Once retail dominated, the Swiss bond market is changing fast, as investment pools are increasingly managed by professionals demanding to buy - and trade - in size.
That has been reflected in the increasing amounts of bonds launched at over Sfr500m in size, and the imminent announcement of reforms of the repo market.
The changes are taking place against the background of increasing demand for Swiss franc bonds as investors flee volatility caused by the Asian crisis as well as the potential instability of the euro. The disappearance of most of western Europe's currencies will also heighten the attractions of the diversification offered to borrowers and buyers alike by the Swiss market.
But friction often accompanies change and innovations such as the advent of the fixed re-offer system have sparked controversy. Neil Day reports.
ANYONE in the Swiss debt markets who returned to work a day late after the New Year holidays could have been forgiven for thinking they might as well have stayed at home, having already missed out on the action. On the first trading day of 1998, Sfr3.5bn ($2.39bn) of foreign bonds hit the market - 13% of the total for all of last year.
But since that explosive start, any laggards will have had a chance to make up for lost time. At Sfr12.2bn, first quarter volume in the Swiss franc market had already reached just under 50% of last year's total.
Propelling that demand: the renewed attraction of the Swiss currency as a safe haven, sheltering investors from the uncertainties of the Asian crisis and the looming single European currency.
But it was not just the weight of new issue volume that reinvigorated the market.
The first day issue roster was all the more unusual for its composition: just three bonds made up the extraordinary volumes. Bayerische Landesbank and Toyota Motor Credit Corporation (TMCC) both launched Sfr1bn benchmarks, while the Republic of Austria returned to the Swiss foreign market for the first time since 1996 with a Sfr1.5bn jumbo - by far the largest ever issue to be launched in the Swiss debt markets.
While dramatic, that day's step up in issue size capped a trend toward larger, benchmark issues that had developed over several years. In part, that reflected the desire for liquidity sweeping most bond markets. But it also reflected the fact the Swiss market, long a classic retail bond market, is becoming increasingly institutionalised.
As in other markets that shift is prompting structural changes.
Today (Friday) the Swiss National Bank looks set to announce that it will accept for repo trades Swiss franc bonds issued by, or guaranteed by, highly rated foreign governments, as well as the Swiss government, cantons and co-operative banks. Aimed at providing a much-needed kick start to the lacklustre Swiss repo market, the move should also inject valuable liquidity into future benchmark issues.
Demand for Swiss franc assets has traditionally been high during times of financial upheaval and the Asian crisis that peaked in October only reiterated the safe haven qualities of the Swiss currency, with the franc rising sharply against the Deutschmark and the dollar.
While the Asian crisis has subsided, another monetary factor has come into play: Europe's push towards the single currency. Despite a much smoother transition and convergence period than many expected, a number of investors remain wary of the single currency and see the Swiss franc as a hedge against a weak euro.
But if the euro is stronger than investors anticipate and the currency survives the speculative attacks that many bankers feel could test it, the potential for growth in the Swiss debt markets remains high.
"The fewer currencies that there are for investors to buy, the fewer opportunities there are for diversification," says an official at SBC Warburg Dillon Read. "So the Swiss franc will make more sense in an investor's portfolio than in the past. The same is true for borrowers."
A syndicate official at Paribas agrees: "The Swiss franc will not only survive, but will prosper, it being the only real alternative currency in Europe. We aim to give borrowers and investors the opportunity to participate in this important market."
The disappearance of an expected 11 currencies from Europe will dramatically reduce the arbitrage opportunities on offer until now. Investors and borrowers will be deprived of the chance to make currency plays, not to mention the convergence plays that have been made in the run up to European monetary union.
"Many investors will face a diversification problem when instead of buying 11 European currencies they can only buy the euro," says an official at UBS. "They will try to diversify and they must consider the Swiss franc. That will be very supportive for our market."
But to garner the full potential of that extra demand, the Swiss foreign bond market may have to change, shedding many of the peculiarities that divide it from the main body of the Euromarkets. The tax regime, syndication methods and thin market liquidity all remain obstacles to attracting the full range of international buyers that syndicate officials now woo.
One syndicate banker puts it bluntly: "If the current interest in Swiss francs is to be sustained, it is clear that the market has to become a lot more sophisticated and professional."
The clearest response to the desire to attract more international accounts to the Swiss foreign market has been to introduce Euromarket practices to the sector, in particular the fixed re-offer price system.
Although the system had been used in Switzerland in the past on a small number of occasions, the deal that did most to generate interest in the syndication method was a Sfr1bn issue for TMCC launched by SBC Warburg Dillon Read on October 7, 1997.
Six months after its launch the 3% November 12, 2002 deal remains the largest ever corporate foreign bond in the Swiss franc market; at its launch it was widely praised by syndicate members. But since the launch of the benchmark transaction, opinion over the advantages of the fixed re-offer price system has diverged sharply.
Syndicate officials agreed that the five year TMCC deal was itself an ideal issue to test the system. TMCC is triple-A rated and attractive to both institutions and retail, while the five year maturity ensured the broadest possible audience.
The deal was launched at a fixed re-offer price of 100.65, yielding 2.86% or 15bp through the five year Swiss franc swap spot rate (bid). Following launch at 9am the deal was free to trade at 1.30pm and was immediately bid at the re-offer price. By the close of trading the issue was bid at 100.75, yielding 2.84% or 18bp through the swap rate.
The bookrunner traded the bonds with a 10 cents bid/offer spread (against the normal 20 cents) for trades of Sfr5m throughout the grey market screen trading period, and benchmarked the issue to the five year swap rate.
The 10 cents bid/offer spread was widened to 20 cents for short periods when interest rates were volatile.
By the end of the grey market period two weeks after launch, the bonds were trading at a yield of 2.60% or 19bp through the swap rate, despite that rate increasing by more than 35bp during that period.
The bonds were successfully distributed to a wide range of accounts. Although early sales were mainly to institutional accounts, at the end of October, 37% of the bonds were in the hands of funds, 31% with retail, 13% with banks and 19% with other institutions.
The bookrunner placed a small portion of the bonds internationally, with 4% of the paper going to non-Swiss based accounts. Of this portion, 87% went to funds, with the remainder going to other institutions.
Several other considerations shaped the pattern of placement, beside the fixed re-offer price system. Although SBC had been looking into the possibility of such a deal since February 1997, conditions in the Euromarkets did much to aid the launch in October. With spreads having ballooned in the dollar sector and under pressure in many other markets, borrowers were keen to find attractive funding. TMCC would not have been able to launch a dollar deal at current market spreads.
SBC persuaded TMCC that although the deal might not achieve the levels it had previously found in the Swiss franc market, the benchmark transaction would allow it to achieve funding closer to levels theoretically available in the dollar market at current spreads. At the time TMCC was known to have an after-swap target of around 23bp through Libor in dollars, but syndicate officials estimated that the Swiss franc transaction achieved only around US dollar Libor minus 10bp.
"The TMCC transaction was clearly priced a lot closer to international levels," says one syndicate official. "But the reason that SBC were able to bring TMCC to the market was that they pointed out that the Swiss franc market offered a chance to launch a deal at a reasonable level when a $500m deal would have been a lot more expensive."
Syndicate officials were unanimous in their praise of the deal's pricing, but were less keen on the concept of SBC keeping a praecipuum while using the fixed re-offer price system.
An official at SBC argues that the lengthy preparations that had been needed to bring the deal to the market justified the praecipuum, but that once the fixed re-offer price system was more widely accepted, the praecipuum would be dropped.
The bookrunner did just that when it launched a second, six year TMCC Sfr1bn benchmark on the first trading day of 1998, without a praecipuum.
Discipline in keeping to the fixed re-offer price before the deal was free to trade was crucial to determining the success of the five year deal. At this point the picture becomes less clear.
SBC insisted that few banks sold their bonds at below the re-offer price during the syndication period, but some bankers reported several syndicate members offloading their paper at any price. Most bankers argued that the presence of two other jumbos in the market damaged the attempt to launch the second TMCC Sfr1bn transaction with the new syndication method.
"The fixed re-offer price system on the six year TMCC deal was the reason why the deal did not sell well initially," says one syndicate official. "It was less successful than both the Austria and Balaba transactions. In this case, the system definitely didn't help us place the bonds."
Another syndicate official agrees. "If you have other competing issues in the market at the same time, investors will turn to the issues that are not launched under the system, as they feel that those deals will be priced at a true market level. When the price is fixed, some investors will have the feeling that it is not at the price it should be at and they will simply wait for the deal to be free to trade."
Nevertheless, an official at SBC said that the introduction of the system was designed to ensure orderly rather than speedy placement. "The fixed re-offer price system implies a moderately higher margin for syndicate banks which is justified by the size and strategic nature of the transaction."
Despite the mixed record of the fixed re-offer experiment, a number of syndicate officials welcome the opportunity to launch deals this way, avoiding the all-too-common sight of tightly priced deals hitting the market only to be immediately quoted at full fees.
Fierce competition in the Swiss market is one reason why SBC sees more deals of Sfr500m and higher being launched with a fixed re-offer price. "As margins become smaller and smaller we will see fewer banks appearing in the league tables and there will be a growing consensus that the fixed re-offer price system makes sense," says the trader.
Another syndicate official agrees. "Many people anticipate a reduction in the size of syndicates and that will make the fixed re-offer price system easier to maintain."
Employment of the syndication method could also depend on the development of interest rates over the year. Although rates should not change dramatically, yields are to move upwards from their historical lows as the Swiss and European economies pick up.
But just what a falling market means for the fixed re-offer price system is unclear. Some bankers say that the system has been unnecessary in the long rally that the market has enjoyed. Deals have been launched on the back of falling yields and paper has been relatively easy to place. However, a less friendly market could enhance support for a rigid syndication process if it were the only way to guarantee making a profit on a deal.
Some syndicate officials take the opposite view. "Deals using the system have to be launched into a market where rates are considered to be stable or falling," says one. "When rates are falling everybody will stick to the re-offer price as they can be sure of a decent profit. But when rates are rising you will always have people off loading at the break even price, and they aren't going to wait for a call from the lead manager telling them when the deal is free to trade."
Just what the future of the syndication method will be depends on the attitude of the banks involved. "It is a question of discipline," says one syndicate official. "And potential lead managers won't stick to the system as the competition is too great."
The syndicate official pointed out that the future of the fixed re-offer price will depend equally on the driving factor behind nearly all bond issuance: the funding targets of borrowers. The system depends on a certain level of fees being paid by issuers, and many bankers predict that there will always be a competing bank willing to give up fees that would be taken by a lead manager proposing a deal syndicated under the new method. This has led some syndicate officials to expect a limited use of the system.
"The fixed price re-offer system will be used on a case by case basis," says an official at Credit Suisse First Boston. "If you have a clear market and time to engage in a price discovery exercise, then the fixed re-offer price system can work, as it did for our Citibank deal and the first TMCC benchmark."
The CSFB official explained that this reasoning was why the bank employed the new syndication method for its landmark asset backed Citibank transaction, but not for the Sfr1.5bn Austria transaction at the beginning of the year.
"For the Citibank deal, we had time to discuss pricing with investors and could use a fixed re-offer price. But the Austria mandate was awarded after competitive bids and the deal was launched into a busy market."
If the view that the fixed re-offer price system will only flourish with the launch of more strategic benchmark transactions is correct, the system may have a future in the Swiss market, as the needs of borrowers and the demands of investors combine to ensure that the trend towards larger transactions continues.
Before 1997, issuance of deals of Sfr500m in size was uncommon. In 1996 only Sfr1bn of benchmark issues hit the market, but since the beginning of 1998, Sfr8.25bn of issuance has been of bonds totalling at least Sfr500m.
A UBS official explains the reasoning for this growth. "Borrowers have a natural desire to tap the Swiss franc market because of the cheap funding it can provide," he says. "The low rates that prevail in the Swiss market and the fact that the market offers the best arbitrage opportunities attract big deals from major borrowers.
"On the other side, the institutionalisation of retail has been a major factor in jumbo issuance. We still see pure retail buyers, but not as much as before and not so much in the primary market. What you increasingly see is medium term bond funds and they have been the driving force behind many of the big deals."
The pooling of cash that previously made retail investors such an important component of the Swiss market is a preoccupation of all syndicate officials. Many say they have been told by portfolio managers that they are no longer interested in the Sfr100m to Sfr200m issues that have made up such a large proportion of the market in the past. Sfr500m is now described as a decent size by many portfolio managers, with Sfr300m being the bare minimum.
The desire by portfolio managers for larger deals can be explained by the constraints on many funds. If a portfolio manager wants to buy a Sfr50m ticket of a deal, but can only buy a maximum of 10% of any one transaction, the deal size must be at least Sfr500m.
"The market will increasingly be split between larger institutional driven deals and smaller deals targeted at what remains of retail," says an official at Deutsche Morgan Grenfell.
That means that the many of the traditional characteristics of the Swiss market will linger on. "The decision of retail funds whether to buy is driven as much by their needs to invest new inflows of cash and reinvest redemptions as anything else," says one syndicate official.
The buy and hold attitude of many accounts will also remain a fact of life in the Swiss market for some time. One reason for this is that many investors are not yet sophisticated enough to engage in secondary market trading. Another is that transaction costs in Swiss capital markets can be prohibitively high.
"The benefits of switching out of one bond into a higher yielding issue are offset by the transaction costs involved," says one syndicate official.
Bankers are unanimous in the view that the stamp tax applied to all domestic securities transactions and, to a lesser extent, withholding tax act as a break on increased international participation in the Swiss market. Such taxes are a problem for domestic participants and discourage increased international interest in the Swiss government bond market.
A government working group is examining the effects of the tax and possible changes to the current regime. Although most syndicate officials anticipate the eventual removal of the stamp tax, change is expected to be slow.
The Swiss government has said that it aims to produce a balanced budget by 2001, but it has much work to do, with the federal deficit widening from Sfr4.36bn in 1996 to Sfr5.27bn in 1997. The stamp tax is an important element of government revenues, raising Sfr2.5bn in 1997, 27.1% more than in 1996.
Political opposition to any removal of the stamp tax is therefore high. As in many countries, it will be difficult to garner public support for the abolition of what is seen as a tax on the financial community. Most bankers expect that the lost government revenues will have to be made up by a new tax on the financial community, with a new capital gains tax and a tax on the insurance industry among the possible candidates.
More immediate action is expected on plans to increase the liquidity of the Swiss debt markets, with the Swiss National Bank set to introduce centralised clearing for domestic repurchase agreements in the near future. SNB chairman Bruno Gehrig said: "Having an efficient repo market available in Swiss francs is of strategic importance in the long run because our money market is still not where it should be."
The SNB announcement on repo eligibility should go some way to acheiving that aim.
Repo trades will be cleared through SEGA, the Swiss depository and clearing organisation, along with internal settlement systems in banks themselves. SEGA already clears bonds and equities and has a link to the Swiss Interbank Clearing system, allowing payments in the repo market to be made at the same time as securities trades.
Along with the attractive funding opportunities that the Swiss franc market can provide, and its growing importance after the introduction of the euro, the market represents a way for borrowers to enhance their reputation with an important investor base.
Switzerland is the world's largest centre for private asset management. An estimated $3tr of cross-border private banking funds are composed of accounts of more than $1m in size; 35% of those funds are estimated to be held in Switzerland.
Three of the top 10 largest asset managers in the world - CS Group, Zurich Insurance and the merged UBS and SBC - are resident in Switzerland and the 10 largest Swiss asset managers have well over $2tr of funds under management.
"Maintaining your reputation in Switzerland, the largest market for private asset management, gives you a competitive advantage when you issue in other currencies," says a syndicate official at Merrill Lynch. "If you are established in the Swiss franc market you have a backbone of investors for your Euromarket transactions."
Borrowers have been quick to understand this, particularly as Emu is only 10 months away. "Until now we had to compete with banks not just in Switzerland, but also abroad when trying to persuade a borrower to launch a Swiss franc deal," says one syndicate official. "Now issuers are competing to access the Swiss market and the only problem is that there is not enough demand."
Deals for Caisse Nationale des Autoroutes and Réseau Ferré de France this year have highlighted the implications of the rush to issue in the Swiss market, with CSFB launching deals for the two triple-A rated French borrowers at levels back from where many issuers of comparable quality had previously tapped the market.
The Swiss market has always been known as one where name recognition is of primary importance, and although having a good reputation remains essential, investors are becoming increasingly sophisticated and are looking more closely at relative credit quality. Hand in hand with this development has been an increase in spread trading.
"In the past there was a given level for certain issuers," says one syndicate official. "But now investors are gradually adapting to international practices and they don't buy purely on the basis of name recognition any more."
The institutionalisation of retail has been another factor that has accelerated the focus on credit quality and price. "When it comes to big issues, when your audience is institutional, they look more and more at relative value, and that means spreads and credit quality."
Lead managers are responding to this increase in demand for information from investors with more credit research and analysis for both foreign and domestic issuers. One of the best examples of the sophistication of investors has been the growing acceptance of asset backed securities.
"We see this growth in demand for deals such as our Citibank transaction because it is a top quality product and it offers a higher yield," says an official at CSFB. "This fits in perfectly with what investors are looking for. The Swiss market will become an important sector for asset backed security issuers which have issued heavily in other currencies."
Alongside larger deals and larger institutional investors has come the creation of the largest Swiss bank. The merger of UBS and SBC will dramatically change the Swiss market.
Already foreign banks are looking at how to best profit from the opportunities that will arise. Deutsche Morgan Grenfell has already made large strides over the past couple of years, placing itself in fourth place in the foreign market league tables with successful retail targeted transactions. Paribas is moving to the heart of the Swiss financial marketplace in Zurich from its previous home in Geneva.
ABN Amro plans to expand its Swiss operations to become the largest foreign bank in Switzerland (although not necessarily to become third in the foreign bond league table). And Merrill Lynch has been at the forefront of launching innovative transactions that have pointed towards the future shape of the market.
The attention that major foreign players are paying to the Swiss debt markets only underlines the importance of a market that continues to evolve toward international norms while maintaining strengths that only it can offer.