Who'd be an agency or supranational treasurer? Swap spreads in both euros and dollars are so tight that, for many top quality issuers, borrowing in the public markets is often uneconomic. For others, arbitrage opportunities are few and far between. Here, Sebastian Boyd examines the macro-economic factors driving swap spreads and considers the options for smaller agency and supranational issuers.
Changes in the market for supranationals and agencies are being driven by factors beyond their control. In the euro market, they are having difficulty squaring their funding targets with market clearing levels because of swap spread tightening that has been partly caused by the issuance and duration management of sovereigns.
In dollars, corporate treasurers and their worries about market access are causing problems. Levels of corporate issuance have boomed since the beginning of 2001, driven by treasurers seeking to lock into low interest rates and to term out debt in a bid to avoid the liquidity crises that can result from market volatility or rating downgrades. These record levels have put pressure on swap spreads, again closing off arbitrage opportunities for top borrowers.
"This is a very significant and very unusual event," says John Butler, head of debt strategy at Dresdner Kleinwort Wasserstein (DrKW) in London. "It is rare that this market access issue becomes separate from underlying financing issues, and it is rare for there to be such a short term change in corporate treasurers' perceptions of market access."
Since the collapse of Enron, investors and rating agencies have been looking more closely than ever at borrowers' liquidity. One of the results is that corporates have been terming out their commercial paper by issuing in the term markets.
"The CP market has effectively been closed and banks are not providing liquidity facilities to a number of corporates," says Scott Graham, co-head of agencies at Greenwich Capital Markets. "So what those corporates are doing is issuing term debt and then swapping the fixed portion of that to floating. As they have done that they have driven the US swap and agency markets to very tight levels against Treasuries."
But corporate treasurers are also concerned about continued access to other sources of liquidity, including the term debt markets. Several borrowers had to pull deals in the first week of May after the telecoms blowout led by WorldCom left investors wary of committing money to all but the highest quality corporates. Corporate treasurers have realised that the best policy is to access the market when the can, even if they do not need the financing, to save for a rainy day.
"It is not only market access for the CP market," says DrKW's Butler, "but perhaps also general market access in the long term. If you are worried about market access, then you will issue a bigger bond than you think you are going to need, just in case a witch-hunt mentality grips the market."
The result has been a tightening of dollar swap spreads, which, while not as severe as in euros, threatens to cut off the attractive Libor opportunities that prompted so many borrowers to tap the global dollar market in 2001. However, the dollar market retains its attractions. "The basis swap in most maturities favours euro-based issuers willing to issue in dollars," says Ziad Awad, syndicate manager at Goldman Sachs in London.
The disparity between euro and dollar funding costs is not as dramatic as it has been at times. At the beginning of May, for example, the EIB's March 2005 dollars issue was trading at around 19bp through dollar Libor, while its April 2005 EARN was at about 11bp through Euribor. Nevertheless, even if the differential is not as great for the EIB as a borrower such as Freddie Mac, the dollar option is clearly more economical.
Not everyone has suffered from the situation. "If you compare the second half of 2001 and the first half of 2002 with the first half of 2001 and the year 2000," says an official at Landwirtschaftliche Rentenbank, "we have improved the levels on our benchmark issues by 1bp-1.5bp, and we feel that the primary placement and secondary performance of Rentenbank issues has improved."
But to overcome the market's difficulties, Rentenbank has had to be proactive in its approach. "The improved levels are probably due to the fact that we have become a more prominent borrower because of our SEC registration and global programme," adds the Rentenbank official. "That has got us on to the buy-lists of a number of central banks, especially in Asia."
Benchmarks: not for everyone
The EIB and KfW have funding requirements of around Eu37bn and Eu40bn, respectively, this year. This may be small compared with Freddie Mac, which has already issued more than Eu50bn equivalent in bullet reference deals alone this year, but it puts them in a league ahead of the smaller European agency issuers such as BNG, Cades, ICO, L-Bank and Rentenbank. Apart from the big two, European agencies seldom have funding requirements in excess of Eu7bn-Eu10bn.
These issuers sometimes argue, as the Council of Europe Development Fund does, that investors buying their credits can avoid the volatility of more liquid deals. But there are clouds on their horizons.
"The Council of Europe is very interesting," says Christopher Marks, the official who covers the supranational for BNP Paribas in London. "It brings one or two benchmarks a year, but because of its relatively small funding needs it does not have a benchmark programme. Instead it does its funding in dollars, where it has been cheaper for a number of years.
"Its worry, which BNG shares, is that the level investors will consider to be acceptably liquid has been rising, even though its borrowing programme has not changed in size."
As the size of what is considered a benchmark increases - it is perhaps at least Eu1.5bn-Eu2bn depending on the name today - it becomes harder for an agency to issue two benchmark deals a year when it only needs Eu5bn. The Council of Europe, however, argues that its debt allows investors to get exposure to a triple-A rated European name without the volatility inherent in a liquid benchmark.
Those arguments appeal to buy and hold investors who mark to market. Part of the reason for the lower liquidity of deals from issuers like the Council of Europe or L-Bank is that they tap into both institutional and retail demand, mainly with Eurodollar issuance, and as the paper sells down to retail over time, the quoted spreads grind tighter. "The distribution of Eurobonds into Europe is less skewed to retail than it was in the past," says Awad at Goldman Sachs, "but the retail component continues to help outperformance over time."
For example, the October 2005 deal that the Council of Europe tapped last year through BNP Paribas was trading last month at 25bp through Libor. Although only $400m when first issued in 1998, that deal is now up to $1.2bn.
Oesterreichische Kontrollbank (OKB) is another borrower to find that its role in the international bond markets is modest today. But given that the agency has had an international presence since the early 1970s, it can now take advantage of its name recognition to access all the major markets and only issue where funding levels are attractive.
"Our annual funding volume is Eu4bn," says Anton Ebner, director of the international finance department at OKB. "We usually issue one or two transactions in the global market. So far we have used dollars, and two years ago we issued a yen global. We are Libor-based and, with our long track record in the dollar market, we have strong name recognition there, which allows us to get a better investor base and better results than we can in euros."
Like most agency and supranational treasury officials, Ebner is avoiding the euro for now. "On a global basis the euro cannot compete in terms of investor base - it does not have the penetration," he says. "So our strategy is to go for the dollar, which allows very broad distribution and we achieve better funding because the arbitrage is better than in the euro market. About a third of our funding is done in the MTN and private placement market."
For the smaller European agencies, says Pierre Blandin, head of public sector debt capital markets at DrKW in London, "a significant proportion of funding can come from private placements in retail currencies. You can easily fund 50% in those structures." However, this does not preclude benchmarks. "A large transaction is a marketing platform," says Blandin. "It is the best way for those borrowers to market their name and help investors understand their credit. It is probably difficult for the smaller agencies to be completely out of the public market."
The Spanish agency, ICO, for example, has a borrowing requirement of Eu6bn. It commits itself to issue one benchmark a year, but the rest of its funding is in the private markets. The borrower is zero risk-weighted and has a guarantee from the Kingdom of Spain. It also benefits from rarity, having only ever issued two global deals.
"I tend to look more favourably at the traditional Eurobond format than the global format because it is more flexible," says its Madrid-based CFO, Federico Ferrer. "In the global format you need to gather momentum, and once you have gathered it you cannot stop even if the market is not that favourable at that time.
"And the fact is that globals do not really offer better funding than Eurobonds. The global gives you better access to the US investor base, and of course we are trying to diversify our investor base, but the truth is that we have not been a very large issuer in the past so we do not need to go to the ends of the earth just to diversify."
Rentenbank takes a similar approach to its peers, but places more emphasis on its home market. "We have an Eu8bn-Eu10bn funding requirement," says a treasury official at Rentenbank, "which we fund using a wide array of funding instruments in various different markets. Our basic approach is to split that volume into benchmark transactions on the one hand and smaller Eurobonds and private placement transactions on the other.
"As a euro zone borrower, we feel it is appropriate to target two euro benchmarks a year, although we might do more or fewer. The second important market for us is the dollar, which we tend to approach one or two times a year with a benchmark transaction, most likely in a global format."
One recently introduced factor into the considerations of agency and supranational issuers is the MTS trading platform. With its Eu5bn and Eu3bn eligibility criteria for EuroMTS and EuroCredit MTS, respectively, the platform is beyond the reach of many of the smaller issuers. But even though the smaller benchmark issuers cannot issue in large enough size to be MTS eligible, says Marks at BNP Paribas, they can try to catch demand from investors interested in liquidity and who are buying bonds to make a directional play.
One of the advantages of dollar issuance for triple-A issuers is that the established benchmark size in dollars is much smaller, at $1bn-$2bn. There is a tier of dollar borrowers, such as the World Bank, KfW and Italy, that can issue the $3bn to have their deals listed on the TradeWeb dealer-investor trading platform, but smaller issuers can benefit from the greater liquidity of the market as a whole, and often win a diversification premium that compensates for the relative lack of liquidity of their deals. OKB for example, with $1.25bn, has the same investor base as KfW and trades in the same price range.
Another borrower to profit from the advantages of the dollar market is the Asian Development Bank, which issued a $2bn five year global earlier this year through HSBC and Nomura International. It was the ADB's joint largest ever deal, and came 2.5bp behind Fannie Mae. That was considered punchy for US investors, but the ADB's loyal fan base in Asia ensured that the deal worked.
"The investor work and rarity value of the credit coupled with a strategic approach to pricing the bond - not only at an opportune time but also the correct market level - ensured both a successful transaction and one that guaranteed that the issuer's next deal should also receive a positive reception," says Ed Mizuhara, a syndicate official at HSBC.
Whether dollars will provide attractive arbitrage for the remainder of the year remains to be seen. "I personally believe that swap spreads will not be this narrow forever," says Ferrer at ICO, "and with our present solid liquidity position we can wait until things improve. If they do not, we will probably stick with short dated dollars, which is the best window open to us, and while not ideal provides acceptable funding levels."
But borrowers such as ICO have other options available. "We are also looking at non-vanilla issuance and may have to access the structured yen market, where we have traditionally not been a large issuer," says Ferrer.
Structured funding, says Marks at BNP Paribas, "is a complement to the relatively expensive but higher volume funding issuers can do in benchmarks." Launched off their MTN programmes, structured issuance plays a major part in the funding of all the supranational and agency borrowers. Some names, like Swedish Export Credit (SEK), do little else.
Usually, as the year progresses, the levels available through structured yen issues get tighter, and by the end of the year the most popular issuers such as the World Bank and Rentenbank can get funding at 60bp or more through Libor for a ¥1bn issue with a one year call. "Japan remains a very key investor base for all sorts of structured transactions," says Blandin, "and we have seen a lot of transactions targeted at retail domestic investors in other currencies."
One banker believes that a European agency could knock 30bp-40bp off its structured funding costs with the hire of a couple of MTN experts.
The problem with non-vanilla issuance is that for most borrowers, it can only provide a minor part of their funding needs as each transaction is so small. For an issuer like KfW with a Eu40bn funding requirement, deep sub-Libor MTNs can only be a small part of annual issuance. Recently, however, there has been a growing interest in issuing non-vanilla transactions, such as callables and floaters, in larger size.
"Investors are starting to look for less custom approaches to their needs," says Jeff Diehl, head of supranationals and agencies at HSBC, "and are prepared to pay a little bit more for something more structured." But they prefer size. "If you are going to be part of an issue," Diehl says, "it is much better to be in a $1bn global than a $100m MTN."
There is still plenty of demand for tailored MTNs, but for an investor looking to take a view on interest rates, or to hedge convexity, liquidity offers advantages. KfW's recent $1bn floating rate note was only a qualified success in the primary market, coming as it did during golden week, but the logic - allowing investors to put on an extension trade ahead of rising interest rates - was sound.
KfW had more success with its $1bn three year non-call one transaction in March. The first issue by a non-US issuer in the global agency market, it was jointly led by Bear Stearns and Merrill Lynch. "KfW made good use of its market presence in the US to do its callable," says Marks at BNP Paribas. "It was not like the $10m-$20m callables that every large issuer does on the side. Large callables are clever complements to the larger more expensive benchmarks."
Dollar callables bring in a retail investor base, but they can also appeal to institutional investors. "The callable sector is certainly an area which a broader range of investors has been looking at," says Diehl, "and they are also looking at larger liquid issues. We are taking big orders, but where investors have the confidence that there will be a tight bid-offer. That is even the case in MTNs where we are seeing Freddie Mac doing $1bn size deals."
The growth in demand for large callables is linked to the attractive volatility in the dollar market - something not prevalent in euros. The EIB has been looking at structured trades in euros, but euro volatility is lower than in dollars. There is also less convexity hedging in euros because of the different structure European mortgage market. "The relatively lower volatility of the euro makes callables less attractive," says Awad at Goldman Sachs.
Although most dollar issuance has been confined to the short end since the interest rate easing cycle started at the beginning of last year, some bankers believe that that may be about to change. The question remains when and by how much. Some dollar investors have been tentatively moving along the curve since the first quarter, but any negative numbers are generally enough to reverse flattening.
"If we see flattening of the curve you might see European asset managers active at the longer end," says Blandin. "Without that demand, supras and agencies will be dependent on the US investor base, which is unlikely to provide a price advantage."
Nevertheless, there has been some slight evidence of a flattening play, although signals are still too mixed to say that a trend is starting. The economic data and interest rate markets are sending confusing signals to investors.
It was into this environment that KfW issued its $1bn three year floater via JP Morgan. "People are confused over whether this is the usual volatility of data that you get accompanying a turnaround," says Scott Lampard, a syndicate manager at JP Morgan, "or whether the upturn is running out of steam and we are about to move back down into a double dip.
"Over the last 12 months, because of the generally bullish views on interest rates, there has been very little demand for FRNs, and consequently supply," he adds. "But as a result of negative views on rates, there is now demand creeping back into the FRN market.
Investors, says Lampard, are still nervous about taking a long term yield curve view, but there is a consensus that over at least a 12 month period, interest rates will have increased. "That is leading some investors to start looking at extension trades, which they have been hesitantly doing since the first quarter, as the perception grows that perhaps the long end has now built up significant yield to compensate for the risk," adds Lampard.
"Leveraged investors have nibbled at extending along the curve in the last few months," says Greenwich Capital's Graham. "There is enough positive carry for trades from leveraged accounts. When the Fed does signal that it is ready to start tightening, those trades will become much more favourable and once you have a flattening trade under way, I think you will see agencies outperforming the swap market."
In the meantime, though, things look likely to remain tough for supras and agencies. Even those who do not issue against Libor tend to be issuing at very tight levels to underlying assets.
At the end of April, Pimco strategist Lee Thomas announced his belief that the recession is over.
"Mr Greenspan has successfully reflated the economy one more time," Thomas said in a market commentary called Two Cheers for the US Economy, "but no cold turkey for Americans means that the US economy's imbalances have not been eliminated by its mild recession. We remain addicted to shop-till-you-drop. The US starts its next economic expansion with too much debt, not enough savings, and a large current account deficit. The dollar is vulnerable."
If Thomas is right, one would expect to see investment flows into longer dated dollars as the Fed starts to tighten, and into the euro as the dollar weakens.
"A gradual appreciation of the euro would ease the pressure on inflation and reduce the pressure on the European Central Bank to raise interest rates in a hurry," says Kerryn Fowlie, an economist at Moody's Investor Services. "But the market still looks like it is pricing in a 50bp rate hike by the end of this year."
That is positive news. Significant changes in the exchange rate would allow agencies such as OKB to reappraise euro issuance. "Asian central banks have about 70% of their portfolios in dollars," says OKB's Ebner. "In the US, the euro is not a strong investment currency.
"We cannot achieve the kind of attention in euros that we can in dollars, and the arbitrage is not there. So far the success of a deal in euros is very much dependent on exchange rate expectations and movement."
To date, there has been some evidence of slowing flows into dollar assets, but little as yet to support a large long term move into euros.
"We have been consistently recommending the euro as the currency of choice," says Brian Lawson, head of international syndicate at Nomura International. "It has not got to deal-driving size at institutional level, but at the retail level we have seen a growth of interest and half of our retail deals are now in euros."
Butler at DrKW points to the market positioning data for futures contracts at the Chicago Board of Trade. They show a record long position on euros versus dollars. "The speculative community is overextended," he says, "and it is not in a position to survive a correction in that extended position."
The result is that for vanilla issues, dollars are likely to remain the currency of choice for some time. And in dollars, the short end still offers the most attractive funding.
Although a significant extension trade remains a possibility, "it is pretty rare to see international investors' appetite strong enough at the 10 year part of the dollar curve to make the arbitrage attractive," says Pierre Blandin of DrKW.
"If you look at the large public transactions," he adds, "arbitrage is probably not going to massively improve in euros, so one would expect the same sort of issuance in the next few months. However, the borrowers with the largest funding requirements will be in the euro for strategic reasons."
So how do bankers expect the situation to evolve? "The general trend is for swap spreads to tighten," says Sean Taor of Barclays Capital in London, "and, in the short term, they are not likely to widen to any great extent, which makes things very hard for Libor borrowers."
Most market participants agree that the current squeeze will not last, and that either a fall in value of the dollar, a drop-off of corporate issuance or a change in interest rates would open up other market sectors.
But while any of those may happen this year, there is little indication of when. *