Borrowers count their air miles
It was the year of the Kangaroo and the Maple in the non-core dollar bond sector in 2006, with both markets witnessing an increase in the volume and type of issuers visiting them. Matthew Attwood speaks to the year's leading players and asks them to explain both markets' popularity and what their predictions are for 2007.
The Australian domestic bond market is thriving, with A$50bn of issuance recorded for 2006 by mid-November, a figure that looked certain to rise by the end of the year to above 2005's total of A$56bn.
Kangaroo deals have dominated, accounting for 59% of issuance in the Australian domestic segment in mid-November, up from less than half for the whole of 2005.
A spur for — or some say a by-product of — this trend was the decline in Australian dollar denominated Eurobond issuance.
"The Australian dollar Eurobond market was much quieter than it was in 2005, which is a function of the cyclical nature of the alternative dollar sector. Historically an Aussie deal would typically yield 200bp over US Treasuries a year ago, now it's less than half that spread," says Paul Eustace, head of syndicate at TD Securities in London.
"With short end rates in the US having backed up in the last 18 months investors can achieve 5.50% coupons in US dollar Eurobonds, so there is little incentive to buy Australian dollar bonds with 6.00% coupons. With most European investors Australian dollar bonds are purely a coupon game."
Notable deals in the Kangaroo sector included the European Investment Bank's A$250m CPI-linked bond, led by Citigroup and National Australia Bank (NAB). The 14 year trade, announced in September, added to the A$3.5bn of issuance the borrower has outstanding, at three, five and seven year maturities.
The deal plugged a gap left when the Australian government stopped issuing inflation-linked deals three years before.
Another treat came in July, when Caisse d'Amortissement de la Dette Sociale (Cades) gave Australian domestic investors their first taste of the French sovereign credit.
The French social security debt repayment agency's A$500m five year trade, led by TD Securities, was snapped up by domestic accounts, which took 70%. Market observers noted the A$500m size, which was a great achievement for a debut trade.
"Average volumes are increasing, with 12 issuers having priced transactions of A$1bn or more in 2005 and 15 having done so in 2006 year to date," says Fergus Kiely, head of origination at National Australia Bank in London.
"Ideal market conditions have driven supply, including tight credit spreads and wide swap spreads."
Piers Ronan, an originator at NAB in London, identifies "increasing contributions to fixed income funds driven primarily by mandatory pension contributions and healthy equity markets.
"With the EIB deal, our sales force identified strong demand from a number of superannuation accounts for fresh supply of inflation linked product," he says.
Another stand-out deal in the sector came at the end of March, when Goldman Sachs priced A$1.65bn in a single day.
The four tranches comprised a five year FRN of A$1bn, a five year fixed coupon of A$250m, a 10 year FRN of A$200m and a 10 year fixed coupon of A$200m. The transaction was led by Goldman Sachs, NAB and Westpac.
"A Kangaroo benchmark used to be in the region of A$200m, but nowadays Goldman Sachs, for example, is able to raise A$1bn in a single trade," says Eustace at TD Securities.
"Both Kangaroos and Maples have matured in this way — Goldman went straight to Canadian dollars after issuing in Aussies and easily raised C$1.25bn. Bear Stearns and Lehman Brothers have achieved similar results."
The entry of US financial institutions into the Kangaroo market came as a surprise to some market participants, who deemed the sector insufficiently liquid to satisfy those borrowers' funding needs.
But a strong bid from Australian buyers, especially for new names, Asian investors and even European institutional accounts, ensured a variety of audiences for each Kangaroo transaction.
"Investor diversification is the key driver for these issuers and is behind their motivation to set up Australian MTN programmes and invest time and effort roadshowing in Australia," says Eustace.
Down the capital curve
The Maple market in Canadian dollars, just a glint in syndicate managers' eyes in 2003, has come a long way since its inception in early 2005, when it was an exclusive market for triple-A borrowers.
TD Securities reports an expansion in issuance during 2006, with issuers previously uninterested in Maples approaching the bank to discuss new deals.
A feature of 2005 was the development of a market in Maples for subordinated bank debt, driven largely by Merrill Lynch through its bank capital business.
Royal Bank of Scotland was the first issuer to bring a lower tier two deal, in March 2005, and the borrower returned in May 2006 to bring the first upper tier two, again via Merrill Lynch.
The twice oversubscribed C$700m transaction was also the market's first perpetual bond. Other issuers attracted to the same point of the capital curve since then include Nordea, Bank of Ireland, Citigroup and the Commonwealth Bank of Australia.
Further Merrill Lynch-led innovation came in August, with the first tier one Maple instrument from Crédit Agricole, which was also the market's first deal from a French financial institution. Royal Bank of Canada was joint lead.
The C$400m perpetual non-call 10 trade came while the basis swap was narrowing — a problem that has serious implications for the market — but still achieved good cost of funding for the issuer, even though European comparables were narrowing while Canadian comparables were selling off.
"We could have pushed for a bigger trade but we wanted to have a well performing transaction in the secondary market to help the Maple sector mature," said a spokesman for one of the leads at the time.
"When landmarks, such as the first tier one, are reached, people keep an eye on their performance and it is essential for the continued health of the market for this one to tell a positive story."
The credit spectrum in Maples also widened to accommodate corporate names in 2006, beginning in June with a five year C$200m issue from the UK's National Grid via Royal Bank of Canada and TD Securities.
France Télécom followed shortly after, with a C$450m five year deal through Merrill Lynch and Royal Bank of Canada, comprising a C$250m five year deal and a C$200m 10 year.
Investors more demanding
Even though the market has grown in many directions in 2006, there is a cloud on the horizon in the form of cost of funding challenges.
"There was a big increase in Maple new issuance in 2006, from a whole host of new names across all sectors," says TD's Paul Eustace. "This has had a major impact on the cross-currency swap between Canadian and US dollars, which has tightened by 10bp during this period. The basis now stands at just plus 1bp across the curve from one to 10 years.
"Clearly this move in the basis swap has massively affected arbitrage opportunities for international issuers especially with domestic investors in Canada generally looking for a pick-up versus domestic names."
Eustace cites the Kangaroo market as a similar case: the basis swap widened and investors' initial enthusiasm was replaced by scepticism, with issuers accused of being committed to arbitrage opportunities only.
"This situation doesn't happen in Australia at all now, in fact almost the reverse is true these days. As we have seen in Kangaroos, Maple issuance will slow a little, the basis swap will widen out, sentiment will improve, and international issuers will return," he says.
Market participants agree that the bid for subordinated debt endures, along with a hunger from pension funds for duration: the EIB and KfW have 2045 and 2037 Maple trades outstanding respectively and Réseau Ferré de France (RFF) issued a 2035 deal in November.
"There continue to be two important areas of interest for domestic investors. The first is for bank capital trades where Merrill Lynch, for example, has done well," says Eustace.
"The second is for long dated deals. As in the UK, Canadian investors are increasingly looking to match their long dated liabilities with long dated assets and this trend looks set to continue."
In the bank capital sector of the Maple market, Merrill Lynch officials foresee a year of opportunity.
"In 2007, we anticipate the expansion of the Canadian secured lending market," says Yves Locas, director and head of syndicate at Merrill Lynch Canada.
"We expect an increase in investor participation in this market, to some extent mirroring the US experience. The likely beneficiaries of this trend will be issuers of higher quality short dated assets."
Foreign issuers are also potential beneficiaries of the Canadian federal government's decision to make income trusts taxable. This was done partly in response to recent announcements from leading Canadian corporations seeking to convert to the income trust model, with adverse consequences for the exchequer.
"An unintended consequence of the government's decision is that the loan-backed special purpose vehicle structures currently used for tier one issuance may be affected, leaving issuers until 2011 to find a new solution," says Siddharth Prasad, managing director and head of the financial institutions group at Merrill Lynch in London.
"We believe an exemption is unlikely though a possibility, so domestic tier one issuance is most likely to decline in the short term leaving the way open for foreign borrowers to take advantage of this void in the market. The tier one sector already offers the biggest arbitrage for international issuers, and this is likely to increase as domestic borrowers switch to bringing more tier two instruments."