euroyen format, we marketed the transaction with Uridashi public offering documentation to avoid the constraint of the 49 investor rule. And, equally as important, we provided investors with a Japanese prospectus."
US agricultural products company Cargill used the same format for its inaugural ¥30bn yen issue in June, as did American Express, which raised ¥35bn in October and American Family Life Assurance Co of Columbus (Aflac), which issued a ¥45bn three tranche bond in September.
While much of the Samurai volume was supplied by the stalwart Korean borrowers and by Hungary and Poland, which visit the market annually, one newcomer was welcomed in the sector — Kaupthing Bank.
Iceland's largest bank issued a ¥50bn three year bond in October through Daiwa and Nomura. It was the first Samurai from Iceland and the first from a Nordic financial institution since 2000. Kaupthing chose the Samurai market over Euroyen to reach Japanese investors.
"We have a relatively small retail depositor base and therefore need access to as broad a range of wholesale finance as possible," says Gudni Adalsteinsson, chief treasurer at Kaupthing Bank in Reykjavik. "We plan to be a regular issuer in Japan and for that market to account for as much as 25% of our annual global issuance."