The European Union has given a carve out from a new withholding tax for issuers that add to benchmark issues until March 1, 2002, without being subject to the tax. The granfathering arrangement has quelled strong concerns over the fungibility of new tranches, or re-openings tied to pre-March 1, 2001 issues, but the announcement actually came after the tax had taken effect. "It isn't like they waited for the 11th hour, it was more like they corrected it sometime after midnight," says Crispin Southgate, strategist at Merrill Lynch in London.
In the past few years, frequent issuers in the European market have built up the liquidity of their existing issues by re-opening them, or issuing new tranches. These taps have come under threat by an EU directive meant to prevent tax evasion. For countries with strict banking secrecy laws, such as Belgium, Luxembourg and Austria, a temporary withholding tax has been instituted until these countries change banking regulations to allow them to share information with other EU tax authorities. Bonds issued before the withholding tax deadline have different covenants than bonds issued afterward, eliminating the interchangeability, or fungibility, of the issues.
In a move highlighting the confusion surrounding the withholding tax, the March 1 deadline passed without any announcement from the Council, and Euroclear, one of the main clearing houses for international bonds, announced re-openings of existing issues on or after March 1 would be non-fungible with older issues. But, 48 hours after Euroclear's announcement, the Council clarified its position and Euroclear rescinded their decision.
If frequent issuers can't tap into existing issues, the bonds will gradually lose their liquidity, says Southgate. By extending the date for which issues can be safely tapped into and still be fungible with the new paper, allows large issuers to finish adding liquidity to existing paper, and time to begin issuing anew following the instituting of the tax. "A liquidity crunch will be avoided," says Southgate. "Issuers now have a year to build up what they started. Think of it as a mourning for taps."
Large issuers enjoy taps as a way to build benchmark issues that are popular among investors. "We buy the benchmark bonds," says Mark Freeman, portfolio manager at Westwood Management Corp in Dallas. "We always buy the biggest, most liquid names, such as the International Bank for Reconstruction and Development's 8 5/8% of '16." According to Southgate, if the EU hadn't extended the cut-off, IBRD bonds would have been one of the top five issuers to be hardest hit by illiquidity. The others include European Investment Bank, Italy, the German agency KFW and Freddie Mac, who has recently been beefing up its European coverage. Freddie Mac most recently re-opened 30-year reference bonds, adding an additional $1 billion worth of 6.75% notes of '31.
George Johnston, director of sovereign credit strategist at Barclays Capital in London, notes the irony in the fact the EU has instituted a deadline for the withholding tax, but has yet to come to an agreement on actually instituting the tax itself. "They've put the grandfathering in place to protect something that hasn't even happened yet," he notes. Johnston adds that the extending of the March 1 deadline also facilitates large, liquid issuers in accessing the primary market. "It helps them issue on good terms for new paper, if their old issues are still liquid."