The US dollar market was the arbitrage market of choice this year, and duly accessed by a range of sovereign borrowers. Susanna Rust learns that, key conditions permitting, arbitrage issuance is expected to retain an important role in helping sovereigns cost-effectively meet higher funding needs, with dollars still very much a focus of attention.
Arbitrage issuance, by virtue of its strong opportunistic nature, is difficult to predict. What is clear, however, is that an increase in the size of sovereigns’ funding programmes means that these borrowers, if they weren’t so already, need to be receptive to availing themselves of arbitrage opportunities as a way of diversifying their funding sources and relieving pressure on their core markets.
"I don’t think sovereigns are becoming strategic about it in the sense that they want to set up commitments to issue regularly in a particular foreign currency, and in the past they usually were mostly open, but you definitely get the feeling that they are likely to actually execute a deal if all the stars became aligned," says Myles Clarke, global co-head of the frequent borrower group at Royal Bank of Scotland.
That alignment of the stars was something that the dollar market was able to offer sovereign euro borrowers this year on the back of a combination of an advantageous dollar/euro basis swap and healthy demand for public sector dollar paper.
The sovereign borrowers of countries such Austria, Belgium, Denmark, Finland, Germany, Italy, Poland, Spain and Sweden all raised funding in dollars in 2009, according to Dealogic, with the Republic of Germany making its first appearance in the market in over four years.
"This year has been dominated by US dollars, which, because of an extreme movement in the basis swap, has facilitated very attractive Euribor levels for sovereign borrowers compared to their domestic curves," says Greg Arkus, managing director in DCM at Credit Suisse in London.
The Republic of Germany, for example, saved 25bp compared to Euribor levels when it priced a $4bn three year bond at mid-swaps less 25bp on September 14, Carl Heinz Daube, managing director of Bundesrepublik Deutschland Finanzagentur, told EuroWeek at the time of the deal.
And while market participants talk of a link between sovereigns’ increased funding targets and their likelihood to seek, and seize, cost-effective foreign currency funding opportunities, Daube said that Germany’s $4bn bond had nothing to do with the expansion of the borrower’s funding needs.
"It was purely an opportunistic exercise to take advantage of what we thought was sufficiently deep arbitrage, and had nothing to do with the financial crisis," he says.
Peter Nijsse, head of cash management, issuance and trading at the Dutch State Treasury, describes the relationship between the growth in the borrower’s funding targets and its approach to foreign currency funding in the capital market as an enabling one.
"We look at a broad range of instruments, but our funding needs were more limited before the crisis so any issuance away from euro benchmarks would have reduced the amount we could issue in our core market, and potentially reduce the liquidity of our bonds," he says.
"We can easily fund ourselves in euros, but now that our funding needs are larger this makes it easier for us to consider other possibilities besides our core programme of liquid euro benchmark bonds. Foreign currency funding would be one of those options."
Bankers have mentioned the Netherlands as a candidate for dollar issuance next year, with Greece and France also identified as possible new entrants. The Dutch State Treasury’s 2009 policy outlook identifies a foreign currency bond as an option for capital market issuance, and Nijsse confirmed that this is seriously under consideration.
The dollar market is expected to remain an advantageous source of funding for sovereigns.
"Sovereigns will generally have increased borrowing requirements in 2010 and there is a natural desire to diversify sources of funding," says PJ Bye, head of frequent borrower syndicate at HSBC. "The US dollar market is the best alternative to their respective domestic markets, offering depth, liquidity and a broad range of potential investors for sovereign paper.
"Sovereigns should be keen to use the dollar option, simply to avoid concentrating all their firepower in the euro market."
A key variable is whether the cost of funding remains competitive in dollars when swapped back to euros, with the currency swap being the main dynamic. That has contracted from historic lows that were brought about earlier this year as a direct result of the credit crisis, but was still offering a pick-up in late November.
"As long as there is arbitrage in the basis swap market we will see more issuance in dollars, but the relative cost of funds will remain critical for most sovereigns," says Bye.
There are other moving parts that will influence the relative attractiveness of the dollar market, such as the level of competing supply from traditional dollar issuers, the magnitude of a sovereign’s borrowing targets, and absolute arbitrage, which takes into account not only the cross-currency swap but where a borrower trades in euros.
One development that was central to enabling dollar issuance by sovereign euro borrowers this year was US investors’ ability to pick up a slack in demand that was created as central banks adopted a defensive approach and reduced their participation.
Yet with the Federal Deposit Insurance Corporation’s Temporary Liquidity Guarantee Programme coming to a halt, a reduction in issuance by government sponsored enterprises such as Fannie Mae and Freddie Mac and the cessation of funding by borrowers such as Société de Financement de l’Economie Française (SFEF), accounts will have fewer investment alternatives in dollars.
"The outlook for the economy is still somewhat fragile, so sovereign paper will still be sought," says Scott Graham, global joint head of the frequent borrower group at RBS in Stamford, Connecticut. "The question is: how do you satisfy that demand if you have all these programmes that are status quo or shrinking.
"Our expectation is that the dollar basis should begin to normalise at some point, but you could also see a situation where pure demand, including that among US investors, will help drive a price tension that still makes arbitrage very relevant."
Nick Dent, head of public sector syndicate at Bank of America Merrill lynch believes that 2010 could well be a watershed year in the US market — for investors and sovereign borrowers alike. "Obviously while there are strategic objectives to foreign currency issuance for sovereigns, particularly US dollars, all-in costs remain the key driver," he says. "There will be a number of interesting developments as we enter 2010. First of all we will see a maturing of the domestic US account base. 2009 was a banner year for SSA product being sold into the US, as accounts have become comfortable with 144a/Regs structures, and international financial names under the government guaranteed programmes have had positive knock-on effects for demand across the flow product universe.
"As we enter next year, basis swaps aside, some of the key influences will be the advent of a fully fledged US dollar covered bond market, and also possible reduction of term GSE supply, which will mean that there will be plenty of opportunities for new names entering this market. Sovereigns obviously sit at the top of this pile, and will clearly benefit from the global demand for dollar debt."
...but it’s not the only game in town
While the dollar market is expected to remain beneficial for euro takers, other currency markets will also have a role to play for sovereigns seeking to meet large funding targets at the best possible price.
"Sterling will be very important, yen will be very important and so will some of the other dollar markets," says Sean Taor, head of sovereign and supranational syndicate at Barclays Capital. "From an investor point of view there is diversification and for issuers there is a clear willingness and need to look at other markets, so we will see a continued focus on a wide range of currencies as markets recover."
But the relevance of some of these currencies to benchmark funding may be limited.
"From an MTN perspective there is arbitrage in currencies such as yen, Norwegian kroner and Hong Kong dollar, but if you venture into the benchmark public space that’s not the case, and in the current market with adverse basis condition issuers would probably end up paying up compared to the dollar market," says Kiso Kentaro, head of MTN syndicate and head of public sector group, EMEA at Barclays.
Arbitrage opportunities were available in the Swiss franc market at the beginning of the year, but have since disappeared, says Martin Meili, head of Swiss franc syndicate at RBS in Zurich.
But accessing foreign currency markets in the absence of obvious arbitrage can still make sense from a strategic point of view, and Meili says that the Swiss franc market can offer sovereigns an opportunity to diversify their funding and investor base. The Republic of Austria, the Czech Republic and Poland have all priced Swiss franc deals this year.
"The Czech Republic and Poland deals are the best evidence that investors are more comfortable with government debt," says Meili. "I think there is more room available and that sovereigns could become a bigger issuer category in the Swiss franc market."
Sovereigns wishing to increase the average duration of their portfolios could also benefit from demand for Swiss francs at the long end of the curve, where the Swiss government is less active, say other bankers.
"The market will be able to offer funding opportunities and arbitrage in the longer tenors," says Fred Colpo, director in Swiss DCM at Credit Suisse in Zurich. "This was historically the case and I see it staying that way."