All change, with or without Emu

  • 01 Mar 1998
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A sea change is sweeping through every aspect of the UK capital markets as the European continent gets ready for the single currency and as the strength of sterling and the UK economy continues to expand the use of the UK's financial markets by international issuers and investors.

Whether or not the UK eventually signs up for Emu -- and the odds are increasingly that it will do so in 2002 -- the introduction of the euro will transform business life in the UK, in the financial and industrial sectors alike, and trigger a wave of new products in the debt and equity capital markets.

As Europe's capital markets become driven by credit rather than currency, the race is on for investment banks to develop innovative instruments -- in the bond, loan and equity markets -- and respond to the changing needs of issuing and investing clients.

The long term effects of Emu on the sterling capital markets are impossible to predict. But, whatever happens, there is every indication that the City of London -- which has thrived on change so often in the past -- is well placed to benefit from the euro and strengthen its position as the international financial centre of the united European continent.

Philip Moore reports.

Sterling.1. n. Until at least 2002, British money. Historically weak. Now very strong. 2.a. Of solid worth, genuine, reliable.

Virtually everybody involved in every area of the UK capital market is having to learn an entirely new language. This is being manifested at the most basic level on the business cards of thousands of London-based bank employees.

No sooner had the old hands at SG Warburg got used to the idea of being employees of SBC Warburg than they found themselves having to append the words Dillon Read to their calling cards.

More recently, equity specialists at another British institution proud of its pedigree found themselves required to shuffle across Canary Wharf and to amalgamate the names of CSFB and BZW.

In April, their counterparts at NatWest Equities will also consign their old business cards to the rubbish bin, rechristening themselves as employees of BT Alex Brown.

It is not just consolidation within the UK's financial services industry which is fuelling the bonanza for printers of business cards. The promotion and acceptance of new products in the UK capital market is doing the same.

Possibly one of the most telling recent alterations to bankers' business cards has emerged in the high yield department at Bankers Trust. These tell you that Bankers Trust is no longer just plain Bankers Trust. No, Sir. It is now Bankers Trust, Architects of Value.

The addition of those three words says much about the recent evolution of the UK capital market and about likely future developments in the sector.

And Bankers Trust is by no means alone in having to add new words to its existing financial lexicon. Bond investors in the UK are having to rewrite their manuals, incorporating expressions like "high yield" and "stock picking" which were previously almost the exclusive domain of equity investors.

Equity investors, for their part, are increasingly having to disregard traditional diction and ignore historical valuation yardsticks such as P/E ratios and dividend yields, and focus more intently on supply and demand models galvanised by corporate restructuring, balance sheet management and share buybacks.

Even bank lenders in the UK are being forced to reach for the dictionary and look up expressions long regarded as an irrelevance in their particular field -- such as "loan trading", "portfolio management" and at the primary level, "price range" and "price talk".

At the same time, a host of time-honoured British financial expressions are either dead or dying. The jobber has long since gone. The offer for sale has been a more recent casualty. The merchant bank is looking increasingly obsolete. The Gilt is fast becoming an endangered species.

A by-product of this process is that products are becoming blurred, and traditional demarcation lines between individual responsibilities are being broken down.

Over the last 12 to 18 months there have been a number of examples of this in the UK debt capital market: Fannie Mae launching a global sterling denominated bond intended to trade as a Gilt; Colt Telecom raising a high yield bond which, the words of one banker "actually trades much more like an equity issue than a bond"; Welcome Break issuing a four-tranche structure which, as the then BZW noted at the time, "takes elements from securitisation technology as well as more traditional secured sterling bond characteristics for the fixed rate tranches"; and Nomura's principal finance team securitising Angel Trains in a deal which one competitor says looks much more like venture capital than securitisation.

The precise name tag given to any of these individual transactions is less important than the underlying theme which characterises all three. This is that in each case architects of value (to borrow the Bankers Trust expression) have sought to build on existing products -- either by injecting liquidity (as in the case of Fannie Mae), or by stressing an underlying credit story.

If this process is to accelerate, as many observers believe it will, the next logical step would be for UK institutional investors to overhaul their structures, and for individual departments which have historically been highly segmented to become more integrated.

The process would dictate that bond investors would start to borrow techniques from their equity counterparts in assessing credit, and vice versa.

These changes are being fuelled by a number of phenomena, the most important of which is the biggest linguistic shift of them all, which most analysts believe will come in 2002 when the UK follows its European competitors into the single European currency.

The UK's eventual acceptance of the euro -- which is already factored into long term spreads between Gilts and Bunds -- heralds the disappearance of the UK's government bond market and will force investors to focus on credit-based alternatives more intently than ever before.

The broadening of the sterling bond market over the last two years, with the proliferation of corporate issuance, securitised transactions and higher yielding bonds, suggests that this process has already begun.

The process is also one which is sweeping relentlessly across Europe, and which is neatly summed up by Alexander Justham, a member of JP Morgan's securitisation team in London.

"Historically investors in Europe have made money by punting on absolute interest rates and foreign exchange volatility rather than on credits," he says.

"And it has been a great business. Foreign exchange volatility is a marvellous thing if you're on the right side of the equation. But all that is going to go -- the euro will take away foreign exchange volatility and interest rate differentials. So the only way to make money will be on judgements about credit and on spotting relative values on credit, and securitisation is one product which will benefit enormously as a result."

A by-product of the UK's apparently inexorable drift towards the euro -- the performance of the economy -- is also playing into the hands of the development of the UK's capital market.

For the time being at least, New Labour appears to be committed to delivering on most of the economic pledges traditionally associated with Old Conservatives, which points towards restrained public spending and continued low inflation.

As a result, says a recent report published by NatWest Markets, "economic growth should slow to sustainable, not recessionary levels, inflation remains under control [and] corporate earnings are set to grow at still historically healthy levels. With low Gilt yields also providing support the UK enters 1998 as one of the more attractive investment opportunities for international investors this year."

None of this is to say that the UK is without its risks. One of these is that under the dual pressure of relatively high interest rates and the strength of sterling -- exacerbated in some quarters by the ongoing fragility in Asia -- the UK teeters from respectable and sustainable low growth into a full-blown recession.

As Smith Barney noted early in December, "the UK is set to dive from near the top of the European growth league in 1997 to near the bottom in 1998."

Given the strength of the UK economy relative to its European counterparts in recent years, a slowdown in growth need not be a bad thing; a sharp downturn translating into recession, on the other hand, most obviously would.

"Worries about a recession are probably a bit overdone," thinks David Hillier, UK economist at Barclays Capital, "although the recent CBI survey did show for the first time that the manufacturing sector is clearly on its knees as a result of the strength of the pound."

At Salomon Smith Barney, UK economist and managing director Michael Saunders agrees that at current levels UK exporters are in a parlous position.

"Exporters are getting slaughtered," he says. "For them, the present climate is as bad as the last recession." Encouragingly, however, Saunders says that the Bank of England is sympathetic towards exporters and that interest rates would already have been raised much higher than they already are had sterling been valued at, say, 50 pfennigs below its current level.

Be that as it may, there appears to be a broad consensus that all the macroeconomic trends appear to be heading in the right way for the UK economy. If they continue to do so, the events of 1998 will prove to be a glorious vindication of the unexpected decision announced shortly after last May's general election by Britain's new Chancellor of the Exchequer, Gordon Brown, to grant full independence to the Bank of England.

Above all, as far as the UK's beleaguered exporters are concerned, there is a broad consensus that sterling is overvalued and heading for a fall against both the dollar and the Deutschmark.

In its December 1997 update on the UK economy, entitled Fundamentals, the insurance company Legal & General published the expectations of 11 banks (together with L&G's own forecasts) on the likely exchange rate of sterling against the key benchmarks in December 1998, finding that the consensus view is for DM2.70/£ and $1.62/£.

Goldman Sachs, SBC Warburg and L&G Investment Management itself saw sterling falling by even further than this against the Deutschmark, to DM2.60/£ by the end of 1998, with only one house, Credit Suisse First Boston, maintaining a sufficiently bullish stance on sterling to forecast a level of DM3/£ at year end.

This is explained in a recent update on first quarter prospects published by CSFB which says that "we would argue that sterling is likely to remain stronger than many expect, even as growth slows" due to "a structurally stronger current account, a re-rated policy process and a persistently large and positive interest rate differential which is likely to continue."

Somewhat less decisive about the outlook for sterling is Morgan Stanley, which seemed in a recent analysis on currency movements to engage in a classic piece of bet hedging. "At these levels or higher," this noted, "sterling is bound, at some stage, to impose a significant cost on the UK economy in terms of a worsening current account position and other economic imbalances. But, as long as these issues are not clearly visible, there is little to be gained from shorting sterling aggressively. Sell it eventually, but not yet."

While most commentators are therefore looking for a fall in the value of sterling (even if some refuse to say when they are expecting this to come), they also seem uniform in agreeing that there is room for base rates to end the year lower than their current rate of 7.5%.

Between them, the 11 forecasters expressing a view in the Legal & General bulletin plumped for a year end average base rate of 6.88%, although here too there was a considerable split of opinion between houses such as HSBC James Capel and Goldman Sachs (which forecast year end levels of 8% and 7.8% respectively) and SBC Warburg Dillon Read (which with a forecast of 6.5% was the lowest of the 11).

Another risk for the sterling capital markets is that UK companies or investors choose to overlook or fail to lay the groundwork for sterling's eventual entry into the single European currency.

This is because however many political rumblings there may be about Britain's membership of Emu in whatever phase or whatever year, it seems a certainty that Britain will join at some stage. This is clearly what the Gilt market is saying, loud and clear, with the 100bp+ spot spread of Gilts to Bunds entirely eroded in future spreads.

As Salomon Smith Barney noted in a November update on the UK, "the Gilt market currently prices in little chance of Emu membership before the next election, but a high chance of Emu entry in 2002-2003. We suspect that the markets have got the odds about right and expectations of eventual Emu entry are likely to keep the UK-German five year spread pinned to narrow levels."

And with good reason. An important shift which has come about over the course of the last six months or so is that choices regarding Emu -- across the whole of Europe -- are increasingly being taken not at a political level but in the boardrooms of Europe's leading companies.

In this respect a severe blow for Britain's eurosceptics was delivered early in February when ICI unveiled its annual results. At the time, the chemicals giant's chief executive, Charles Miller Smith, followed in the footsteps of several continental European companies by warning his British suppliers that if they failed to prepare for the new currency they ran the risk of being "abandoned" as ICI's business partners.

If and when the British business community recognises, like ICI, that it has no choice but to accept and prepare for the euro, public opinion will move quickly and decisively in favour of Britain's entry into the single currency.

For the time being, as a Salomon Smith Barney report published last October points out, the British people appear to be firmly opposed to the UK's membership of Emu.

Salomon Smith Barney described the results of a survey conducted between October 2 and October 7 as being "striking", pointing out that "public opinion over Emu remains very sceptical -- by two to one against -- and has not changed at all since the spring."

By the early weeks of 1998, however, the sands seemed to be shifting somewhat. When Salomon Smith Barney returned to analyse the feelings of British people towards Emu at the end of January it found that "there continues to be a modest pro-Emu shift, although overall public opinion remains opposed."

The firm noted: "The balance of opinion against Emu fell from 27% in April and October [1997] to 22% in November -- after the government's statement that, in principle, it favoured Emu entry (subject to a referendum and satisfactory economic conditions). It has now edged down to 19%, the lowest in recent years."

With UK companies increasingly likely (either through choice or necessity) to do the same as ICI, and make active preparations for Emu-based operations, it is probable that pro-Emu sentiment among the UK general public will expand apace.

This is because however sentimental the British people may be about their national identity, job preservation will be a more important priority than the Queen's head on their one pound coins.

If the UK is to enter Emu in some second phase, arriving late to a party where all of the guests have already got to know one another, there are concerns that in the intervening months the UK capital market will become peripheral.

"I'm not sure it will happen," says one banker in London, thinking aloud, "but you could argue that in a relatively short space of time the UK market is going to atrophy."

Certainly some of the leading investment banks in London -- consciously or otherwise -- give the impression that, in comparison to the opportunities which they see unfolding in Europe (in the immediate future) and in emerging markets (perhaps a little later), the UK market is becoming mature to the point of being dull.

This is most evident in the equity market where the UK privatisation programme has run its course and new issues are thin on the ground. But it is also true in other pockets of the capital market: talk to London-based bankers about the opportunities arising in securitisation and project finance, for example, and they seem impatient to stop talking about the UK and quickly move onto the subject of Europe.

Clearly a handful of UK borrowers are already very alive to the threat of the UK's capital market becoming marginalised, and none more so than Abbey National, which has arguably been preparing for Emu since 1986.

This was the year of its demutualisation from a building society into a fully-fledged bank, since when it has been one of Europe's most prolific borrowers, assiduously courting an investor base in currencies such as French francs and Italian lire.

Abbey took the process a step further at the beginning of February when it became the first UK borrower to follow in the footsteps of Europhiles such as the EIB and L-Bank in launching a euro denominated bond.

The Eu1bn five year issue, priced at 17bp over the Ecu denominated OAT, was led by Paribas and Salomon Smith Barney and was warmly received by continental European accounts.

An even more groundbreaking deal from a UK corporate beating the drum for euro-awareness came later in the same month when the defence to electronics group, GEC, unveiled plans to launch the first ever euro denominated syndicated loan.

The Eu6 billion facility -- around $5.5 billion in today's language -- was mandated to eight arrangers and underwriters, comprising Barclays Capital, BCI, BNP, Chase, JP Morgan, Midland, SBC Warburg and West LB.

But to date issues such as these have tended to be the exception rather than the rule among UK issuers, with one banker in London saying that "for most UK companies Emu is something which is vaguely going to happen some time in the future, and does not yet need to be prepared for." Companies with attitudes like this, suggests the same banker, could be in for a shock.

Complacency about the effects of Emu potentially spells danger for issuers in both the sterling bond and equity markets. As a comprehensive NatWest Markets analysis on the subject published in January warns in its introduction, "as European monetary union approaches it is clear that the impact of the shift to a universe of Emu based stock indices will be both substantial and dramatic."

It added: "Investors will face a permanent change to their benchmark indices and thus attitudes towards performance measurement, risk analysis and sector allocation will have to adapt to this new environment."

A very dangerous view for UK companies would be to assume that investors will act in a similar way, say, to European bank depositors -- and be more motivated by Italian-style regionalism, or campanilismo, than by performance -- sticking by companies with which they have linguistic ties or close personal links at a management level.

"I'd buy that argument if we were talking about retail banking or insurance," says one sceptic. "But pressure to perform among fund managers is too intense for the same thing to happen in the equity market. Fund managers will go to wherever quality or undervaluation lies."

Another imponderable arising from the launch of the euro is the role which the City of London and the main UK investment banks will play in the post-Emu environment.

In this respect it is notable that in the early weeks of this year Barclays Capital, for one, was very keen to promote its capabilities in currencies other than sterling.

Robert Thorne, managing director of debt capital markets at the bank's new headquarters in Canary Wharf, is confident about the new challenges which Emu will bring.

"We've always been a multicurrency bookrunner," he says, "and on the primary side we have had a significant bond trading franchise for a long time. We led about DM4bn in the Deutschmark sector alone in the first few weeks of January, which demonstrates that we are ready for the euro."

Significantly, too, Barclays Capital won a position on the syndicate announced early in February for Spain's groundbreaking 30 year euro denominated bond.

But aside from ensuring they are in the vanguard of banks willing and able to lead manage capital market issues in currencies other than sterling, the UK's banks are also becoming increasingly preoccupied by other bread-and-butter business which may be threatened by the launch of the single currency.

"Like every other bank we've done a lot of work analysing the effect of the euro and whether or not our business is going to die when the new currency comes in," says Tim Pettit, managing director and head of derivatives marketing at Greenwich NatWest in London.

"But we are predominantly doing interest rate hedges for which there will still be very strong demand after the euro comes in. So we don't expect overall levels of business to decline. In fact, we expect customers to hedge even more because of the increase in liquidity which Emu will bring."

For the time being, says Pettit, a great deal of the focus at Greenwich NatWest's derivatives business is on educating the client base about the threats and opportunities which Emu will produce.

"We had our first euro conference in November 1996," he says, "and last year we had a further nine or ten and about 1,000 people turned up, so clearly UK businesses are very serious about their preparations for the euro."

As to the future of London itself in the context of the euro, the City's cheerleaders have been out in force over the last six months or so, impressing upon anybody prepared to listen not just that London is ready for the euro, but that it will thrive and prosper under the new currency regime.

In February, for example, David Clementi, deputy governor of the Bank of England, visited New York with Morgan Stanley's European head, Sir David Walker, to impress upon an American audience just how prepared London was.

"We are ensuring that the necessary financial infrastructure is in place so that anyone who wishes to do so can trade and settle in euros in London from the first day of Emu," the deputy governor assured his audience.

"We are also helping to ensure that City firms -- whatever their nationality -- are properly prepared so that they and their customer can make full use of the infrastructure." EW

  • 01 Mar 1998

All International Bonds

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • Today
1 Citi 416,634.23 1594 9.03%
2 JPMorgan 379,647.36 1732 8.23%
3 Bank of America Merrill Lynch 359,625.73 1304 7.80%
4 Barclays 267,126.92 1079 5.79%
5 Goldman Sachs 267,110.09 921 5.79%

Bookrunners of All Syndicated Loans EMEA

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • Today
1 HSBC 45,314.03 193 6.64%
2 Deutsche Bank 37,536.19 138 5.50%
3 BNP Paribas 36,532.54 211 5.36%
4 JPMorgan 34,490.59 115 5.06%
5 Bank of America Merrill Lynch 33,700.87 110 4.94%

Bookrunners of all EMEA ECM Issuance

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • Today
1 JPMorgan 22,398.41 104 8.66%
2 Morgan Stanley 19,092.40 102 7.38%
3 Citi 17,812.08 111 6.89%
4 UBS 17,693.89 71 6.84%
5 Goldman Sachs 17,256.05 98 6.67%