The pressure is on for sovereigns to use private placements in a bid to lower funding costs and find new investors. But the complex product brings its own set of challenges for debt management offices. Francesca Young reports.
Government debt management offices are in a bind. They need to borrow more cash than ever before and want to take the pressure of overloaded benchmark bond programmes and auctions, reduce interest costs and find new investors for their debt — at the same time as their peers are all trying to do the same.
It should be a perfect time for sovereign issuers to step up their use of private placements and structured MTNs — for years now, the flexible, low-cost funding tool beloved of supranational and sovereign agency borrowers. As deficits have ballooned over the last year, some have indeed started to use the product, but many more still find reasons to give it a miss, and others have even found cause to reduce their MTN issuance.
MTN dealers are frustrated by the lack of progress. They are used to working with sophisticated issuers that over many years have built up the front and back office skills needed to cope with a reverse enquiry market, small ticket sizes and complex structures. As a result, sovereigns struggle to compete with the market-leading agency borrowers — the likes of European Investment Bank, KfW, Instituto de Credito Oficial, and the World Bank.
"Sovereigns have to keep in mind that they’re dealing with an already occupied space," says Julie Edinburgh director, head of EMTNs at Credit Suisse in London. "The likes of KfW, EIB and ICO are all flexible with regards to sizes and structures and most investors will put these and the sovereigns in the same pool."
While the likes of the Republic of Italy, the Hellenic Republic and the Republic of Austria all used to regularly issue structured notes — mainly CMS or inflation-linked, with some currency linked deals — they rarely bothered with sizes below Eu100m. Since the financial crisis struck, demand for those trades has dried up.
"There was a time when some of the European sovereigns would issue a lot of different structures, but only for large size," says Edinburgh. "With increased funding plans, sovereigns are going to have to manage themselves more like the European agencies — not every trade can bring Eu200m.
"The more willing you are to be reactive to a reverse enquiry the better off you will be in terms of gaining as much arbitrage funding as you can. But this will require sovereigns to invest in their back offices, as most do not have the infrastructure to cope with EMTN flows. "
One scoop of vanilla
One area with increased sovereign activity this year is plain vanilla private placements. Sovereigns have responded to investors willing to pay up for odd maturities that are off the issuer’s benchmark curve, or for large sizes that investors can’t source in a tight secondary market. That has led to many $500m-$1bn trades, and some as large as $2bn for those sovereigns willing to entertain the inquiry — which is at levels significantly through benchmark curves.
Although only a handful of sovereigns have set up MTN programmes, many more are looking to do so. Portugal issued for the first time this year and Belgium heavily increased its use of the method. Both were lured to the product by its cheaper costs than the benchmark market, as was Poland.
"Our private placement activity is developing well, as we and other sovereigns use this market more and more," says Anna Suszynska, deputy director of the financial assets and liabilities department within the Polish finance ministry. "We think it’s advantageous to be first to soak up demand in this market and become a well known name — other sovereigns in the region may follow."
Belgium set up its MTN programme in late 2007. This year it has only used it to issue private placements to complement its normal OLO programme, though it could also issue syndicated deals from the facility. It has raised Eu2.5bn on an opportunistic basis, where it can save money when comparing the cost to OLO issuance.
"Our plan is that EMTNs take up 10%-12% of our funding," says Marc Comans, new product manager at the Belgium Treasury. "But we have no target for private placements versus public placements. It all depends on the cost-effectiveness compared to the OLO curve. On the private side, we’ve priced deals this year ranging from 30bp tighter than the OLO curve to 8bp tighter for the larger transactions."
Portugal meanwhile is planning on spreading its MTN wings. "They came to London earlier this year to meet with desks to take advice on what products they should be issuing," says Edinburgh. "We suggested vanilla and lightly structured CMS notes and inflation-linked notes."
These new issuers are open to the idea of using structured notes and non-native currencies with a swap to lower the cost of funding, but most — at least for now —approach these enquiries on an ad hoc basis.
"Many sovereigns are open to lightly structured notes but few of them have done anything in that market this year," says Toby Croasdell, vice president of MTNs/structured note trading at Barclays Capital in London. "The main activity at the moment is non-core currencies and tenors that the public deals don’t cover. That’s expected to continue."
The newer issuers in the private placement market have not yet had to decide whether to set up dedicated structured MTN funding teams as demand remains so poor. Flows have switched from around 80% structured and 20% vanilla in 2007 to about 75% vanilla 25% structured in 2009, driven by the increase in demand from investors for simple, transparent, liquid products.
"For proposals of a good size that gave us a lower cost of funding, we’d be willing to consider issuing structures and think of putting a team in place to manage this," says Suszynska. "In terms of currencies, we’re most keen to fund in zloty and euro, but are also happy to issue bonds in dollars, Swiss francs and yen. However, we’re not confined by those currencies. We’d be happy to take on board other risk if the demand and cost saving is evident."
Belgium has the same attitude to currencies. "We are authorised to issue bonds in all OECD currencies — we’ve been approached about issuing in Aussie dollars, dollars, yen, sterling and Norwegian kroner, and we’re happy to consider all those trades, but it is all swapped back, we don’t keep the currency," says Comans in Brussels.
However structured notes for Belgium are not yet on the agenda.
"We’re focusing on vanilla private placements only," says Anne Leclercq, director of treasury and capital markets in Brussels. "We’re reasonably new to MTNs, so for the moment we’re not going to run before we can walk. We never say never, but for the moment the structured note market isn’t a priority for us."
Staying away
Greece, meanwhile, no longer issues structured notes after a public row in 2007 over a Eu280m CMS linked deal that left local pension funds nursing losses. Other sovereigns are anxious to stay away from private placements entirely, even vanilla notes.
In December 2008 the UK Debt Management Office issued a consultation document to identify new and alternative ways of accessing liquidity given its increased financing burden in which the DMO made clear that it would potentially consider private placements or MTNs. However it was at pains to point out that the hurdle to consider these would necessarily have to be very high as it did not want to undermine what it calls the principles of transparency and predictability.
The consultation responses showed that the market was not, on the whole, comfortable with the MTN concept. This was especially true of the GEMMs, but was also the case for the index-tracking investor community who play a large part in the DMOs market and who would have struggled to balance their portfolios against the backdrop of any MTN issuance.
"Our focus is on building large, liquid, actively traded, benchmark Gilts, on the basis that this helps to minimise the long-term costs of the Government’s debt," says Robert Stheeman, chief executive of the DMO in London. "As such, private placements or structured loan products issued under MTN programmes do not really meet these criteria. For example, an MTN issue raises all sorts of questions about wider market knowledge of what we are issuing as it could mean that one specific investor would be privy to more information than would otherwise be widely available."
This also tends to be the case for larger EU sovereigns such as France and Germany. However, southern European and smaller EU sovereigns place less emphasis on this issue and can afford to be more nimble and flexible in the way they access the market.
Join the club
However, even for those sovereigns that do issue in the MTN market, advantageous funding costs are limited in the issuer’s domestic currency, though foreign currency deals can still offer cost savings.
"It is increasingly difficult to place native currency private placements for borrowers through their relevant benchmark curve as rational investors would simply buy the relevant benchmark in the secondary market rather than pay a premium for a small, illiquid private placement," says Chris Jones, global head of MTNs and structured notes at HSBC in London. "The art lies in exploiting arbitrage opportunities in other currencies and off the run maturities."
"I expect in 2010 to continue seeing what what’ve seen in 2009 — fewer, larger transactions," he adds. "Herding together of investors into ‘club’ deals gives greater liquidity to investors and greater ease of execution for issuers."
Foreign currency placements have their own drawbacks — particularly for niche currencies in which there is often demand from investors — because the sizes required are usually small.
Even though issuers can achieve optically cheaper coupons, the overall funding price doesn’t appear so attractive once associated back and middle office costs are factored in. A small sized private deal can take almost as much work for DMOs as a public deal, so deal size is a key factor in overall cost-efficiency.
"The notional is a key factor for private placements. For some niche currencies, you can say goodbye to that straight away," said Conrad Baker, private placement and structured notes trader at Deutsche Bank. "Trading dollars, Swiss francs and yen are potentially do-able but its very unlikely there would be a chance in something like Romanian leu. Also, a lot of these currencies will mean that the bond will carry high coupons and optically the sovereigns won’t be keen on that. If your swap disappears, you’ll be suddenly left liable for a very high coupon for a niche currency."
Open for business
Dealers are emphatic that there is good demand for sovereigns at the moment, particularly in longer tenors, though spreads are starting to contract at the long-end. Pure sovereign issuers are often in competition with semi-sovereigns such as agencies to issue private placements. But because sovereigns tend to have longer-dated liabilities than agencies they often offer more generous spreads. Investors are also looking at long-dated sovereign placements because agency paper is scarce as those borrowers complete their funding programmes and aggressively tighten levels.
"At the moment our private placement activity is all done on the basis of reverse enquiry. Banks frequently approach us with ideas and sizes of around Eu400m-500m," says Comans. "The trend earlier this year was for shorter maturities and there was no demand for longer maturities, so we did shorter maturities. Now the demand is for longer maturities, so we’re doing more longer dated paper, and at the moment we are reluctant to do maturities of less than three years."
But although demand is strong, sovereigns are not engaging in the MTN market in the way that dealers would like. Instead of posting levels, deals are done exclusively on the basis of reverse enquiry or a request for proposals process where issuers specify amounts, tenors and a timeframe, making it difficult for dealers to be creative with these issuers.
"With an RFP process, you can tick the boxes of all the usual investors to approach, but you’re never going to find many new investors within such a short period of time," says Edinburgh. "For MTNs, it’s better to have an open funding plan which is managed evenly throughout the year."
Sovereigns do have one great advantage on their side however — there is a small group of investors that can only buy sovereign names. These investors have not been as active this year as previous years because they did not want to buy illiquid private placement paper. But as the market and investors become more confident, dealers say that it is likely that over the next six months more of these investors will return to MTNs for vanilla and lightly structured paper, focusing more on the quality of the name than the spread.
That would give sovereign debt managers just one more reason to keep on paying attention to developments in the structured note and MTN markets.