New challenges for defensive credits as recovery takes hold

Every crisis has its winners and losers. In the eurozone tumult, it is the peripheral borrowers that have suffered. But Washington supranationals and Nordic, German and Japanese agencies have been the main beneficiaries of the aversion to risk. Steven Gilmore looks at how they may be affected by investors’ return to risk.

  • 29 Mar 2011
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Though in their search for higher yields investors have shown willing to return to names they abandoned during the height of the peripheral sovereign crisis, the market environment remains undoubtedly in favour of safe-haven borrowers, namely the Washington supranationals, Nordic and German issuers and Japanese agencies.

Guy Reid, head of SSA DCM, EMEA, at UBS in London, says that although the market has begun to normalise, investors remain very credit conscious. "A number of investors have minimum rating guidelines, and as some issuers have been downgraded their investor base has naturally narrowed," he says. "Central bank investors remain focused on the highest quality issuers and this naturally reduced market access for others, particularly in the US dollar market."

Nordic issuers have benefited from their distance from the problems of southern Europe, with Norwegian and Swedish krona allowing European retail investors to diversify out of EU assets. And German issuers, though closer to the area of concern, have remained popular due to the country’s strong fundamentals.

"As we are guaranteed by one of those countries investors see as outperforming others we have enjoyed continued demand," says Horst Seissinger, head of capital markets at KfW.

Raymond Seager, director, public sector DCM at Bank of America Merrill Lynch in London, says Washington supranationals have also retained their safe-haven status. "Much of their funding is in the dollar market which is traditionally dominated by central banks, though this has broadened out in the last year or two," he says. "The dollar has retained its own safe-haven status, adding to the appeal of these names."

As investors have shied away from peripheral Europe the bid has also increased for Japanese agencies, which benefit from their remoteness and their higher yields. "They have not been affected by the financial crisis or the problems in Europe," says Reiko Hayashi, head of DCM for Bank of America Merrill Lynch in Tokyo, "Nor are they rated as highly as their American or European counterparts, and so have paid up slightly."

The implications of Europe’s debt problems for the safe-havens, however, have not been uniformly positive. Though rating requirements and perceived security have benefited some issuers more than others, Reid points out that all issuers saw their spreads widen.

Still, the safe-haven SSAs show no sign of relinquishing their status, which George Richardson, head of funding at the World Bank, says is one of the unique benefits of being in this issuer class.

"It’s as a sector that enjoys steady, continuous demand and there is always a large central bank buyer base for our paper to replace treasuries or Bunds," he says. "When there is a new position on interest rates, or currencies, or commodities that investors wish to take in the structured market, they usually don’t want to take on credit risk as well."

Proving popular

This desire to look for higher spreads without taking on credit risk has resulted in safe havens enjoying success in a wide variety of products, with distinct trends in currency, structure and duration.

"With the impact of the European peripheral crisis the Australian dollar has come into favour," says Ben Powell, deputy head of funding at KBN. "We’ve also done more Brazilian real, and demand for KBN in Norwegian kroner was a very strong."

Issuance across this range of currencies, he says, is still continuing.

"Australian dollars in Kangaroo format has already been strong this year, as has demand for Brazilian real from Japan," he says. "It’s a sign people are looking into more exotic currencies while still focusing on the triple-A credit."

Demand across a range of currencies has complemented borrowers’ desire to continually diversify; the ability to issue across currencies and structures is one of the hallmarks of top tier supras and agencies.

"Diversification of currencies and of investor base is always important," says Jens Hellerup, head of funding at the Nordic Investment Bank. "We did 16% of our funding in Australian dollars last year, and also some New Zealand dollars and Brazilian reais, we don’t want to be dependent on one market."

Other markets, however, have suffered as investors return to borrowers previously deemed off limits. "The market for structured products aimed at Japanese investors has tailed off during recent years," says Hellerup. "This year we expect fewer zero callables, which have been very popular with Asian investors."

Powell says that as yields have come in, and returns for investors reduced, the move towards higher rates has been reflected in the Uridashi market.

"There has been a shift in structured products from equity-linked to FX-linked," he says. "Though it is contained within this market for the moment."

Investor interest in the Nordic issuers’ core products, however, has not waned. Powell says KBN has seen a strong preference for liquid assets in the form of its euro and dollar benchmarks. And Hellerup reports that the public markets have worked well for NIB. "Central banks have always been important, but we’re seeing more asset managers, and even corporates participating in our dollar benchmarks," he says.

Petra Wehlert, head of new issues at KfW, says that the duration of issuance has also changed as investors look for higher yields. "Our average duration last year was over five years, when it’s usually around five," she says. "There has even been demand from Asia for 10 year bonds, an investor base that traditionally looks to the shorter end."

This broad sweep of opportunities has prompted some borrowers to alter their programmes.

Søren Elbech, chief of the treasury division at the Inter American Development Bank, says the IADB is building capacity to price more structured products, though the bank’s overall strategy remains the same.

Seager believes that though spreads may tighten, the benchmark investor base will remain. And while Washington supra issuance in the Uridashi market may be falling slightly, demand for other products is rising to take its place.

"Some central banks and fund managers are diversifying, not in terms of issuer type but rather in terms of payout for SSA bonds," he says. "One of the key themes has been the commodity currency play using a high quality SSA name to get higher yields, rather than buying a vanilla corporate bond in euros or dollars."

The bid remains the same

Given their preeminence, there is a consensus that when peripheral Europe’s problems are resolved, the implications for safe-haven SSAs are minimal.

"Investors are starting to return to the southern region," says Ulrik Ross, head of EMEA public sector DCM at HSBC in London, "But this renewed investor interest is not going to change the demand for the current safe-haven issuers."

The asset managers and emerging market investors who now have money to invest in the peripheral supras and agencies, Ross says, constitute a separate investor base. "It’s not a trend that will alter pricing or volumes for the top tier issuers," he says.

And while buyers begin to return to riskier credits, the investor base of some safe-have issuers continues to broaden.

"There is a more diverse investor base in our dollar benchmarks," says Hellerup. "Central banks have always been important, but we’re seeing more asset managers, and even corporates participating."

As such, the peripheral crisis and its prospective resolution have not prompted any change in strategy for most borrowers. "The funding strategy model we’ve used for many years still holds true," says Elbech. "[It is] a combination of strong and continued presence in the global benchmark market, issuing a small amount in structured and other products in response to specific demand."

Doris Herrera-Pol, director, capital markets, at the World Bank says that the Bank’s strategy has been modified only as a result of growing borrowing needs in recent years, prompting it to look to new markets.

"One market in which we had not issued before was the callable bond segment in US dollars," she says, "Our opportunity to enter into this asset class at cost-effective terms was prompted by a decline in activity from the government-sponsored enterprises."

Seager foresees few problems for the Washington supras, though the spread between them and European agencies has, he says, moved largely in line with the headline risk from Europe during the peripheral crisis,

"They will always form a core part of a diverse portfolio for certain investors," he says. "When the crisis is eventually resolved they’ll likely return to trading at a slight premium to European SSA paper, in contrast to the 10bp-15bp we have seen at times during the crisis."

Threats from below

Ben Powell at KBN thinks investors will always seek higher yields, though the effect on the SSA market will be determined by their risk appetite.

"Perhaps they will start to look at covered bonds, or further down the credit curve," he says.

With US covered bond legislation being prepared, there has been renewed concern that the asset class may impinge on the SSA investor base. Herrera-Pol, however, is not concerned.

"It’s a case of been there, done that," she says. "Six or seven years ago we saw the first sales pitch about the covered bond market and the competition that it would be pose to traditional triple-A issuers, and it didn’t materialise."

Investors will, she believes, continue to differentiate between top quality SSA paper and covered bonds.

Jigme Shingsar, managing director, debt capital markets at Royal Bank of Canada, says that before the financial crisis covered bonds were viewed as a rates instrument and a potential substitute for SSAs. "I don’t think we’ve come out of the crisis with that same view," he says, "and though from a ratings and credit quality perspective they appear similar to some of the SSA names, we are not currently at a point where they are a major concern."

Olcay Yagci, director, public sector DCM at Bank of America Merrill Lynch in London points out there have been competing products introduced into the market before. "Around $500bn of government guaranteed bonds issued by non-US financials has entered the market since 2008," he says.

Though this influx of GG paper proved popular with the US investor base, Yagci says the effect was detrimental only in the short term during 2009.

"SSA primary and secondary market spreads did widen, but the long-term positive impact was notable," he says. "More US investors came into the SSA space, moving from the GG bonds into those issued by IBRD, IADB, IFC or European issuers like EIB and KfW, and they stuck with them even as spreads tightened."

Though Yagci concedes there may be a supply problem in the triple-A space, and US covered bonds may attract some investors, top quality SSA paper will remain in strong demand.

"It always keeps its purity, especially when everyone knows the mandate of many of these institutions is to finance infrastructure," he says. "Some $40tr will be required in the next 20-25 years, and investors know they will be around not in the next three years, but the next 30."

He adds: "There was concern about investors moving down the credit curve pre-crisis, or away from structured, away from fixed income. But the supras and agencies have such a broad range of markets available to them in terms of currencies and structures that they can adapt to the changing market place faster and more easily than any other issuer group."

If and when the peripheral crisis is finally resolved, the effect on the supranational and agencies will be difficult to predict. There will be potential competition from other asset classes as well as new agencies.

"There are lots of things that determine costs and funding strategies," says Seissinger at KfW. "From our point of view an increase in demand for the peripherals is one variable." Competition, he says, is always present. "There were questions about whether issuance from the EFSF or the EU would hit demand, but these are substitutes for government debt and therefore should not create additional supply."

Lessons learned

One lesson from the peripheral crisis, says Seager, has been the importance of the dollar market, and specifically the US investor base. With the GSE’s portfolio shrinking and the entities themselves evolving, issuers are approaching the investor base in different ways.

"Many issuers are moving to put 144A documentation in place, while Washington supranationals have looked at large callable structures, $500m or $1bn European callables, trying to make themselves more like the GSEs," he says. "The Washington supranationals and issuers like EIB and KfW have worked hard to make themselves into GSE surrogates."

Given how quickly the market can change, issuers have also learned to be fast in their execution.

"SSAs have always been quick in responding to investor demand," says Reid. "However the timeframe is now even shorter and the execution timetable has also narrowed as a reflection of continuing market volatility."

Though the peripheral crisis may have eased, sovereign financing requirements will remain elevated for some years to come, says Reid, meaning continued competition for investor demand and will necessitate issuers reach as many investors as possible.

"Flexibility has become far more important as timing has become harder," he says. "It’s difficult to forecast a few weeks in advance whether you will be able to issue at a certain date, or in a certain currency or maturity."

Sessinger says issuers have learnt that they must maintain a close relationship with investment banks and investors in order to be able to react quickly when demand is present. "Certain volumes are no longer guaranteed at any time," he says. "Sometimes demand is limited, or there is a change in pricing."

The importance of flexibility has also been brought home to Japanese issuers, which Hayashi says have in the past been more rigid with regard to deal size and maturity.

"They would issue $1bn or below, and five years or longer in any instance," she says. "As a result of the increase in demand they are trying to be more flexible, for example issuing larger deals to secured liquidity if necessary."

She adds that JBIC has issued successful two and three year deals in the past two years. "Japanese issuers have also been focusing more in investor relations as its clear that you need to have solid demand from various jurisdictions and markets," she says. "JFM and DBJ have established MTN programmes to better tap the market, and SEC/144A documentation has also become more popular."

The outlook then is rosy for safe-haven supras and agencies. Their most-preferred status brought them strong demand and an increased investor base during the worst of the peripheral crisis. Many have been driven to ensure further access to new markets and structures, leaving them even more resilient and flexible. This will stand them in good stead to deal with prospective rival asset classes. Given their enduring popularity and breadth of operation, the confidence of issuers that appetite for their paper will remain strong seems well founded.
  • 29 Mar 2011

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5 Trust Investment Advisors 31.87 2 9.90%