Sitting together in one medium-sized meeting room at Euromoney's international borrowers and investors conference in London last month were two women and four men who between them, for the year to date, represented 56% of new investment grade bond issues in the US.
The six main government sponsored entities (GSEs), Freddie Mac, Federal Home Loan Bank System, Fannie Mae, Federal Farm Credit Banks Funding Corp, Tennessee Valley Authority and Sallie Mae, contrive to churn out mind-boggling statistics. As David Smith, chief financial officer of TVA joked, the best thing about sitting on such a panel is that only among these peers can he talk about having total debt outstanding of only $27 billion.
Take Federal Home Loan Bank, which funds the non-conventional mortgage lending of 5,800 member depository institutions. Last year in the US, it raised $116 billion, through 2,216 separate issues with an average size of $59 million. That works out at between 10 and 11 deals each business day from a single borrower: surely, an origination officer's dream. In the first quarter of this year, it was borrowing at such a rate that it was on track to raise $172 billion by the end of 1996. But its borrowing team has calmed down a little since then, as expectations of interest rate rises have pushed its callable debt (78% of total out-standing term debt) out of the money.
Freddie Mac sold $31 billion of long-term debt last year and will raise between $30 billion and $35 billion in 1996. It also rolled over $800 billion of (short-term) discount notes last year with $50 billion outstanding at the end of 1995. Since January, these notes have been offered for sale continuously around the world in local markets, at local time.
Fannie Mae plans to raise between $60 billion and $70 billion this year. Sallie Mae's requirement is a more paltry $15 billion to $20 billion of long-term debt.
It's only in comparison with such huge sums that the agencies' activities in the international markets look modest. In the year since Euromoney's 1995 conference, they have together raised $20 billion in 39 international deals. The scale of their domestic borrowing is a reminder to bankers and investors that the agencies together might create a huge splash in the international bond markets. Most are weighing up the benefits of broadening their investor base against the possible higher costs outside their home market.
So far their experiences have been mixed. Federal Farm Credit has yet to borrow outside the US, but intends to this autumn, according to executive vice-president, Lee Nash. It will be the last agency to take that leap. Fannie Mae, by contrast hopes to raise between 10% and 15% of its funds from global markets. So far, it has sold 17 deals, including callable, bullet deals and even three non-dollar global bonds, all together raising $12.2 billion. Five of these were for over $1 billion. It has also rolled over $28 billion of short-term discount notes on which it has posted levels during London hours since February 1995.
David Levine, director of debt marketing strategy at Fannie Mae, is enthusiastic about the benefits. He points out that a recent domestic issue of five-year bonds launched at 16 basis points (bp) over treasuries saw its spread tighten following a strong performance for its global bonds.
Others are not so sure. Federal Home Loan Bank wasn't taking half measures when it first entered the international markets in 1995. It set up a $20 billion borrowing facility and issued $5.5 billion last year. But in the first six months of 1996, it has raised just $750 million from international markets through one callable and one step-up deal. Wallace describes it as "the single largest source of frustration for us. We seem uniquely un-suited for a market that expects issuers to sell $500 million to $1 billion at a time." In the US, its average deal size remains between $55 million and $60 million, and it prides itself on responding with great flexibility to the funding requirements of its members.
But Wallace is not entirely dis-couraged. "We will be trying to bring our MTN tool-box to the international markets and we are considering the establishment of an international discount note programme within a couple of months."
Most importantly, he sees a real chance to develop a callable debt market in Europe. The agencies, except for TVA, face considerable prepayment risk on their asset side and need to build matching flexibility into their portfolios of liabilities. International investors remain suspicious of callable bonds. One questioner at the conference asked how, when conventional bullet bonds of an agency might yield 12bp over treasuries, callable deals for the same credit could be sold on an option-adjusted spread of 6bp over treasuries or even less. The implication: investors are not receiving adequate return for granting call options.
How to assess the right compensation to investors for taking convexity risk is a subject of some debate among market participants. Even calculating the option-adjusted spread on a new issue is not straightforward: it requires assumptions about volatilities and yield curves.
More broadly, the agencies argue that, if American investors are prepared to buy them, international investors may eventually accept callable bonds. When a bubble of new issues arose in the American mortgage-backed securities market in 1993, built on exotic structures and insupportable options pricing, it quickly burst and a $350 billion a year primary market disappeared almost overnight. Investors cannot be hoodwinked for long.
Wallace takes a long optimistic view based on the advent of the single European currency. "That will dramatically change the way the fund management community in Europe operates. Today currency risk dominates the return on their portfolios. That will disappear. And their value-added will come from taking sector risk, credit risk and convexity risk." Levine at Fannie Mae is also optimistic: "I understand that it will take time to develop international liquidity for callables. We have to work with underwriters to create more tradeability."
Peter Lee
COMMODITIES
Commodity comeback For those who haven't been whipsawed in the copper market, commodity derivatives still offer manageable opportunities, particularly in the oil market.
Last year oil companies pursued a policy of running down inventories as a cost-cutting measure. This meant stocks were unable to absorb the demands of an unexpectedly cold December, and crude oil prices rose around 6% in December alone. Though the price dropped in January, by April it had jumped again and was up more than 21% on the year. Forward prices, though, reflect the market's assumption that the short squeeze will not last long and that prices will fall significantly when Iraqi oil is available. This has created an extremely steeply inverted forward curve that has been exploited by investors who have simply bought the front month futures contract and rolled it over as it nears expiration. This strategy has earned returns of around 50% from a spot price change of 21% since December 1.
Similar directional punts have been profitable in the grain market. A world production weighted basket of corn, wheat and soya beans rose 21% between March and April and is up 78% year-on-year. In April a rolling futures investment in wheat rose almost 27%.
Some funds have gone further than simple directional plays. A recent favourite in the base metals market combined spread and volatility trading. Mark Kirkland, global head of commodity finance at Merrill Lynch in New York, explains: "The historical volatilities of copper and aluminium are generally similar. However, there was a point where that spread had diverged: aluminium was in the region of 24% and copper in the region of 16%. Some funds took the view that these spreads would fall back in line and so went short aluminium volatility and long copper volatility."
The providers of commodity derivatives like to stress not just the speculative end of the market but the more down to earth hedging uses of the instruments. These have increased as prices have risen - again the energy market has been the most active. Here, one clear trend has been an increase in the number of refiners looking to lock in rising refinery margins (or crack spreads, as they are called). This is the margin between the price of the crude oil the refinery buys and the distillates - gasoil, gasoline, naphtha and so on - that it sells. A glut in global refining capacity has kept refining margins low for the past two years, too low for refiners to be interested in locking them in. Now, unexpectedly high demand for oil for heating and for gasoline plus low inventories have pushed up the margin. In addition, there is always a lag between rises in crude oil prices and rises in the price of distillates, because the refiners keep stocks of crude purchased at pre-rise prices. They can pass on crude price rises to consumers immediately, before they incur the rise themselves, pushing margins up further.
By using a crack spread swap refiners can lock in a budgeted margin on a mix of distillates that mimics the basket of petroleum compounds their refinery produces. "For a long time the numbers from the refiners' point of view were dismal and they were just price takers," says David Sobotka, vice-president at Lehman Brothers in London. "Now they can lock in the fact that the curve has risen and they are happier."
This crack spread - on which there are also options - is a popular play with the hedge funds, because it can be thought of as a highly specific proxy for shares in a refinery company.
Hedging activity has also been driven higher by banks' insistence on incorporating price protection into loans, particularly project financings. "In the corporate sector we have seen a huge increase in hedging activity, driven largely by the banks which lend them money. Increasingly, lenders such as us are telling them that if we are to lend them money then they must get price protection at some reasonable break-even level."
Merrill Lynch has been at the forefront of this sector, bringing private deals for Slovnaft, the Slovenian oil company, Lot, the Polish national airline and TAP the Portuguese carrier. In some cases commodity derivatives have been used to create highly-leveraged acquisition financings. One recent deal structured by Bankers Trust in the gold sector involved a company one-third the size of its target being able to raise the funds to complete an LBO only because of the hedges in place in the financing. Ultimately the target found a white knight twice its size but, as a banker on the deal comments: "This was a company no-one would have believed could have financed this kind of takeover. But with the help of commodity hedges we put together leveraged financing that would have enabled them to do it."
Derivatives-linked financings have also become more popular with the major mining and energy companies as the size of new project financings in these sectors has been growing. "Big is beautiful in production. Big projects require big money, big investments. And that in turn entails big risks," says Kevin Heffron, vice-president, Bankers Trust in London. "Because of the economies of scale achievable in these large projects, companies are looking for ways to do them. They may not want to finance them as they did more traditional ventures - from cashflow. They may want to enter into project specific alliances or to take them entirely off-balance sheet.
The most flexible structure is the hedged volumetric production payment. A special purpose vehicle (SPV) is set up to which a commodity producer grants an interest in a set amount of the commodity being produced. The SPV enters into derivatives contracts that fix the value of the commodity flows so that cashflows to it are predictable. The SPV then issues debt against the cashflows - and usually there is an element of over-collateralization: the debt represents only, say, 90% of the cashflow predicted. The proceeds from the debt issues then pass to the commodity producer.
The producing company has no obligation to the SPV or its creditors other than to deliver the revenue from the agreed volume of the commodity. On maturity the economic interest in the commodity disappears and all rights to the underlying property's output and cashflow revert to the commodity producer. All the hedging is done with the SPV, which has the contractual right to the cashflow from the underlying production. The producer simply sells the production at market prices.
This enables the producer to acount for the transaction as a sale of asset and as a debt, for tax purposes - it appears as a tax-free sales of reserves. The debt is off-balance sheet and non-recourse, and because of the over-collateralization is highly rated and so low cost. And the producer keeps all the upside potential associated with the underlying assets: it sells at market prices; the SPV deals with ensuring sufficient cash flow to service the debt.
There is one other benefit: the producer uses debt rather than valuable equity to finance the production. This is particularly attractive to oil companies which, faced with large development projects, often resort to what are known as farm-ins - joint ventures. An outside partner is brought in to reduce risks and provide fund.
Mark Parsley
FOREIGN EXCHANGE
White markets If you don't sometimes share the suspicion that the global foreign exchange markets are too big and too volatile to serve the world economy, read no further.
However, if you do feel there might be a better model for the biggest market in the world, consider the proposal of Mark White, a financial markets consultant in Mexico City.
White argues that instead of abandoning our future to massive speculative capital flows, central banks should, bilaterally, set up alternative commission-free electronic currency auction markets for what he calls fundamental primary market transactions. These include direct investments, foreign exchange receivables and interest payments.
Before your hackles rise, don't confuse this with previous attempts at dual or managed exchange rates.
The auctions White envisages would be used for price discovery, not price manipulation or stabilization. Where there is fundamental demand for currency, a periodic call auction, held as frequently as every minute if necessary, would establish a single price at which bids, offers and market orders would be transacted. Users would pay no bid/offer spread.
In the parallel interbank market, open to all traders, two central banks or a consortium of central banks would be prepared to use their international reserves and domestic money supply to absorb any speculative demand at the auction price, maintaining a single price until the next auction starts taking orders.
The effect, argues White, would be to reduce volatility and make foreign exchange markets less attractive to speculative, short-term position-takers. It is this speculation, he believes, which makes today's markets overshoot and renders their price discovery process inefficient and damaging. Particularly for a country such as Mexico, which has made many attempts to stem speculation with exchange rate management, the White market, with its auction system, could reduce volumes to more fundamental levels and pare down volatility.
The argument that volatility declines with higher trading volume doesn't hold, he says. As an example he compares the volatile behaviour of closed-end investment funds and open-end investment funds. Closed funds are prone to speculative bubbles because trading volume directly drives the price. With their flexible size, open-end funds use quantity adjustments to dampen price volatility until it matches precisely the changes in net asset value. Likewise, in the new market, changes in the size of central bank reserves and money supply will dampen pressures on exchange rate volatility.
The proposed commission-free, central bank-sponsored market will not appeal to commercial banks and brokers, says White, since they thrive on volatility and volume. But that should not lead central bankers to reject the proposal. In fact the more boring and uninteresting the speculators find the new market, the more it will fulfil central bankers' requirements, he argues.
White would like to test the market's guiding principle in controlled laboratory market experiments. Vernon Smith at the University of Arizona, or Charles Plott at California Institute of Technology, leaders in the field of experimental markets (see Euromoney, January 1996, page 30), would be ideal candidates, he says. But a larger-scale experiment could be conducted on the Internet, where real auctions might be held.
By sponsoring such experiments, central banks could be on the road to saving themselves the much greater expense of research into the dynamics of existing exchange markets and the huge settlement and other systemic risks involved, White argues.
Four questions spring to mind, and White has some answers ready:
1) How would central banks restrict the auction to so-called fundamental participants?
They monitor foreign portfolio investment to ensure that it flows through the interbank market.
2) How would futures markets function?
Just as they do today - current exchange and interest rates determine the forward price, and if the forward price diverges, arbitrage brings it back into line.
3) Would fundamental participants hedge their future foreign exchange needs in the auction market or would they have to use the parallel interbank market?
Hedging would go on in the parallel interbank market prior to contract signing for the fundamental transaction; once the contract is signed the user can exchange currencies in the auction and finance the position - this gives exactly the forward rate as long as no arbitrage opportunities exist, and they rarely do.
4) Wouldn't concerted position-taking in the speculative (interbank) market drive the price-discovery process in the auction market?
It could, if the central banks lost their commitment or capability. However, working in tandem they could defeat any speculative threat - one central bank's international reserves is the other's money supply, so speculators could never exhaust their liquidity. David Shirreff Anyone wanting to take the debate further should contact Mark White at White&Associates in Mexico City. Tel: (52) 5 595 6045, Fax: (52) 5 683 5874; E-mail: white@profmexis.sar.net.
BELGIUM
Now for the equities New stock listings don't come often in Belgium, so they are usually cause for celebration and optimism in the country's growing equity culture. But financiers in Brussels had mixed feelings when Lernout & Hauspie (L&H), a Flemish firm which makes speech-recognition systems, went public earlier this year. For L&H bypassed the Brussels stock exchange and went straight to Nasdaq, the computerised trading system for OTC stocks in the United States.
"Nasdaq makes more sense than the Brussels bourse for a hi-tech firm regardless of its size," comments Marcel Stappers, head of KB Securities in Brussels. "The pricing is a lot better." He points out that the average price-earnings ratio on Nasdaq is 25 compared with 13 on the Brussels stock exchange.
"The fact that firms go to Nasdaq is not good news for the Brussels stock exchange," concedes Olivier Lefebvre, chairman of the bourse management committee. After just six months in office, Lefebvre is determined to look on the bright side. "But it's also quite encouraging because it shows there's a demand for industrial technology offerings."
Belgium's equity market still plays a limited role in the nation's economy - last year Belgian companies raised just Bfr21 billion ($700 million). There were only two initial public offerings (IPOs) on the Brussels stock exchange last year. The number of listed companies actually declined.
Yet both the government and stock exchange believe there are a number of medium-sized Belgian firms which could launch IPOs with help from the financial community. Finance minister Philippe Maystadt has encouraged traditional brokers, to develop into what he calls banques d'investissement, a Belgian version of British or Dutch investment banks.
The government hopes these banks will begin to finance mergers and acquisitions and IPOS. Some criticize the government for not encouraging Belgium's equity culture with tax concessions. Lefebvre disagrees. "The problem is really one of financial culture. Tax breaks are not the key to the success of this market."
The Brussels stock exchange has long needed a new trading system. Known as NTS, a price-driven electronic trading system is being introduced in stages. First to go electronic were the smaller stocks; the Bel-20 index, where liquidity is concentrated, will follow on July 4.
The NTS enabled market players to develop more effective derivatives products - and that has created enormous volatility. After a disastrously chaotic session at close of trading on March 15 (the Belgian market was quick to dub it Black Friday), stock exchange officials suspected price manipulation and opened an enquiry.
The problem arose because the growing number of mutual funds linked to Belgium's Bel-20 stock index were too strongly dependent on the closing price on certain days. Typically, their reference price is derived from the Bel-20 closing price over several days, or in some cases, on a single day. During the spring, traders spotted arbitrage opportunities on these days and began selling gradually in advance, then buying back heavily just before the close of trading in order to push up the closing price.
The fault appears to lie in Brussels although professionals play down the problem. "I told Lefebvre not to call it manipulation," says Daniel de Meeus, head of equities at Generale Bank. "That exacerbated the situation. When the bourse announced that it wanted to carry out an enquiry, I thought that was a bit exaggerated." In turn, Brussels traders blamed arbitrageurs in London. Ultimately, the investigation threw up no evidence of manipulation, either in Brussels or London and the stock exchange concluded that the market dive was a 'coincidence': several large players decided to divest portfolios at the same time on the same day.
Lefebvre has now recommended that fund managers get away from closing prices altogether and use settlement prices averaged over several days. Laura Covill |