Quality issuers - We're dedicated followers of fashion

Remember jumbos? Those enormous, highly liquid bonds that would set a benchmark for years to come? In 1989 the first global bond, issued by the World Bank, was an earth-shattering $1.5 billion. Now big deals have become so commonplace that the word jumbo seems to have fallen into disuse. "This year we will see a few borrowers pushing the envelope in terms of size," predicts Niall Cameron, global head of fixed-income syndicate at ABN Amro.

Even before the last of the millennium party debris was cleared away in the first weeks of 2000, there was a flurry of multi-billion dollar deals. Fannie Mae issued $6 billion of 10-year bonds and $4 billion of two-year paper. Freddie Mac brought a $6 billion five-year deal. The World Bank launched a $3 billion global. And, for those who didn't notice, there was also a $1 billion deal from the European Investment Bank and globals of a billion dollars or more from GECC and GMAC. Oh yes - and the small matter of syndicated government bond offerings by Belgium, Portugal and Austria worth a few billion euros each.

Big, highly rated borrowers have encountered huge appetite for their paper in the first weeks of the year. That is partly a quirk of the turn of century, with investors holding large amounts of cash after a cautious run-up to the millennium. But is this frenzy of gigantism the normal pattern of borrowing for years to come? Or is it simply the final excesses of a fashion that will shortly run its course?

First in 1998 and then with growing enthusiasm in 1999, large, creditworthy borrowers have embraced this new trend: borrow less often but in larger amounts. "Some borrowers felt that too frequent entry to the market was having a destabilizing effect on their spreads," says Cameron. "At the same time, investors who were used to the highly liquid government bond markets were demanding the same kind of liquidity from other large borrowers."

The trend really began in January 1998 with the launch of Fannie Mae's benchmark notes programme. The agency led the way in creating a calendar of issuance, modelled on government borrowing programmes. Fannie promised to issue bonds of a particular maturity on set dates throughout the year. It didn't spell out at the beginning of the year how large each of these issues would be. But they would be big and, therefore, liquid. Bookrunners would be appointed well in advance of an offering to allow them longer to prepare the market. "The size of our deals is always based on demand," says John The Losen, vice-president for debt marketing at Fannie Mae. "For our latest 10-year deal [priced on January 12] we gave an indication of $4 billion. But we had an idea that demand would be greater. In fact we increased it to $6 billion and it was still vastly oversubscribed."

And with a full yield curve of highly liquid securities, investors and traders could use the Fannie Mae bonds as replacements for treasuries, at a time when US government borrowing is declining. That would make Fannie Mae's bonds more desirable and, over time, bring down its borrowing costs.

Terrific liquidity

Fannie Mae's strategy was simple, bold and - two years on - has been an undoubted success. Bankers agree that spreads on the agency's bonds have tightened and that it has probably saved money in the long run. "Our securities were liquid before, says The Losen. "Now there is evidence of terrific liquidity." The benchmark notes programme raised $42.25 billion in 1998, accounting for just under 29% of Fannie Mae's total long-term borrowing. According to The Losen, benchmark notes accounted for 45% of all long-term funding in 1999 and as much as 80% when callable bonds are excluded from the total.

The success of Fannie Mae's strategy can also be judged by the number of borrowers that have copied it. In 1999 Freddie Mac decided to take a leaf out of its great rival's book by beginning its own programme of regular borrowing, through issues known as reference notes.

David Winter

Other US agencies have followed suit, although with somewhat less restrictive straitjackets. Since last April, Federal Farm Credit Bank has run a programme of issuing what are known as designated bonds, of which it issued four in 1999. The bank is a much smaller borrower than Fannie or Freddie and its benchmarks are generally between $1 billion and $1.5 billion and for maturities of two years or less.

Last year the two biggest US agencies extended their strategy to the large part of their funding raised through callable bonds. Fannie Mae inaugurated its callable benchmark notes programme in April with a $2 billion issue and Freddie Mac followed suit a few days later with a $3 billion callable reference note.

Then in July, Ford Motor Credit became the first non-agency US borrower to adopt a similar approach to its funding. It unveiled its GlobLS programme of global bonds, with a three-tranche issue totalling $7.5 billion. The programme would replace a proliferation of smaller targeted issuers with no more than four large bonds a year, to raise a combined total of around $10 billion.

Even those borrowers that have not given their benchmark bonds a new name and set a calendar for issuance have been influenced by the trend towards larger bonds and longer marketing periods. The World Bank has a borrowing strategy rather different from that of Fannie Mae and Freddie Mac. Although it has always issued benchmarks - in 1999 it issued several US dollar bonds of $1 billion at several points along the yield curve - much of its funding consists of smaller issues, many in the exotic currencies it uses to lend to its clients.

But the World Bank's web-distributed $3 billion global, on which lead-managers were appointed several weeks in advance, was designed to bring a new level of liquidity to its securities by reaching smaller dollar investors and giving them greater ability to trade in the secondary market. "Our strategy is to offer a wide array of products to a broad investor base," says Gumersindo Oliveros, director of treasury finance at the World Bank. "We have a strong franchise in all major investor groups, including the more specialized buyers of structured financing, and the challenge going forward is to maintain that edge."

Europe has no borrowers comparable with the largest US agencies in terms of volume of issuance. Most nationally owned agencies and development banks have funding needs of less than $10 billion a year.

However, one of Europe's biggest borrowers, the European Investment Bank, has come up with something that looks similar to the US agencies' big branded borrowing programmes, at least on the surface. The EIB inaugurated its Earns programme of euro-denominated bonds in April 1999 with a e2 billion ($2 billion) 10-year deal. Some e15 billion a year, about half the issuer's total volume, was to be issued under the Earns programme in large, liquid deals rather than smaller, more targeted borrowings. This seemed an abrupt change of strategy for a borrower that has a reputation for squeezing the tightest terms possible out of the market. "The word opportunistic was invented for the EIB," says one banker.

Initially, the strategy seemed to have achieved its desired effect of turning EIB bonds into Europe's most liquid benchmarks after French and German government bonds. There were reports of investors switching out of smaller government bonds into EIB securities. Secondary spreads tightened, making the EIB's debt the most expensive, from an investor's point of view, of any non-sovereign borrower in euros.

But the EIB also began to run into criticism from bankers for its refusal to issue new bonds under the programme. Until the appearance of a e2 billion offering in November, all the Earns bonds were reopenings of existing lines.

The banks' most heartfelt criticism is that, unlike Fannie Mae and Freddie Mac, the EIB has avoided paying any premium on its benchmark offerings to achieve liquidity. The danger of that policy is that bookrunners' fees are squeezed and too much paper ends up on the banks' own books rather than finding its way into the hands of a large and diverse group of investors. However, the fact that EIB bonds continue to trade at tighter levels than many European government securities suggests that the bonds are liquid in spite of their high initial price.

Earns paid off

And some bankers point out that the programme has achieved a great deal, considering the difficult time at which it was launched. "The EIB was brave to launch the Earns programme when they did," says David Soanes, head of fixed-income origination at Warburg Dillon Read. "Last year was not a fantastic year for triple-A euros. So they had to struggle to achieve what they had to do. But they achieved better pricing than if they hadn't had the Earns programme."

But Earns is not like the US agencies' benchmark note and reference notes programmes. In fact, the differences are more striking than the similarities. The EIB has no calendar of issuance. Rather, it promises to issue a certain volume every quarter. And unlike the US agency benchmarks, Earns deals are announced only days before they are priced, giving the banks involved less time to market the bonds than on the US agency programmes.

With Earns, the EIB gives the market only a little more in the way of information and predictability than it did in the past. But it demands rather more of its bankers in return: tying bookrunners into a legal obligation to make a market in its bonds, for example. That may account for much of the bad feeling Earns has generated among banks.

But the full-blown agency-style borrowing programme may simply not be suitable for any European borrower. John Winter, head of debt capital markets at Deutsche Bank, thinks that calendars are not as important for smaller issuers. "Borrowers that issue huge volumes, such as US agencies Fannie Mae and Freddie Mac, can set precise calendars the way a large government does," he says. "For smaller borrowers it is less important to be as precise. The goal of creating liquid benchmarks is the same and they should still try to give the market as much information as possible. But they can allow themselves to be more demand-driven and flexible."

Cameron at ABN Amro believes that a strategy of creating benchmarks makes sense even for issuers with relatively moderate borrowing requirements. "Even smaller borrowers can provide substantially more liquidity than their bonds had in the past," he says. "Investors understand that these benchmark deals will be in proportion to the size of their funding programmes. They can be anything from $1 billion to $9 billion."

What may simply not be appropriate to the more fickle European market is the use of strict issuance calendars. "For Fannie Mae and Freddie Mac setting a borrowing calendar is absolutely the right strategy," says Soanes at Warburg Dillon Read. "They have introduced a great deal of certainty. But it isn't necessarily the right strategy for smaller issuers or for issuers who have to lend on Libor margins. If a smaller borrower says it will issue a certain amount on a particular day and the market just isn't there on that day, it will have to cancel the deal."

There seems little danger of any of Europe's larger borrowers falling into that trap. Frank Czichowski, head of capital markets at the German government-guaranteed Kreditanstalt für Wiederaufbau, doesn't believe a borrowing calendar is right for the agency. "With a volume of e30 billion a year, which we issue in many different currencies, we have neither the possibility nor the necessity to have a predetermined issuance calendar," he says. "It is better to issue large, liquid securities into a market which is accessible than to have a predetermined calendar."

But KfW doesn't seem immune to the fashion for bigger deals. Czichowski suggests that KfW will issue a number of larger deals this year. The agency's total volume of longer-dated issuance in 1999 was e35.5 billion and Czichowski expects the total for 2000 to be a little lower, at around e30.

KfW is the archetypal Eurobond borrower. The German agency issued more than 40 bonds in 1999. Even though its funding requirements are almost entirely in euros, it issued in a dizzying array of structures and currencies. Those bonds in the public domain had an average size of around $700 million according to Capital Data Bondware. Fannie Mae, with a much larger funding requirement, issued fewer bonds; its deals were of an average size of more than $2 billion.

Some believe that KfW's approach, so unfashionable at the moment, could soon be back in vogue. "The key to much of the popularity of large deals is that the US bid for dollars is better than Europe's at the moment," says Soanes at Warburg Dillon Read. "The price is set in the US. And the US is a more orderly market than Europe, so calendarization is in vogue and big is seen as better. When Europeans start buying dollars in any volume we may see traditional Eurobond practices come back into fashion."

Others dispute this assessment. "Demand for greater liquidity is coming from investors everywhere," says Cameron at ABN Amro. "This is not a geographic issue, it's a type-of-investor issue. We are seeing the relative importance of institutional investors compared with retail investors growing all the time. And institutional investors want liquidity. That is why there is a clear trend towards a more homogeneous style, both in terms of documentation and deal size."

Although borrowers may disagree on the value of borrowing calendars and the best mix of benchmark and opportunistic funding, all agree that broadening their investor base should help to lower their funding costs.

Czichowski at KfW believes there are still plenty of investors in Europe that would buy the agency's bonds that don't yet know about KfW. "I think a lot more can be done to reach all pockets of potential demand," he says. "With the introduction of the euro, the integration of Europe's different markets has improved. But it still has some way to go. Tapping those pockets of potential demand will involve us working with banks that have distribution capability in specialized markets in certain parts of Europe."

Other borrowers are working to broaden their investor base to decrease their dependence on traditional sources of funding. "Attracting new investors is the key to increasing liquidity," says Soanes at Warburg Dillon Read. "The IDB, for example, has spent a long time on the road and that has paid off. It has been able to do deals in yen and Canadian dollars which have reduced pressure on its traditional dollar investor base. Their latest dollar global has proved their efforts to be worthwhile."

Web distribution to new buyers

Most high-grade borrowers agree that the internet has a part to play in tapping a larger group of investors and increasing secondary market liquidity. Issuers are getting excited about two different but potentially overlapping opportunities. The first is the race by banks to develop web-based bond distribution platforms. At the moment these do little more than automate and centralize the process of disseminating information about new bonds. But bankers are confident it will soon move beyond that level and begin to revolutionize the bond markets.

"Web distribution is about the whole business, from A to Z," says Cameron at ABN Amro. "It starts with a more transparent and efficient book-building system, running through quickly to order-taking for institutional clients. Ultimately, retail investors will be able to trade in the secondary market and switch bonds."

At the moment, distributing bonds remains a sales-driven process. Any bank that decided to send its salesforce on a month's sabbatical and let the website do the work would quickly find itself losing market share. And, for the most part, orders sent by e-mail or chat facilities through a bank's web platform still have to be confirmed by a phone call or e-mail message from the bank.

Nevertheless, it is clear that investors are responding to the new systems, and are buying and selling over the net. "Deutsche's Autobahn system [Deutsche's own electronic bond distribution system] adds greatly to liquidity," says Winter. "We wrote 1,900 Eurobond tickets on the system in one day recently. It's a very straightforward and relatively costless way to trade bonds."

But for issuers, one of the biggest benefits of web distribution is that it gives more information. Instead of having to rely on the lead-manager's assessment of how the order book is building up, the borrower can see which investors are logging on to websites, who is placing orders and, as important, who isn't.

Another tempting prospect is that the internet could enable borrowers to access new types of investors, particularly internet-savvy US retail buyers. The World Bank used what it describes as an e*syndicate on its $3 billion global, in which each syndicate member was required to be able to take orders electronically. Oliveros estimates that one-third of orders for the deal were placed electronically. "With this initiative we have been able to reach a number of middle-market and retail accounts in North America that would not have otherwise had access to our securities," he says. "It also provides links into a secondary electronic trading platform which allows an investor to trade the bond electronically immediately after pricing and increases efficiency in trading."

The Losen at Fannie Mae is also cautiously optimistic about web distribution. "It will certainly have its benefits in future," he says. "It's too early to quantify yet. But it certainly has potential in increasing our distribution into new market segments."

However, although banks are keen to promote secondary trading on their websites, these platforms do not yet give investors access to a wide universe of potential trading counterparties. A true marketplace for non-government bonds is more likely to come from another source.

Several systems, notably Euro-MTS in Europe and Bondhub based in the US, are competing to become a true secondary marketplace for the most liquid fixed-income products. At the moment they are limited to government bonds, but several large issuers are working to have their securities included in these platforms.

KfW is in discussions with Euro-MTS to allow its securities to be listed on the system. "At the moment there are no real secondary trading platforms for our bonds," says Czichowski at KfW. "There are several systems where government bonds are traded, and a lot of work is being done to extend those platforms." Euro-MTS has already been extended from sovereign securities to include Pfandbriefe as soon as individual bonds become large enough to be eligible.

"Euro-MTS works," says Winter at Deutsche. "It increases liquidity, and governments want their bonds to be traded on it. But a sovereign bond issue needs to be of at least e5 billion before it can be listed on Euro-MTS. So that is one reason euroland sovereigns are now issuing larger bonds. As other borrowers become eligible to join the system, they too will need to do very large issues."

But for many smaller issuers, having their bonds traded on an active secondary marketplace such as Euro-MTS seems a distant prospect. A more realistic hope to reduce the spreads on their securities would be to persuade their lead-managers to make a more active two-way market in the bonds they underwrite.

Market-making equals liquidity

To Oliveros at the World Bank, market-making should follow naturally if an issuer has taken the trouble to build relationships with a large number of banks. "We find that a strong commitment to the issuer and its product range from a broad base of financial intermediaries is essential," he says. "This takes quite some time to build but eventually delivers a trading performance track record that investors and traders value. It is particularly helpful at times of stress to the system, when liquidity disappears and investors find that only a couple of triple-A names get traded. We saw that happen at the time of the Russian crisis in 1998, when we funded a substantial portion of our programme at very attractive levels while other triple-As were locked out of the market."

One legalistic method of encouraging more active market-making, borrowed from the practices of the German Pfandbrief market, is to include a market-making commitment as a requirement for dealers involved in an issuance programme. That is the approach the EIB has taken with its Earns programme.

But the carrot may be more effective than the stick. "Deal size itself demands market-making," says Cameron at ABN Amro. "If a deal is large enough and sensibly priced, traders will want to trade it."

That is certainly the approach that Fannie Mae takes. "All of our top dealers understand that if they have a senior role on a deal there is strong secondary market-making expected," says The Losen. "And they certainly don't think that is onerous."

Market-making is as much a reaction to liquidity as it is a cause of it. And that is also true of other activities that borrowers have identified as likely to enhance the tradeability of their securities. Big, frequent borrowers are keen to persuade investors to use their bonds as they would a liquid government security. And increasingly, US agency bonds are being used in place of treasuries for repo trades, as collateral and in hedging strategies.

The Losen believes that such activities flow naturally from the predictability of Fannie Mae's issuance programmes. And he is enthusiastic about other ways that buyers might use Fannie Mae securities. "Now that people see that we're committed to issuing at so many points on the curve, they are realizing the benefit of using our benchmark securities curve as an analytical tool," he says. "Other issuers, for example, are conducting price talk versus our curve. and I think we will see increasing use of it in trading strategies. Somebody may want to put on a bar bell trade in terms of their view of our benchmark curve, for example."

But there will only ever be one or two standards off which other bond issuers are priced. In euros fewer benchmarks are likely to be used in future as one government yield curve or other gains ascendancy. There seems little likelihood of the EIB or KfW rivalling the Bund or Oat as the pre-eminent benchmark in euros.

Many of the benefits of large and predictable borrowing programmes, such as having securities used as collateral, are likely to flow only to the very biggest bond issuers. For smaller borrowers than Fannie Mae or Freddie Mac, even the biggest benchmark bonds will never be more than a tiny part of the ever expanding fixed-income universe. How long before the fashion for the big and the liquid gives way to a new trend: small is beautiful?