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Everyone's invited to dollar arb party

02 Dec 2005

This year the dollar bond market has made top flight issuers an offer they cannot refuse: new investors, benchmark sizes and extremely attractive funding. A colourful array of borrowers from the sovereign, supranational and agency sector has taken up the offer and reinvigorated the market.

Judging by the most transparent measure available in the international bond markets — price — the dollar market has proven hard to beat for highly rated benchmark issuers in 2005.

"Swap spreads have been exceptionally attractive this year, compared to previous years," says Monika Seitelberger, director of international finance at Oesterreichische Kontrollbank in Vienna. "OKB has been able to achieve very tight pricing levels, which have been in line with our peer group. The dollar market has also provided higher arbitrage than in previous years."

Dollar benchmark bonds have held up better than some other funding sources. "The dollar market is one of the few markets that still offers relatively good sub-Libor funding in some volume," says Allegra Berman, head of frequent borrower origination at UBS in London.

"Some of the structured products that frequent issuers have relied on have held up in terms of volume but the funding they have provided has maybe not been as good as in the past, while dollars has remained an extremely robust market for a lot of them."

This has resulted in a surge of deals, as established issuers have built on their previous work in the dollar market to take full advantage of the funding costs available.

Landwirtschaftliche Rentenbank, for example, first tapped the dollar market in 2001 and has previously raised around 40% of its funding in the currency. But this year the German agricultural financing agency relied on dollars more heavily, raising roughly half of its approximately Eu10bn funding this year in dollars.

"We have launched three dollar issues in global format," says Stefan Goebel, co-head of funding and assets at Rentenbank in Frankfurt, "a five year in January, a three year in March, and just recently our first 10 year global.

"On top of that we have issued a number of large sized Eurodollar transactions, mostly in shorter maturities, such as a two year and a two year non-call one for our short term funding, but also a big seven year and a couple of increases in five and six years."

Rentenbank's issuance has propelled it into a select group of issuers that has launched dollar benchmarks in the three, five and 10 year maturities.

"They have had a phenomenally good year," says one frequent issuer debt capital markets (DCM) banker. "They have really improved their cost of funding and it is great that they have been able to finish off the year with a very successful 10 year dollar, which is a difficult deal to do in the best of circumstances and even for issuers that have been doing 10 years for some time. They have also been able to achieve great distribution."

However, it is cost that has drawn Rentenbank further into dollars this year.

"If you look at the funding strategy we set out for the year," says Goebel, "we stated that we would have four benchmarks, whereas in previous years we had said we would do two in euros and two in dollars.

"This was because dollar funding levels had already significantly decoupled from euros, where, simply because of tight swap spreads, funding is not as good as in dollars. As a consequence we were already considering at the beginning of the year issuing three dollar benchmarks and only one in euros."

Having launched two five year dollar benchmarks in 2004 at mid-swaps minus 6.5bp and minus 7bp, Rentenbank was able to sell this year's $1bn March 2010 benchmark at 11.5bp through. Bank of America, Credit Suisse First Boston and Morgan Stanley led the deal.

Now it gets interesting

While issuers like Rentenbank have taken more out of the dollar market this year than in the past, in both funding cost and volume, they are not the only ones that have gained.

"The US agencies have tightened during the course of the year and the most expensive triple-A names — such as the European Investment Bank and KfW — have remained where they are, in deep sub-Libor territory," says one sovereign, supranational and agency (SSA) coverage officer. "So investors are looking around for something that offers a yield pick-up.

"Investors that want to do this but not move down the rating spectrum have therefore felt comfortable buying some of the cheaper triple-A names that offer a little bit more value."

This has led to a surge of interest in dollar benchmarks from such credits. "If you look at the agencies that trade behind the very tightest names such as the EIB, KfW, World Bank, etc," says Rob Whichello, co-head of the European syndicate at BNP Paribas in London, "we have seen that market explode and the number of issuers has increased.

"There is now a whole range of agencies that have varying degrees of state or local government ownership but don't have explicit guarantees, and that has made this a much more interesting sector."

While this has not exactly made sovereigns, supras and agencies a credit market with high event risk, it has made the sector less commoditised.

"They all have different ownership structures," says Whichello, "so there actually needs to be a lot more credit work done by salesforces and investors to understand the differentials. And while the market has been fairly generic in the past, you are increasingly going to see these issuers trade at differerent levels depending on their different ownership structures and approach to the market.

"Some, such as Eksportfinans, have the rarity of issuance from Norway as an advantage ; some have strong links to the central government such as Rentenbank, and others to local governments, such as Kommuninvest."

Kommunalbanken writes the textbook

The Norwegian local government funding agency launched its first dollar benchmark issue in early October, a $1bn five year Eurodollar, led by Citigroup, Deutsche Bank and Nomura.

The issue was priced at 35bp over the five year Treasury, equivalent to 10.75bp through Libor.

Kommunalbanken's previous largest dollar deal had been for $500m in 2001, and was sold to a mix of retail and institutional accounts.

Kristine Falkgård, head of funding at Kommunalbanken in Oslo, says the agency has turned to dollar benchmark issues to help meet its higher funding needs.

"We have been growing quite extensively in the last five years," she says, "from an annual requirement of $1.5bn in 2000 to $5bn this year and an expected $5bn-$6bn in 2006. This has been due to strong lending growth of above 20% annually.

"And while we expect growth of approximately 13% for 2005 and a bit less next year, our lending and hence funding needs will still be growing."

Dollar benchmarks will form one of four pillars of Kommunalbanken's funding programme, alongside structured private placements; retail targeted bonds in Europe and Japan; and smaller institutional markets such as the Australian , Canadian, sterling and Swiss markets.

The bank chose the five year maturity to suit the market as well as its own requirements. "Five years fits well with our asset-liability management policy," says Falkgård, "and it is also a good reference maturity for the market, especially for a debut issuer as it stays a reference bond over a long period, which was important for us when seeking to establish a good presence in this market."

But that choice of maturity meant Kommunalbanken had to wait patiently before making its entrance. "The dollar market has been volatile this year, particularly in five years," says Falkgård. "In addition, we were out of the market in July while updating our programme in line with the new Prospectus Directive. We roadshowed in April and then monitored the market with investors, looking for the best time to issue."

The issue finally emerged in October, but it proved worth the wait and attracted a book of $1.6bn. "Kommunalbanken is a name the market had been awaiting for some time, offering investors a rare opportunity to get exposure to Norway and the sovereign," says Falkgård. "And in the secondary market the paper has tightened and outperformed the market."

Kommunalbanken now intends to issue in dollars once or twice a year, with three to five year transactions being the most suitable for the borrower.

One SSA syndicate manager says Kommunalbanken's success is typical of this year's activity. "If investors want to buy some triple-A securities in size in dollars, how many really good, highly rated issuers are there?" he asks. "Not that many. You can't keep buying EIB and KfW ad infinitum, so new names like Kommunalbanken or those that have returned after a long absence, such as Asfinag, can take a premium from the market for offering diversification."

Dollars a win-win for covered issuers

Apart from sovereigns, supranational bodies and government agencies, another group of triple-A credits has sought out the attractive funding opportunities in dollars: covered bond issuers.

Before 2005, only Depfa had committed itself to the dollar market, but its peers have begun to look at the currency more closely.

Compagnie de Financement Foncier, the vehicle that issues obligations foncières for Crédit Foncier de France (CFF), has issued two deals of at least $1bn this year.

The first was a $1bn three year transaction in late May, led by CSFB and Nomura. Sandrine Guérin, CFO of CFF in Paris, said at the time that the funding cost of 7bp through Libor was the chief attraction of the issue.

"We can achieve a better all-in cost in dollars than euros," she said, "and of course our first aim is to be efficient in our funding."

The deal also enabled CFF to sell almost 60% of the paper in Asia. When it returned to the dollar market in October, with a $1.25bn long three year issue, it placed more than 40% in the region.

"The dollar market offers a good diversification of our investor base," says Paul Dudouit, head of investor relations at CFF in Paris, "and with an annual funding programme of around Eu12bn we need more and more diversification. So it was a great success for us to be able to place around half of our issues in Asia, and in particular with central banks."

Dudouit estimates that the second transaction gave CFF an all-in cost of funding some 3bp inside what it could achieve in euros.

Led by ABN Amro, Dresdner Kleinwort Wasserstein and UBS, the January 2009 issue was priced at 34bp over the 4.125% August 2008 Treasury, equivalent to almost 11bp through Libor.

In the same week as CFF's follow-up, Bayerische Landesbank and Landesbank Baden-Württemberg also launched $500m long three year covered bonds.

All three were following in the footsteps of Hypothekenbank in Essen, which a fortnight earlier had issued a $1bn December 2008 public sector Pfandbrief via ABN Amro, Goldman Sachs and HSBC, with Commerzbank as joint lead.

Views differ on how strategic these transactions were and to what extent they qualify as benchmarks.

"I think they are more big, opportunistic trades than benchmarks, really," says one frequent issuer DCM banker. "The issuers have been shown a relatively good cost, given where swap spreads are in euros and dollars, and, with the exception of perhaps someone like Depfa, have been keen to take advantage of the arbitrage."

But others point out that the strategic goals of such issues have been as important — and as successfully met — as arbitrage considerations.

"The distribution patterns of the dollar Pfandbriefe and in particular CFF's issue were very interesting for these borrowers," says Tim Skeet, managing director of financial institutions origination at ABN Amro in London. "Asia and Europe bought into the product in a big way. The fact that it offered arbitrage as well was also convenient."

Nick Dent, head of the frequent borrower syndicate at CSFB in London, says issuers' moves into the dollar market have been helped by some investors' new global outlook.

"You no longer just have a domestic name that trades in its home network in euros," he says. "The likes of the Asian central banks have been diversifying their portfolios, not just in terms of currency — although they have been putting more money to work in euros than previously — but also in product areas. They have been expanding their agency portfolios to include new names, and covered bonds in particular.

"And if they are buying them in euros, then it is only natural for them to look at these names in dollars as well, so issuers can find it a lot easier to traverse markets than in the past."

Building a global brand

One way in which market participants separate strategic from opportunistic dollar issuers is according to whether they use the global format.

"Some of the more traditional covered bond issuers are quite committed to the dollar market," says one syndicate manager in London, "but there is a difference between the likes of Depfa, which is completely committed to the dollar market, and other names that use the Eurodollar method to take advantage of the arbitrage."

After its recent Eurodollar bond, Essenhyp has decided to launch its next transaction with Reg S/144A documentation. Bookrunners Bear Stearns and Dresdner Kleinwort Wasserstein were roadshowing it in mid to late November.

Günter Pless, Essenhyp's head of treasury, told EuroWeek when announcing the plan: "Asian accounts like Pfandbriefe in dollars, and we hope it will work in the US as well."

Other covered bond issuers do not feel they need US distribution. Dudouit, for example, says CFF's funding programme is too small to require support from US investors.

But a growing number of sovereign, supra and agency issuers are moving towards the global format — some quickly, some slowly.

L-Bank, the state bank of Baden-Württemberg, chose a tough week to launch its first ever dollar global bond in mid-July. KfW Bankengruppe, the Kingdom of Spain and Swedish Export Credit were all competing for investors' attention and issuance for the week totalled $25bn. But L-Bank proved a clear favourite with investors.

Lead managers Citigroup, Dresdner Kleinwort Wasserstein and HSBC priced the issue at 37bp over Treasuries from mid to high 30s guidance, amassed a $1.7bn book and increased it twice.

"We are more than pleased with our debut dollar global," said Sven Lautenschläger, international funding officer at L-Bank in Karlsruhe. "We had a very good reception in the market. We initially wanted to go for a $1bn trade but finally we ended up with $1.5bn. This was the result of strong demand from investors, and we were really happy with the commitment they showed."

One of the key reasons for the transaction was to highlight L-Bank's status as a state bank and distinguish it from the Landesbanks, which were on the verge of having their ties to the German Länder cut.

"Being able to file with the SEC (US Securities and Exchange Commission) as a so-called Schedule B filer," said Lautenschläger, "gives a clear signal to investors that we are a quasi-sovereign, as the SEC has put us into the foreign government bracket, alongside KfW for example. That classification clearly helps us to convince investors of the status of L-Bank and was a very important point for us."

All this was possible while saving L-Bank several basis points in its funding. The issuer launched its first dollar benchmark in 2003 at Libor flat, achieved minus 1bp in 2004, and this year reached minus 7bp.

Following in Columbus's footsteps

At Spain's Instituto de Crédito Oficial (ICO), chief executive Federico Ferrer told EuroWeek on the US's Columbus Day holiday in October that he could foresee the agency changing its strategy, after many years of issuing Eurodollars.

"If we see a good opportunity then we could issue in global format in dollars," he said. "Now we have plenty of demand from high quality investors in Asia and across the continent in Europe, but we have substantially fewer in the US and that is something we would like to address.

"We have become a large issuer, so why should we eschew such a big concentration of investors?"

That ICO has so far had little trouble finding buyers was borne out by its $1bn five year benchmark in mid-October. Led by Barclays Capital, Deutsche and HSBC, the issue was one of ICO's most successful dollar transactions yet.

It followed a $1.25bn long three year in April, led by CSFB, DrKW and Lehman Brothers, which was also well received.

NRW Bank, guaranteed by the state of North Rhine-Westphalia, plans to switch to the global format, though it only launched its first Eurodollar benchmark in late October. That $1.25bn five year transaction, led by Deutsche and JP Morgan, was the first step in a long term strategy for the issuer.

"The spread equated to 2bp through Libor, which is the same level as we fund at in euros," said a NRW Bank spokesperson. "We did not expect to achieve a tighter level with our debut dollar bond — we have to build a track record first — but we do hope to see the benefits with our next transactions."

Having sold 34% of its issue in Asia, NRW Bank will in future target US accounts as well. "We realise we have to offer a global format eventually and we have decided to start with an SEC filing in 2006," said the spokesperson.

Kommunalbanken, meanwhile, does not rule out going global. "We do not have a global programme yet, so it was a simple decision to go the Eurodollar route," says Falkgård. "We believe, and this transaction (the $1bn five year in October) proved, with a very favourable distribution into Asia and Europe, that with our current funding programme we have no strong need for the support of the US investor base as well.

"That said, as our funding programme keeps growing, the size of benchmark transactions may increase, so to have the additional support for such transactions, there could be some arguments that we should be looking at establishing a US programme as well. This will be in line with other larger issues such as Rentenbank and something that we will be considering."

Eksportfinans reaps the rewards

When considering the potential benefits of US distribution, the success of Kommunal-banken's compatriot, Eksportfinans, provides a useful example.

The Norwegian export credit agency launched its first global bond in June 2004, and out of $2bn of globals it sold that year, some $750m was placed in the US.

This year Eksportfinans approached the market in mid-November via Citigroup, Deutsche and Goldman Sachs with a $1bn three year global, priced at 32bp over the Treasury

Some 41% of the deal was sold to US accounts, while Asia took just 24%. One of the lead managers described the US distribution as one of the largest he had ever seen in such an issue.

"We have been marketing ourselves quite heavily in recent years to establish Eksportfinans as a true global borrower and the strong reception for this transaction is another testament to the success of that strategy," said Søren Elbech, the agency's deputy director of finance and head of capital markets in Oslo.

"We increased our US distribution from 38% in the last bond to 41% in this issue. The number of accounts was larger than last time and we have new names buying Eksportfinans paper for the first time."

The funding cost also improved. "At Libor less 13bp, we came at 5bp or 6bp over KfW — we have never been so compressed in price before," said Elbech. "Our last three year printed at less 10.5bp."

However, the global format is no magic formula, and must be backed up by the right approach. "Do your deals right," says Whichello at BNP Paribas. "Show some performance and investors will pay you back."

He points to Eksportfinans and Rentenbank as examples of borrowers that have followed the right strategy. "Eksportfinans have done their third global now and have made great progress in terms of the levels they are getting," he says. "The same with Rentenbank. They have taken a strategic approach to the dollar market over several years and have been paid back."

Investors can be quick to reward issuers that were not always the most market-friendly in the past, but have changed their ways, says one DCM official.

"This year the Council of Europe mandated its deal, approached the market in a much more investor-friendly fashion, and had an oversubscribed issue," he says, "whereas in previous years its deals had not been fully sold and tended not always to perform in the secondary market.

"The issuer looked at the market, realised that it needed to be a bit more strategic, got the balance right between a good economic level and a strategic approach, and had a blow-out deal. And when it comes back to the market next time it will be repaid."

$1bn is more valuable than $2bn

The Council of Europe Development Bank's three year Eurobond, led by BNP Paribas, CSFB and RBC Capital Markets, was its first $1bn deal.

"Part of the reason for the deal's success is the size of $1bn, which is larger than the Council typically issues," said a syndicate manager at RBC. "It appeals to a broad range of investors but does not overburden the market."

Indeed, $1bn has become the minimum size for benchmark status in dollars. Kommunalbanken knew this when setting out its stall.

"That is a reference benchmark size," says Falkgård. "Any smaller than that can be regarded as a more opportunistic trade and some investors set a minimum of $1bn. We therefore issued that size to send the correct signal to the market."

OKB, which has a long track record in the dollar market, confirms this. "It has been our experience that investors look for a minimum benchmark size of $1bn," says OKB's Seitelberger. "The message conveyed to us during investor meetings is that a minimum volume of $1bn provides investors with the necessary liquidity and enhances the perception of a strong performance in the secondary market.

"In the recent past very large transactions in excess of $2bn were not always fully subscribed, due to an increased price sensitivity on the investor side."

That was particularly true in this year's challenging market environment. "With the declining interest rate environment in the past years it used to be much easier to launch successful, often hugely oversubscribed transactions," says Seitelberger. "OKB was often able to increase the issuing volume before pricing."

But in 2005 most investor demand has refocused on the shorter part of the curve. "It has become much tougher to time issues correctly and adapt to the interest rate cycle," says Seitelberger. "Tightly priced deals have become more difficult to place, with investors looking to enhance yield; also, quality order books now are usually just subscribed or slightly oversubscribed at pricing."

OKB overcame these obstacles by avoiding competing deals and navigating the interest rate cycle carefully, says Seitelberger. "It seems to us that investors still focus on smaller sizes and rare names," she adds.

Little and often

Inevitably, the changing market has proved more of a headache for issuers like the European Investment Bank and KfW that have annual funding requirements of around Eu50bn and need to be able to take large amounts out of the market in one go.

Some bankers have suggested that dropping to a $1bn issue size could result in such issuers tapping the market too frequently and losing favour.

However, that has not stopped KfW from lowering its minimum sizes for dollar global benchmarks. In December 2004 the German development bank cut the minimum size of its dollar benchmarks longer than five years from $2bn to $1bn. The minimum for shorter maturities remained $2bn.

The result of this strategy, combined with 2005's market environment, was a $3bn three year global in January, a $2bn five year global in April and a second three year global, this time for $2bn, in November.

Outside its benchmark programme, KfW also launched a $1bn seven year Eurobond in March, a $1bn four year global in June, a $1bn 10 year global in July, and a $1bn three year non-call one global issue in January.

"The final decision whether a global bond is a benchmark is taken by the market," says Horst Seissinger, head of capital markets at KfW in Frankfurt. "One major criterion of whether a bond is a benchmark or not is the maturity. From my point of view the three, five and 10 year sectors are benchmark maturities — probably also the two year.

 "Critical also is the liquidity in the secondary market," he adds. "If an investor buys a benchmark he expects to get a bid at every time and also a tight bid/offer spread."

In 2004 KfW launched a $1bn 10 year global bond outside its benchmark programme, since the size was below the then minimum of $2bn, only to increase it soon afterwards to $2bn and include it in the benchmark programme.

This caused confusion among market participants, but now that KfW has changed its issuance framework, Seissinger says the more flexible approach is well received, as is KfW's greater frequency of issuance.

"Investors were asking us why we weren't more frequently in the market and we responded to that by increasing the number of global bonds under our dollar programme," he says. "We also issued some targeted deals.

"All the deals were priced according to market conditions and sized in an appropriate way. The performance in the secondary markets and the tight spread has encouraged us to follow that route further."

Investment bankers back up Seissinger's comments. "If anything, people welcome the fact that these deals are smaller," says one SSA origination official in London. "Liquidity is no longer the buzzword it once was. People do like a certain amount of liquidity, which means $1bn, but you certainly don't need to be doing $2bn or $3bn all the time.

"People aren't going to say they'd rather have a $2bn deal over a $1bn deal. They want the deal that is right for the market, that is most likely to lead to a good spread performance."

The difficulties of sticking with a predefined minimum size were illustrated by the EIB's experience in late August, when it got caught in the wake of Hurricane Katrina.

Barclays, Goldman Sachs and Morgan Stanley opened the books for a $3bn five year global bond on Monday August 29, and only after that did the hurricane's full fury become clear.

A sharp rally in the Treasury market, prompted by higher oil prices, made for a volatile backdrop and the leads ended up pricing the full size issue ahead of schedule with a book of only just over $2bn for the $3bn benchmark.

"We were faced with the decision of straddling this volatility and going ahead with pricing as scheduled or accelerating pricing to a day earlier," said Sandeep Dhawan, senior capital markets officer at the EIB in Luxembourg. "After speaking to investors we took the latter decision, which was further justified as the market continued to rally more speedily after pricing.

"With the launch of the transaction and refined price guidance, investor buying out of Asia and Japan picked up smartly. In the end, we were left with a manageable residual, which should find a home as the market stabilises."

Germany oversteps the mark

For all the interest that greeted new issuers' appearances in the dollar market this year, it was the Federal Republic of Germany's transaction in late May that aroused most excitement.

The $5bn benchmark was Germany's first foreign currency bond for more than half a century and the largest sovereign, supra or agency deal ever, apart from Fannie Mae and Freddie Mac.

Yet the deal did not gain the support that had been expected.

Up until pricing, everything went well. Price guidance of the mid-teens over Treasuries gave lead managers Deutsche, Goldman Sachs and Morgan Stanley enough momentum to generate $14bn of orders. What had been a minimum $3bn issue was bumped up to $5bn and priced at 12bp over Treasuries, equivalent to around 31.5bp through Libor.

But not long after pricing the issue cheapened, and it stubbornly remained wide. This spoilt both the Federal Republic's deal and the primary market for other SSAs, since a large float of cheap German paper made selling a new issue at tighter levels impossible.

Few market participants had quibbled about the pricing, so they put the deal's problems down to two factors: the demand in the book being less firm than the leads had realised; and a want of support from the lead managers in the aftermarket.

"Everybody was very shocked that what should really have been deal of the year ended up being one of the worst," says one DCM official. "It was too big and they were greedy on the size. The pricing was expensive but not unreasonable, but there was not sufficient vetting of the quality of orders.

"They might have had an order book of $14bn, but if that is going to be the type of account that hits the leads back with the bonds — be it hedge funds or central banks that have started trading more actively — then the book is not that high quality. Maybe the real book of high quality accounts was $6bn or so and that would still have led to a phenomenal $3bn deal."

Another banker agrees. "If the Asian central banks start selling, as they did at that point, then it is very tough to stabilise a $5bn deal, much harder than for a $3bn deal," he says. "It was very clear that the leads did not support the deal in the way that was expected."

Looking back on the deal, Gerhard Schleif, managing director of the Finanzagentur in Berlin, told EuroWeek that Germany had learned from its experience. "We would not have done anything differently regarding our market approach," he says, "but we are discussing changes to the structure of the syndicate that might lead to certain minor changes in future transactions.

"The different business models of banks — with, say, investment banks having a different approach to commercial banks — have different effects on their competitive positioning. Balance sheet, for example, can play an important role in such a deal."

Schleif's pleasure at having saved the German taxpayer an estimated Eu25m-Eu30m over the life of the deal was, however, undiminished.

"We got the final approval from the Ministry of Finance last year when we announced our annual programme," said Schleif, "and we said that this is not part of our regular funding programme for the budget, but is rather an opportunistic transaction that has as its main target reducing funding costs. That means to save money compared to a euro denominated issue and that is what we were able to do."

For this reason alone, bankers predict that despite any problems Germany faced, new sovereign, supranational and agency credits will consider issuing dollar benchmarks in ever greater numbers. 

02 Dec 2005