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Coming on in leaps and bounds

31 Aug 2006

The Kangaroo bond has been one of the biggest success stories in the global capital markets in recent years. Volumes are growing rapidly, thanks in no small part to the huge amount of wealth building up from the growth of the compulsory superannuation funds, which, it is estimated, will have at their disposal over US$2tr in the next 10 years.

The market for offshore borrowers' Australian dollar denominated bonds targeted at local investors lends itself to a fairly obvious pun. "Growing in leaps and bounds" is how the Kangaroo market is described by Enrico Massi, head of Asia Pacific origination and syndication at RBC Capital Markets in Sydney.

The figures speak for themselves, with issuance in the domestic market breaking new records in each of the last two years. Primary market volume reached A$42bn in 2004 and A$55bn in 2005, with close to 60% of last year's volume accounted for by Kangaroo issuance. With issuance volumes continuing to expand in the first half of this year, it is probable that 2006 will be another record year for the market.

Clearly, the Australian dollar sector has come a long way since its previous incarnation as the Matilda market in the early 1990s. Simon Ling, now joint head of debt securities and syndicate at Westpac Institutional Bank in Sydney but at Hambros then, recalls the challenges involved in establishing a domestic Australian dollar market for overseas issuers.

"I remember working on an EIB Matilda bond for A$300m-A$400m back in 1992," says Ling. "Arranging a back-to-back swap with one of the semi-government issuers was extremely difficult, but the deal was successful and it was followed by transactions for borrowers such as Eksportfinans, SEK and SBAB. Then the basis swap collapsed, the market dried up and nothing much happened for two or three years."

The Kangaroo market has also come a long way since the groundbreaking A$1bn five year transaction in September 1998 by the Asian Development Bank (ADB) which prompted a very mixed response.

The good news associated with the deal, led by Warburg Dillon Read with Commonwealth Bank of Australia and Merrill Lynch as joint leads, was that it marked the re-opening of the market after a gap of almost a year. With the spreads on a number of Korean issues launched in the mid-1990s having widened sharply after the Asian financial crisis of 1997, the new issue cupboard had been bare since the previous September.

The ADB deal also demonstrated that the Kangaroo market could deliver jumbo volumes. As a respected triple-A issuer, the ADB transaction was regarded as an important initiative providing investors with a government proxy in a market where Commonwealth government bonds were increasingly scarce.

"There had been a few Korean deals in the market before then, but it was the ADB deal that really opened up the market," recalls Nick Howell, who arrived in Australia with ANZ in July 1998 before joining the syndicate and origination desk at TD Securities in September 2001. His career has allowed him to watch the development of the Kangaroo market from a front-row seat more or less since its inception. After a five year stint at TD, Howell recently moved back to ANZ.

The downside with the ADB transaction was its timing. The shockwaves from Russia's default were still reverberating throughout the global financial system, and KfW — for one — yielded to weak market sentiment by postponing a planned Kangaroo offering in September. With dreadful news following from Asia, sentiment towards Asian borrowers of all kinds was very fragile in the last quarter of 1998, with the ADB no exception.

The result was that ADB's Kangaroo bond took a roasting, with one banker telling EuroWeek at the end of 1998 that the transaction "set the Kangaroo market back by six months". That turned out to be a harsh view, given that 10 transactions followed in 1999 raising over A$4bn.

A stop-go market

Nevertheless, the mixed response to the ADB deal perhaps explains why the market meandered uncertainly over the next few years. "For two or three years after the ADB transaction there was very little continuity in the market," says Howell. "We saw a preponderance of German credits in the market with transactions for borrowers like KfW, DSL Bank and LBBW, and then a raft of US GIC-backed issuers, but it remained very much a stop-go market."

Another important development in the market was the decision in 2001 by the Reserve Bank of Australia (RBA) to grant repo eligibility to Kangaroo issuance by supranationals.

The Inter-American Development Bank (IADB) was the first to take advantage of this new opportunity, launching a five year deal via Commonwealth Bank of Australia and Deutsche Bank in March 2001 that started out as a A$200m transaction, but was increased first to A$500m and subsequently to A$675m.

Thereafter, says Howell, there was a hiatus in Kangaroo issuance targeted at Australian institutions as voracious Japanese retail demand led to a surge in Australian dollar denominated Uridashi issuance. "The peak periods for the Uridashi market were the last quarter of 2002 and the first quarter of 2003, where Japanese appetite was such that we were seeing issuance of as much of A$10bn a quarter, which eventually sucked the Bills/Libor basis swap down to zero," says Howell.

Although the market started gathering important momentum in 2003, it has been in 2005 and the first half of 2006 that the sheer depth of demand within the Australian institutional investor base has impressed itself upon international borrowers in the market.

The result is that virtually every triple-A rated supranational and agency borrower in Europe has tapped the market. When asked in early July if there were any triple-A supranationals or agencies that had not visited the Kangaroo market at least once, one Sydney banker offered France's Cades as the only notable absentee that sprung to mind. That gap was plugged soon afterwards, with the French state social security deficit financing agency launching its inaugural Kangaroo bond in July via TD Securities.

Launched off its A$6bn Australian MTN programme, the Cades transaction was a five year A$500m deal that competed with new issues in the same week from the Inter-American Development Bank (IADB) and the usual suspects from Germany in the form of KfW and Rentenbank — both of which are prolific issuers in the Kangaroo market.

Cades is regarded as quasi-government risk, as is another popular European triple-A issuer which made something of a splash as a newcomer in the Kangaroo market in 2005, Spain's Instituto de Crédito Oficial (ICO). Its debut Kangaroo deal, led by RBC in June 2005, was a A$600m three year transaction originally planned as a A$300m issue.

ICO followed that deal in October with a A$400m seven year deal also via RBC, making the Spanish agency one of the largest issuers in the Kangaroo market in 2005.

It is not just the overall volume of issuance that points to the big increase in the capacity available to borrowers in the Kangaroo market. The size of individual transactions has also increased sharply over the last 24 months, with deals of A$1bn no longer regarded as elusive.

Wells Fargo forges new benchmark

In terms of issue size, the bar was raised most conspicuously in 2005 when the US diversified financial services group, Wells Fargo, chose the Australian dollar market for its first major public bond issue outside the US dollar sector.

At A$2bn, the Wells Fargo five year deal led by NAB and Citigroup in July 2005 broke new ground not just for being the largest Kangaroo bond ever launched, but also for being the largest Australian dollar issue outside the government and quasi-government sector. Pricing, at 23bp over the Bank Bill Swap rate (BBSW), was at the bottom end of guidance and in line with the borrower's funding levels in the US market. Distribution, meanwhile, was well diversified: more than 60 investors participated, with 75% placed with Australian accounts, 14% in Asia and 11% in Europe.

In 2006, the Wells Fargo jumbo has been followed by A$1bn-plus deals from a succession of borrowers from the financial services sector, including Goldman Sachs, Morgan Stanley, Citigroup and Merrill Lynch, as well as Northern Rock of the UK.

Transactions such as these have provided diversification away from the supranational and agency borrowers that have been a lynchpin of supply in the Kangaroo market. "Triple-A bonds certainly have an important place in this market and we are still seeing very strong demand from both onshore and offshore investors for supranational and agency issuance," says RBC's Massi. "But investors are always on the lookout for diversification and the financial issuers that have come to market have provided that — not just the 20% risk-weighted banks but also the US banks and investment banks."

Although many of the domestic institutions that are the mainstay of demand tend to be buy-and-hold accounts, liquidity in the market is improving. "Larger transactions are helping to bolster liquidity," says Chad Karpes, head of Australian dollar syndicate at ABN Amro in Sydney, "and so too are tapped transactions which are building up the size of individual issues. Additionally, the Australian market is quite over-banked. There are between 10 and 12 banks that actively play in this space and each of those are market makers in Kangaroo bonds, which further supports liquidity."

That increase in liquidity has been welcomed by Australian institutions, which to date have expressed little if any interest in anything other than the public market. "One of the first questions a lot of issuers ask us is, 'can we test out the market by doing a private placement?'" says Mark Garrick, head of capital market origination at NAB, Australia.

"We explain that the Australian market is almost entirely public rather than private, for two reasons. First, because investors who were brought up on the government and semi-government markets are still fixated by liquidity. And second, because most Australian institutions need to have their portfolios revalued on a regular basis, and there is no independent verification service available to them for non-public securities."

In tandem with increasing liquidity in the Kangaroo sector, maturities are also starting to become longer and more diverse. Much of the impetus for the extension of the yield curve has been investor demand.

Merrill Lynch has been an active borrower in the Kangaroo market since the end of the 1990s and makes a point of roadshowing in Australia once a year. Its Sydney-based treasurer for Asia, Terry Winder, says that he has noticed two key trends among Australian institutional accounts in recent years. "First, investors have been telling us they are looking for more liquidity, so they like larger issue sizes," he says. "Second, because they have developed their credit skills so well in the last few years, they have been saying that they want to see longer dated transactions that earn them more of a return for their credit work."

Supernannuation system the driver

Foremost among the reasons for this surge of issuance has been the growth in demand among institutional investors in Australia, driven by the compulsory superannuation system introduced by the Keating government in 1992. That scheme, widely mistrusted by the Australian electorate at the time, called for employers to make a minimum contribution of each of their employees' salary into retirement funds. That contribution started at 3% and on July 1 2002 reached its current maximum level of 9%.

The superannuation system has been phenomenally successful in helping to build one of the largest reservoirs of institutional funds under management in the world, with Australia's pot of pension money now the fifth largest in the world according to research published by NAB.

"A huge amount of wealth is building up from the growth of the superannuation market," says Allen McCristal, head of structured sales at Barclays Capital in Sydney. "It is estimated that superannuation funds will have funds at their disposal above US$2tr in the next 10 years. This is truly phenomenal."

It is the diversification opportunity provided by that huge pool of money, say bankers, that is by far the main reason for international issuers to contemplate the potential of the Kangaroo market. "Australian investors still tend not to buy EuroMTNs or globals, so in many cases the Kangaroo market is the only way some international borrowers can access the Australian institutional investor base," says Fergus Kiely, head of debt capital market origination at NAB in the UK.

Another reason why Asian and European investors will look at the Kangaroo market, say bankers, is that it can be quite uncorrelated with other fixed income asset classes. "Of course the Australian market is sensitive to credit events offshore, but it does not necessarily move 100% in sync with international markets," says RBC's Massi. "The Australian market can behave very differently due to structural fundamentals."

There seems to be a division of opinion over the issue of relative value for borrowers in the Australian dollar market. Most bankers agree that the Kangaroo market is not one in which issuers should expect to be able to exploit arbitrage opportunities. "The days when borrowers could come into a domestic market and expect to achieve levels of 10bp inside what they would pay in the US or Europe are long gone," says Westpac's Ling. "Today there is too much linkage between the world's markets for that sort of arbitrage. The Kangaroo market isn't about arbitrage. It's about consistency of pricing."

That also reflects the degree to which the Australian investor base has learned from the experience of borrowers making opportunistic forays into the market in the past. "In the Matilda days, but also in the early days of the Kangaroo market, borrowers would come here, grab their arbitrage opportunities and disappear over the hills," says Ling. "Some investors got quite badly burned by that, which is why roadshows became so important. These days, investors don't just want to hear borrowers' credit stories. They also want to know their plans for issuance in this and other markets. One of the first questions they will ask about any issuer is, 'where are their bonds trading in US dollars and euros'."

The importance of the basis swap

Given that the vast majority of borrowers in the Kangaroo market have no requirement for Australian dollars, a key consideration for most will be the level of the basis swap, which in recent years has worked in favour of offshore borrowers funding in Australian dollars.

"This market is linked very closely to the basis swap, which is why investors are still able to buy double-A rated banks in Kangaroo form that trade over the leading domestic banks," says Westpac's Ling. "But it would be interesting to see what would happen if the basis swap were to come in to the point where double-A banks could only issue in this market at a level that was through the domestic banks. If Citi, for example, was being priced through a Westpac or an ANZ would domestic investors still be prepared to buy? They should be, because they need to put their money somewhere and the multinational banks are obviously much bigger than the domestics." That would suggest that even if the basis swap continues to fall, as it has done since 2004, there is more than enough local institutional demand to mop up offshore issuance.

How likely it is that the basis swap will fall to a level that would start to make the economics of Kangaroo issuance unappealing is open to question. "Not very," says Peter Jolly, head of research at NAB, Australia. "In simple terms, when demand for offshore funding among Australian companies is high the basis swap widens and when it is weak the basis swap narrows.

"And the fact is that although Kangaroo issuance into the Australian market is buoyant at the moment, by far the bigger flow is Australia raising funds offshore. Australia continues to run a current account deficit of around A$55bn which has to be funded every year." That deficit, says Jolly, is driven mainly by household demand underpinned by the leading banks, which in turn makes the Australian banking sector prolific borrowers in the international market.

To illustrate the point, Jolly says that as of May 2006, Australian resident issuers had a total of A$354bn in outstanding issues offshore. By contrast, total non-resident issuance in Australian dollars — in Kangaroos, Eurobonds and Uridashis — at the same date amounted to A$152bn.

Jolly says that continued strong demand for international funds among Australian issuers will continue to prop up the basis swap over the coming months, ensuring that the Kangaroo market remains a competitive source of funding. "The basis swap is towards the low end of its cycle range at the moment, which explains why we have seen a decline in Kangaroo issuance," he says. "But I expect Australian banks' demand for offshore funds will push the basis swap back towards cycle averages of 8bp-9bp over the coming few months."

While arbitrage opportunities for borrowers in the Kangaroo market may be limited, bankers say that the Australian investor base has very warmly welcomed the relative value that much of the unsecured issuance from overseas issuers has provided them with in the last 12-18 months.

ABS takes off

In part, says Howell at ANZ, that has been as a result of some changes in the dynamics of the Australian structured finance market in general and the performance of the Australian market for residential mortgage backed securities (RMBS) in particular. Issuance volumes in the RMBS market have exploded in recent years, with a recent RBA report putting outstandings at A$65bn by mid-2005, with around A$15bn in other types of ABS.

The rise in issuance volumes in the Australian ABS market has been accompanied in recent years by a sharp decline in spreads. "One of the reasons there has been so much appetite of late for unsecured bank issuance in the Kangaroo market is that there has been massive spread tightening in the Australian dollar ABS market," says Howell. "In terms of the number of issuers in the market as well as issuance volume the Australian ABS market is one of the most developed in the world. Domestic investors, which were used to spreads in the mid-to high 40s over Bills for three to five year ABS, have seen those spreads fall to the high teens. So when those same investors are offered spreads of 29bp in five years and 51bp in 10 years for credits like Goldman Sachs they are going to jump at the chance to buy."

The increased sophistication of the Australian investor base is one reason why a growing number of global investment banks are training their sights on the potential of local institutions for a broad range of structured products offering a pick-up over plain vanilla bond portfolios. "There has been a build-up of institutional funds with a shortage of assets," says Barclays Capital's McCristal. "That means there is a substantial opportunity for houses like Barclays to satisfy some of that demand with structured products that Australian-domiciled investors cannot access through the domestic market."

Those opportunities have expanded in recent years, says McCristal, as the Australian fund management community has lessened its dependence on external consultants and on measuring its performance against conventional benchmarks. "Consultants still play a key advisory role," he explains. "But Australian institutional investors are becoming sophisticated and are tending to migrate away from the advice and are increasingly going direct to the underwriters or manufacturers. The result is that fund managers are now running beta-based portfolios along with an alpha-generating strategy."

The importance of the Asian stopover

In order to access Australia's burgeoning base of institutional investors, bankers say that for newcomers to the market a roadshow is essential. As well as visiting accounts in Melbourne and Sydney, issuers are also advised to add a day in Brisbane, to visit the three key institutional players there — Suncorp Investment Management, Queensland Investment Corp (QIC) and Queensland Treasury Corp (QTC). "In the past, a number of issuers relied on conference calls which did not inspire the Australian investor base," says Fergus Kiely, head of debt capital market origination at NAB, UK. "These days issuers like Northern Rock and Leaseplan are aware of the need to take the time to visit investors face to face, which is very much appreciated."

Once they have taken the time and trouble of roadshowing in Australia, issuers are generally urged to add a visit to prospective Asian investors, which bankers say will generally account for between 20% and 30% of placement of Kangaroo bonds. "It is possible to place 100% of an issue in Australia," says Mark Garrick, head of capital markets origination at NAB in Sydney. "But if that happens borrowers will inevitably lose some of the benefits of price tension, which is why we think the ideal execution is probably a 70/30 or 75/25 split between Australian and offshore investors."

"We generally say that if you are a European issuer on your way home from Australia, rather than fly over Asia at 35,000 feet, why not stop over and meet with some of our investors," adds Craig Marran, head of debt capital markets at NAB in Hong Kong.

The potential of New Zealand

Capital market practitioners are forever searching for the next frontier, with some now starting to consider the potential of the domestic New Zealand dollar market. New Zealand's equivalent of the Kangaroo market is the Kauri sector, which takes its name from the largest tree native to New Zealand.

Merrill Lynch kicked the Kauri market off with a NZ$125m five year transaction, which has since been followed by deals for Telstra (NZ$200m in seven and 10 year tranches), Morgan Stanley (with a NZ$150m deal eight year) and HBOS (with FRNs and fixed rate deals raising a total of NZ$775m). That made the Kauri market worth a total of NZ$1.25bn ($798.053bn) as of May 2006. By contrast, NZ$13.2bn was raised in the EuroKiwi market and NZ$12bn in New Zealand dollar Uridashi issues in 2005 alone.

According to a presentation delivered in May by NAB and Bank of New Zealand, corporate issuance in New Zealand has averaged NZ$3bn a year since 2001, but in the first half of 2006 appeared to be picking up, reaching NZ$2.5bn by May.

That suggested that issuance volume for the year as a whole could be heading towards the dizzy heights of NZ$6bn — a drop in the Tasman Sea in comparison with the A$55bn raised in the Australian market in 2005, but an indication that things are moving in a positive direction.

That is the view of Terry Winder, Merrill's Sydney-based treasurer, who says that his bank is contemplating extending its annual Australian roadshow to New Zealand for the first time this year. "Demand is growing in New Zealand, which is why we are looking at possibly doing a second Kauri bond at some stage," he says.

"Can New Zealand replicate the Australian experience?" was the key question posed in NAB's presentation, which concluded by listing nine attributes of the Kangaroo market that would need to form the basis of a strong New Zealand dollar sector. Of the nine boxes, five were ticked: like Australia, New Zealand has a dwindling supply of government bonds, ease of access for international issuers, a global settlement system, a liquid basis swap market, and interest rate differentials.

Three other boxes were filled in the NAB presentation with question marks. Those asked whether a New Zealand dollar market would be able to attract offshore investors, would provide a favourable interest rate withholding tax regime, and would offer the sort of liquidity that issuers and investors would need.

That left one key market driver which appeared at the top of the NAB list and was the only box with a cross rather than a tick or a question mark. Critically, this referred to the issue of mandatory superannuation which has been such a decisive influence in the powerful growth of the Kangaroo market. The absence of a similar scheme in New Zealand means that the pool of institutional savings held there is tiny compared with those in Australia.

Peter Jolly, himself a New Zealander who is now head of research at NAB, Australia, says that in 1998 New Zealand held a referendum on adopting the Australian compulsory superannuation system which was soundly rejected. Jolly says that 93% of the electorate said 'no' to a loaded question about compulsory savings.

31 Aug 2006