Despite a pro-euro Labour government returning to power in early June, the outlook for sterling has rarely been brighter. 2001 has seen the total volume of outstanding sterling denominated non-gilt bonds outstrip the government market - an incredible advance within a relatively short space of time for a market that, according to most investors not so long ago, would become more or less sidelined by the new euro market
In the small hours of June 8, 2001 it was confirmed that Tony Blair's Labour government had been returned to power by an apathetic British electorate clearly not as protective of the pound as the opposition Conservatives had hoped or assumed.
Given the virtual certainty that Blair would be returned, UK strategists and analysts had had plenty of time to prepare their briefings on the implications for the market, and on June 8, 2001, the bulletins began to flow. Some had more imaginative titles than others, with the report from ING Barings - entitled The Blair Switch Project - a contender for first prize in this respect. "A referendum on UK entry into Emu is a scary prospect for sterling," this began. "But the implied fall in sterling is one reason why PM Blair may delay until the next parliament, spelling more instability and renewed dollarisation for sterling."
The ING Barings message was a disappointing one for champions of a speedy UK entry into the single European currency, concluding that a delay in calling a referendum is the most probable eventuality. So too was a Barclays Capital analysis also released on June 8. Entitled Euro test special - still 'non', the front page of this report carried an illustration neatly evocative of all things British - including a cricket bat and ball, a cup of tea and a programme for Royal Ascot, not to mention a pound or two. The conclusion of this report, while careful to include the caveat that Barclays Bank itself "has a neutral position on whether entry to Emu is good or bad for the UK", suggests that entry soon is unlikely.
The view of analysts in the UK seems to be at odds with those of many overseas investors, which have voted with their feet as far as the sterling bond market is concerned. "These days the inactivity of European investors in the sterling market is very much related to the perception that the UK is going to go into the euro at some point," says Nick Atherton, a sterling trader at ABN Amro in London. "That means a devaluation will have to happen, and most of them just aren't prepared to take the risk of a potentially huge currency hit."
Perhaps overseas investors with an actual or prospective exposure to sterling need not fret quite so much - not, at least, at this early stage. This is because if persuading the congenitally insular British to embrace euro membership is like climbing Everest, winning June's general election represented little more than an arrival at base camp for the Labour administration.
Schroder Salomon Smith Barney (SSSB) seems to speak for most observers when it puts the chance of the UK joining Emu before the next election (probably in 2005) at about one in three. "Our latest MORI poll," SSSB noted in June, "suggests that, while public opposition to Emu entry has fallen slightly since April, it is still roughly two to one against. The high balance of opinion against Emu entry suggests that it would be very hard to win a referendum, and the government probably will not push for [one] unless it is confident of winning."
It is not just moribund public opinion that needs to be won over if the UK is to ditch its beloved pound. There is also the none too small matter of the five tests to which the Labour government has committed itself, each of which, according to the official line, need to be passed before the UK throws its lot in with the single European currency.
The five questions that need to be answered in the affirmative if the pound is to join the Deutschmark, franc and others are - with thanks to the ING Barings bulletin - as follows. First, are business cycles and economic structures compatible, so that the UK and others can co-exist comfortably with euro interest rates on a permanent basis? Second, if problems emerge, is there sufficient flexibility to deal with them? Third, would joining the euro create better conditions for firms making long term decisions to invest in the UK? Fourth, would entry into Emu have a positive impact on the competitive position of the UK's financial services industry, and particularly on the wholesale markets of the City of London? And fifth, would joining Emu promote higher growth, stability and a lasting increase in jobs?
Today, there seems to be little consensus among analysts as to what the answer to the these questions are, but very few are prepared to put their head on the block and say that the answer to each is the unequivocal 'yes' needed to ensure a referendum on the subject, let alone entry into the eurozone. Indeed, in its assessment, Barclays Capital says that only one of the five tests appears to have been passed at the moment, which is the question on inward investment. "The fact that we do not appear to pass the other tests is obviously a very significant conclusion," notes the report. "But, just as important - perhaps more so - is the fact that our work also suggests that these tests will not be passed over the next five years."
Against this background, the various debates about what a UK entry into the single currency would do for the broader euro credit market, including the overnight creation of a large investor base for long dated bonds, appear to be premature and even academic.
Non-Gilt record growth
Within a week of the general election, on Tuesday June 12, the sterling market passed a historic milestone This was the day when ABN Amro led a £200m perpetual tier one transaction for Anglo Irish Asset Finance, which in itself was reported by the lead manager to have exceeded its most bullish expectations.
The significance of the Anglo Irish deal was that it marked the moment at which, for the first time in living memory, the total volume of outstanding sterling denominated non-Gilt bonds outstripped the government market. The Anglo Irish bond brought the value of the non-Gilt market up to £245.99bn, compared with a total outstanding Gilts volume of £245.95bn. That would have been unthinkable in the dark days of government overspending in the UK.
But it also marks an impressive advance within a relatively short space of time for a market that, not so long ago, was pretty fearful for its future. At Barclays Capital in London, managing director of investment grade credit research Gary Jenkins makes the point. "A few years ago there were worries among sterling investors that the market would become more or less sidelined by the new euro market," he says. "But sterling itself has managed to become bigger and broader. Its share of the total European pie may be smaller than it was three years ago, but that's only because the sector itself has grown at such a phenomenal speed." Certainly, the speed with which the sterling sector has expanded has hardly been shabby. In 1995, issuance in the non-Gilt sterling market was £10.2bn; in 2000, the total amounted to £50.7bn.
The biggest change in the structure of the sterling market in 2001, however, has been the powerful emergence of corporate issuance and the sharp reduction in triple-A (predominantly supranational) volume which was the main characteristic of 2000. Last year, Germany's KfW almost doubled its issuance in the sterling market, from £2.8bn to £5.3bn, leading some bankers to suggest that the Frankfurt-based AAA issuer ended the year somewhat alarmed at the amount of sterling debt it had accumulated relative to other currencies.
But in 2000, it was the European Investment Bank (EIB) that overshadowed all other borrowers in the sterling market, accounting for comfortably more than 20% of all vanilla issuance in the market. David Clark, head of sterling funding at the bank's Luxembourg headquarters, says that last year the EIB raised £9bn, which was more than the UK's Debt Management Office (DMO). He adds that it was also comfortably more than the £5bn or so that the EIB had expected to raise in the sterling market at the start of 2001.
The reasons for the structural shift in the sterling credit market are not hard to pin down. The guiding hand behind the distortions in the market before last summer was the minimum funding requirement (MFR), which was introduced in the 1995 Pensions Act in response to the shortfall of pension fund assets versus liabilities identified in the wake of the Maxwell fiasco. Although well intentioned, as it aimed to protect pension funds against bankruptcy, the MFR rapidly became a straightjacket for UK funds, forcing them to load up with long dated Gilts at precisely the time when the UK government's borrowing requirement was falling off a cliff. The result was a chaotic imbalance between supply and demand in the Gilts market, and by August 1999 SSSB, for one, was describing the long Gilt as "the richest bonds in the world". The knock-on effect was considerable and, for some borrowers, provided opportunities of unprecedented magnitude.
"If you go back 18 months or so there was a tremendous amount of issuance from the triple-A, top quality borrowers," says Stuart Bell, head of the sterling syndicate at Credit Suisse First Boston (CSFB). "That came about because of the absolute width of swap spreads which enabled issuers to hit very aggressive sub-Libor funding levels largely because buyers were less concerned with value relative to Libor, but with levels over governments. Those very wide swap levels allowed issuers like the EIB to come to the market at levels that were as high as 130bp or 140bp over Gilts. Today those very same bonds are trading in the region of Gilts plus 40bp or 45bp."
"The main element driving swap spreads was the relative expensiveness of the underlying Gilt," Bell adds. "Gilts were artificially expensive because the MFR twisted supply and demand out of kilter and forced pension funds to buy long dated Gilts at a time when the government was not issuing any. As a consequence, at the low point we were seeing yields on the 30 year Gilt that were more than 100bp through Bunds and Treasuries. You had to ask yourself how that could be when Germany and the US have a much better track record than the UK does on inflation and economic performance and the answer was purely supply and demand."
The scrapping of the MFR - promised although not yet enacted - has released institutions from the straightjacket of chasing an asset that was in diminishing supply, and therefore led to UK funds dumping longer dated Gilts in favour of 10 year paper and non-government bonds. The result has been the restoration of some normality to a yield curve which, not so long ago, was grotesquely inverted. Indeed, the selling of Gilts at the longer end of the curve was probably overdone, given that at one point the yield on the 30 year bond was over 5% and has since stepped back to the 4.9% neighbourhood.
"My view is that people who expected a very sharp disinversion of the yield curve post-Myners look as though they have been proved wrong," says Clark at the EIB. "Even if the curve did disinvert in the first instance it has since reinverted significantly, and I think that demonstrates the degree to which corporate pension funds clearly need to hedge themselves and reduce volatility."
Switch to corporates
With a yield curve that is now in the process of normalising itself, the window of opportunity that allowed triple-A issuers to borrow in sterling triple digit spreads over governments has all but closed. At the EIB, Clark says that so far this year his bank has raised about £2bn, much of which has been accounted for by structured and index linked issuance, but he also says that the EIB is perfectly relaxed about this sharp reduction in sterling for at least two reasons. First, he says that there is absolutely no indication that liquidity levels in the EIB's sterling bonds has fallen; indeed, he says that true secondary market volume is up on last year. Second, he says that it has not been as if the reduction in opportunities in the sterling market has come as a surprise to the borrower.
"We knew last year that institutions in the UK wanted to increase their exposure to spread products and that either there was an insufficient supply of corporate paper or that the corporate bonds that were available were not yielding the required spread," says Clark. "So we knew, because we were warned by the some of the insurance companies, that many UK institutions were buying EIB bonds last year and were intending to switch into corporate paper as and when they could, and clearly that is what many of the institutions have been doing this year."
Clark adds that he does not believe that there has been substantial selling of EIB bonds by pension funds this year, and that most of the switching between the supranationals and corporates has come from the insurance companies. As the most obvious Gilt surrogate in the sterling market, demand that EIB bonds command is not about to evaporate overnight, which provides the bank with a sufficiently robust bedrock of buyers in the UK. "We've managed to get £2bn done this year which is fine," says Clark. "It meets our core sterling requirement adequately."
Nevertheless, the erosion of the returns available on EIB and other triple-A paper has meant that investors in search of yield have to search elsewhere for their returns in the sterling market. To all intents and purposes, this means rooting out opportunities in the corporate market, be it plain vanilla or structured, as well as in subordinated bank paper, asset backed issues and foreign bonds.
The process is one that has already gathered noticeable momentum, although most analysts believe it still has a long way to go. In a recent edition of Sterling Weekly, SSSB notes that "it is not yet clear when the government will fulfil its promise to scrap the MFR, or exactly what will replace it". SSSB says anecdotal evidence suggests that a large number of pension funds had their last MFR assessment in early 2000, and will not need their next until early 2003. The report adds: "So one possibility is that the government will, as an interim measure, extend the period between MFR assessments from three years currently to, say, five years, in order to reduce the number of pension funds that are subject to MFR-related restrictions on their asset allocation while a replacement is devised. Such a measure would encourage the ongoing shift of pension fund assets out of Gilts and into other assets, notably non-Gilt sterling bonds and foreign currency bonds."
It is not just the jettisoning of the MFR which is encouraging UK institutions to explore more areas of the bond market away from Gilts. At the Royal Bank of Scotland (RBS) in London, institutional investor strategist Paul Stanworth also believes the shift in asset allocation among UK institutions - especially pension funds - away from equities and into bonds is one that is going to intensify over the coming few years. This will be driven in large measure by changes to accounting regulations, which Stanworth believes will see the UK market evolve into one that more closely resembles the US market in terms of institutional asset allocation. In this respect, Stanworth says that a very important influence will be the adoption of FRS17, the new accounting standard for pension funds which is due to come into force in 2003, although some companies have already begun to use FRS17 in their reporting and accounting. The essential element of FRS17 is that it will nudge pension funds towards adopting a much closer match between their liabilities (which behave like a long dated AA rated corporate bond) and their assets (which at the moment are predominantly in equities).
As a report published by Stanworth on the subject warns: "There is little public information about the asset split for individual companies, but FRS17 will make it available. Assume the average large fund has 75% of its assets in equities with the 25% balance... in bonds, property and cash. The value of the pension liabilities will be determined by interest rates, index linked if the pensions are indexed. This huge mismatch creates a major financial risk for companies, identical to issuing a long term bond and investing the proceeds in equities, which few UK companies would consider!"
"In the US, bond allocations of 40% are quite normal," Stanworth says, "whereas in the UK the norm is much closer to 10%." He adds that if UK institutions were to replicate the US model, back-of-an-envelope calculations would suggest that it would mean that some £90bn-£100bn of new money would flow into the bond market.
"I'm not suggesting the UK is going to move straight to US-style asset allocation," says Stanworth, pointing out that for one thing asset allocation strategies among UK pension funds remains under the supervision of trustees who are probably not always informed when it comes to keeping up with modern portfolio management trends. "In his review, Myners worked out that the average trustee spends something like eight hours a year working on investment strategies," he says, "which means they are still under the influence of their actuarial advisers who are still of the mind that equities will significantly outperform bonds over the long term." As a result, says Stanworth, there is obviously a danger that advisers are living in the past when it comes to assessing the relative merits of equities and bonds. "Historically equities were clearly a very valuable component of institutions' portfolios because they were tax efficient and provided a degree of immunisation against inflation," he explains. "Since the abolition of ACT the tax benefits of owning equities has been diminished. And with most people believing that the outlook is for low inflation, there should generally be less of a desire to hold equities as opposed to bonds from this perspective as well."
Corporate bond performance
Another compelling force that is helping to push forward the sterling corporate bond market - and one which is obvious although sometimes overlooked - is that it has clearly passed muster in terms of its performance track record as an asset class. Gary Jenkins at Barclays points out that in spite of increased issuance, sterling credit has been a very strong performer this year. "It's been a tremendous six months for credit," he says, "which has outperformed not just governments but also equities. All the factors that influence credit have been reasonably positive."
That observation applies, of course, to the euro as well as the sterling denominated credit markets, although the sterling sector has had one or two peculiarities on its side. As Jenkins points out, the so-called new economy is much less represented in the sterling corporate bond market than it is in euros - roughly 35% of euro denominated corporate issues outstanding are from new economy or TMT issuers, compared with just 13% in sterling. That has given the sterling market something approaching safe haven status in relative terms. "The sterling market obviously had some elements of event risk last year, but not as much as the rest of the world," says Jenkins. "This year there has hardly been any event risk in the sterling market, while volatility in global equities has had much less of an impact on sterling bonds than on euro issues. Correlations between triple-B spreads and equities in Europe are very high, but in the sterling market they are virtually non-existent."
Strong performance in the sterling corporate bond market this year has been accompanied by a steady and diverse flow of issuance. At Barclays Capital in London, Marco Baldini, a director on the syndicate desk, picks out the £200m 15 year deal led by Barclays and JP Morgan for BOC in January as a transaction that set the tone for corporate issuance in the sterling market in the first half of this year. Intensively roadshowed and ultimately priced at 165bp over the 2015 Gilt, this A2/A+ offering was reportedly precisely what sterling investors were crying out for at the start of the year - namely, a strong corporate name from an industry outside telecoms that was committed to maintaining its rating. The result was a very healthy order book amounting to more than £300m.
Baldini says that the demand for a deal such as BOC's is demonstrative of the depth of demand within the sterling investor base, which does not seem to have been at all diluted by the wave of consolidation that has taken place at an institutional level in the UK in the last three years, reducing the overall number of accounts likely to participate in any given transaction.
That depth of demand has meant that this year the sterling market has been able to accommodate a huge diversity of borrowers: frequent or first time, large or small, rated or unrated, local or foreign, structured or plain vanilla, issuers have rolled on and off the sterling conveyor belt with smooth regularity. As an example of the range of credits that can now access the market competitively, bankers point to debut issuer Birmingham Airport Finance, an A- entity that came to the market with a £105m 20 year deal via the Royal Bank of Scotland and UBS Warburg in February.
Unrated issuers have also been able to generate strong demand. The retailer John Lewis, for example, tapped the sterling sector in April for the first time since the 1980s with a £200m 2012 issue led by HSBC and the Royal Bank of Scotland. According to HSBC, over 35 accounts placed orders of more than £235m for this offering which was priced at 150bp over the 2012 Gilt, at the tight end of its price talk range of 150bp-160bp. In the same month, a £200m Aggregate Industries issue, led by UBS Warburg, was priced at 212bp over the 2015 Gilt, and was rated BBB by Fitch. "Aggregate is a company with a market capitalisation of about £1bn which has now raised a total of £400m in the sterling market, which I think shows how available and flexible the market is even for the lower rated credits," says Frank Kennedy, managing director of debt capital markets at UBS Warburg in London.
For all the strength of the corporate market, sterling has not been entirely devoid of triple-A quality in the unstructured market. Of all the tap transactions to have been launched in the sterling market in 2001, for example, probably the most popular was the £700m 2028 issue from Italy at the start of the year. Increased from its originally offered £600m and led by Barclays Capital and UBS Warburg, this offered elusive pure sovereign risk at an alluring 96bp spread over Gilts. Perhaps more importantly, by bringing an issue that had originally been launched in 1998 up to the magic £1bn threshold, Italy also created a highly liquid benchmark which was the largest non-Gilt sovereign issue in the sterling market.
"Italy was a fantastic deal," says Kennedy at UBS Warburg. "It offered two things - greatly increased liquidity and exposure to a pure sovereign, which has become increasingly rare in the sterling market. At a time when there was contracting supply in the Gilts market and a search for yield among UK institutions, Italy was offering 18bp above the EIB in a very liquid form."
Italy's deal was a highly successful example of non-UK issuers tapping the sterling market in 2001, and there have been scores of others in the corporate sector. "One of the most striking things about the sterling market over the last year or so has been how receptive it has been to non-UK borrowers," says Geert Vinken, global head of debt syndicate at Barclays Capital in London. "Some people will say that means the UK borrowers are facing much stiffer competition. I don't think that is the case. I think non-UK issuance in the market makes the sterling sector much more sophisticated, liquid and efficient in terms of pricing, which is to everybody's benefit."
Among US issuers, this trend was firmly established at the back end of 2000, most notably by the US retailer, WalMart. Its £500m 30 year transaction led in December by Goldman Sachs and Deutsche Bank was a runaway success, with strength of demand allowing the size of the deal to be raised from an originally planned £300m. Pricing, meanwhile, came at 146bp over the reference Gilt, which was 4bp inside the initial price talk level. "The WalMart transaction proved that the sterling market was available in depth and that investors were looking out for new names and sectors to diversify into," says Martin Hibbert, head of sterling syndicate at Deutsche Bank in London.
In February, United Parcel Service (UPS) picked up where WalMart had left off with an issue that in today's market environment is rare indeed: a corporate bond from an Aaa/AAA rated borrower. The £500m 30 year deal was led by Goldman Sachs and priced at 115bp over the 2028 Gilt, and reportedly attracted a book well over £1.25bn. IBM's debut sterling deal, meanwhile, was a two tranche offering, with the £400m bond divided into two equal tranches of three and five year bonds led by Deutsche Bank and HSBC. Although some regarded the pricing of both tranches as being on the tight side - 63bp over the Gilt for the three year deal and a 73bp spread for the longer tranche - strength of demand allowed the total size to be upped from £300m. According to an HSBC appraisal of the deal, "pricing, as perceived by the market, was tight versus comparable rated bonds, but fair for IBM as investors expected to pay a premium for this credit".
GICs provide rich funding source
Aside from the US corporate issuers that have been active in the sterling (and euro) markets this year, another fertile source of new issuance has been the guaranteed investment contracts (GICs) launched by US life insurers. In a research note published in January, entitled EuroGICs - A New Defensive Option, Dresdner Kleinwort Wasserstein explained that, "US life insurers are increasingly issuing into the euromarkets by means of an SPV. The notes issued are backed by an insurance contract, which usually gives them a ranking superior to senior debt. In the current economic climate these notes are an alternative way to gain exposure to a highly rated and relatively stable sector."
"The GIC market is a good example of a sector that is generating competitive funding costs for double-A rated issuers," says Bell at CSFB. "And it suits UK institutions because they are being given the chance to buy strong double-A paper at Libor plus the mid-30s, which is attractive relative to where senior bank or corporate bonds would trade."
The downside of GICs, say some observers, is that they are unpopular with UK insurance company investors that would rather not buy bonds issued by other companies within their own sector. One banker described that this observation as "pure baloney", and others argue that insurance companies do not care about the provenance of an issuer (by geography or industry) as long as it gives them the yield they are so frantically searching for. "We have been selling GIC issues to a broad spectrum of UK investors, be they life insurance funds, pension funds and unit trust managers," says one London banker, "with most of the demand coming from insurance companies."
Among UK institutional investors, the feelings aroused by the sharp increase in issuance from US issuers appear to be mixed. Gareth Quantrill, a fixed income investment manager at Scottish Widows in Edinburgh, welcomes the industrial diversification that many of the US issuers have brought to the sterling market. "But we do have to keep in mind that it is a global financing market," he adds, "so even though many of these companies do have sterling operations to fund, the main reason that companies raise funds in any given market is that it is perceived to be cheap at the time. My only gripe is that some of the longer dated issues from US companies were issued at pricing levels that were not justified by the fundamentals."
It has by no means been US issuers that have monopolised the sterling market as far as overseas issuers have been concerned. European companies are also becoming more and more active in the market - and not just those such as France's RFF which have a requirement for long dated funds and therefore have virtually no choice but to look to the UK investor base. "If you look back to the early 1990s, the vast majority of names in the sterling market were UK issuers, often unrated companies that UK institutions felt comfortable with," says Dianne Cornes, a director in global debt at Dresdner Kleinwort Wasserstein. "Over the last year or so we have seen an upsurge in the use of the market by non-UK corporates. We include the UK market in debt discussions with all our clients, UK and non-UK, whether as a source of sterling funding for UK acquisitions and operations, or simply as a cost effective and deep source of capital for issuers seeking to extend their investor reach and/or lengthen their maturity profile."
Among the European deals that have tapped the sterling market this year, one of the most popular was launched in April by the German utility RWE. The long awaited transaction eventually emerged as a Eu2bn offering (incorporating a rare 15 year tranche raising Eu500m), alongside two sterling tranches of £250m (for five years) and £350m (for 20 years) led by Barclays Capital, Deutsche Bank and Merrill Lynch. Described by Baldini at Barclays as a blowout transaction, the RWE deal was notable for having swept faultlessly through the market without covenants. According to a Barclays report of the deal, the order book for the 20 year issue included almost all the key investors active at the long end of the sterling market.
Another popular deal from a European industrial issuer came from France's Saint-Gobain which, having made a hugely successful £450m five year debut in the market in 2000, returned to the sterling sector in May with a more modestly sized £150m seven year bond led by HSBC and Goldman Sachs.
These only set the scene for the huge £650m 30 year deal for Electricité de France (EdF) led by Barclays Capital and UBS Warburg at the beginning of July, which set a new benchmark for having been the largest non-UK corporate issue ever launched in the sterling market. An offering that had originally aimed to raise £300m attracted a book worth about £1bn, according to Vinken at Barclays Capital, thereby smashing to pieces the notion that for corporates the sterling market was a relatively illiquid backwater by comparison with its euro counterpart.
Dual tranche transactions
Aside from those non-UK companies that have successfully tapped the sterling market this year, bankers point out that a very discernible trend has been the propensity of companies (UK or otherwise) to launch dual tranche transactions simultaneously tapping into the sterling and euro investor bases.
A good example of a successful dual tranche deal for a UK borrower expanding into the euro funding market was the £300m and Eu800m raised by the retailer J Sainsbury in June. Led by Deutsche Bank and HSBC, this raised 11 year funds in sterling and seven year money in euros (the company's first bond in the European currency), with both tranches of the deal increaed in response to investor demand.
The utility Innogy adopted a similar strategy, tapping the sterling and euro markets on consecutive days in May, raising £300m over 10 years and Eu500m with a seven year maturity via Barclays Capital, BNP Paribas and HSBC. This deal, proceeds for which were earmarked for the refinancing of its acquisition of 94.75% of the Yorkshire Power Group, attracted a book worth more than Eu1.3bn and £715m for the two tranches, according to Barclays Capital.
"The sterling market has shown itself to be a very effective one to tap in conjunction with a euro deal," says Vinken, "and we are seeing many more dual sterling/euro deals than sterling/dollar issues. So the UK investor base is becoming much more of an integral part of the broader European investor base, and I think that trend will continue." *