The treasury official from Spintab in Stockholm says his call is urgent. Can Euromoney supply a list of names of the biggest buyers of bonds in Europe? The Swedish bank is worried about how it will fund itself after European economic and monetary union (Emu). It feels it must begin to market its bonds more widely across Europe, as other foreign borrowers may begin competing for the funds of domestic Swedish investors on which it now relies.
And in Portugal Manuel Pinho, former director of borrowing for the Republic of Portugal and now running the treasury at Banco Espirito de Santo, explains why the bank has just arranged a $1 billion Euro-medium term note programme, even though it has no immediate plans to issue off it and, for now, funds at lower cost in Portugal than it could abroad. The bank, he says, must raise its profile ahead of Emu and prepare mechanisms for borrowing efficiently beyond its national borders.
Across Europe, borrowers big and small are preparing for the enormous change to come with a single currency, when the introduction of the euro will create one huge European domestic market in place of closed, national, domestic markets. Some borrowers have been preparing for months, if not years. “In recent years, all the major German banks have issued French franc bonds,” points out Cyrus Ardalan, global head of bonds at Paribas. “Partly that’s because French rates are so attractive. But it is also to prepare their investor base ahead of 1999. Today, 95% of French franc assets are in French hands. If a German borrower wants its name known among French investors which might account for 25% of its future domestic euro-denominated bond market then it has to issue in French francs.”
The euro gimmick
Since the start of this year, borrowers have focused their attention much more closely on finding ways to steal a march on other borrowers and establish their position in the future domestic euro bond market, before it even exists. The most extreme example has been the borrowers, notably the European Investment Bank (EIB) in February and the Republic of Italy in March, that have launched what they describe as euro-denominated bonds. They have each launched euro 1 billion issues, which will pay their first annual coupons in Ecu and will essentially be Ecu bonds until the single currency is initiated, when they will convert at an exchange rate of one-for-one from Ecus to euros.
The idea has met with a mixed response. “These deals are nothing more than wallpaper,” says the head of international funding at a large European borrower. “The euro doesn’t legally exist yet. These are Ecu bonds, priced off Ecu OATs, incorporating a firm commitment to change over into euros. But what if Emu never happens? It’s nothing but a gimmick. They are not euro benchmarks.” The head of debt capital markets at one banks adds: “In a tough regulatory and legal environment, an issuer would have great difficulty selling bonds in a currency that does not exist.”
Before either of these deals, the Republic of Austria blazed the trail for innovative Emu-related transactions with the first-ever parallel bond, launched in January. This is a ffr5 billion ($877 million) seven-year Eurobond issue, aimed at French and other European investors, carrying a maturity date and coupon exactly matching a domestic Sch15.5 billion ($1.31 billion) Bund. Come monetary union, investors in the French franc Eurobond will have the option of converting into the domestic Bund which will be redenominated into euros, thus giving them a large benchmark euro issue.
Today, Austria sells most of its government debt domestically. The deal is a clever way for it to pre-place domestic euro debt with investors outside Austria and to create a large, liquid issue that will have five years to maturity from 1999. In the future, European investors will be looking for just such large, liquid issues to trade and there will be much competition, particularly between the French and German governments, to position their own bonds as the benchmark sovereign euro issues. The smaller European sovereign borrowers will have to compete, or rely on smaller, structured deals sold off their MTN programmes. “If we add the French franc bond to the Schilling Bund that increases it by Sch10 billion, creating a huge issue in Austrian terms,” points out Helmut Eder, head of Austria’s national debt office. Austria has also tried to entice more foreign investors into its domestic Schilling debt by including as primary dealers in its Bunds eight international firms, some with little presence in Austria.
If buyers of Austria’s French franc bonds don’t want to switch from Eurobonds to domestic Bunds, for tax or legal considerations the legal documentation accompanying a Schilling Bund is a couple of pages compared with the usually voluminous Eurobond prospectus they have the option of consolidating into a new euro-denominated Eurobond. This may be enlarged by other fungible Eurobond issues by Austria, perhaps in Dutch guilders or Deutschmarks, which will also be eligible for redenomination into euros.
Austria’s deal was quickly followed by a glut of parallel, twin-parallel, catamaran, tributary and other bond deals all designed to ease issuers into the coming euro market.
Parallel bonds raise the question for investors of what will happen, following Emu, to their holdings of Eurobonds denominated in currencies that cease to exist after the euro becomes the only currency for participating countries in 2002. It is likely that Belgium, France and probably Germany will immediately redenominate their domestic government bonds into euros. National governments are free to do much as they like with their domestic debt. But the old Euro-Deutschmark and Euro-French franc bonds are more complex contractual obligations, which cannot be redenominated without the prior agreement of all investors. They are likely to remain denominated in the old national currencies until 2002, cut off from the government bonds against which they were originally priced, which will now trade in the new currency.
The old national-currency Eurobonds, which the JP Morgan officials who worked for four months preparing the Austria parallel deal call orphan Eurobonds, will suffer a dramatic loss of liquidity. Since they were originally placed in narrow, domestic markets, there will be few dealers for them. “My guess is that the market will come to insist on redenomination language in all Emu currency Eurobonds,” says Joseph Cook, managing director at JP Morgan.
Rounding worries
But just inserting the language in documentation does not solve the problem. Issuers and lead managers have to think carefully about the form of Eurobonds physical bearer or global note. And they must make their own plans for rounding out investors’ holdings to full amounts of euros, or fractions of euros that will be acceptable to traders, clearers and custodians or for making cash adjustments if no standard market practice emerges after 1999.
The likely fate of orphan bonds may be a particularly pressing question for holders of EIB paper. EIB, the financing arm of the EU, has no large stock of domestic bonds that it can quickly and easily redenominate into euros. Rather it has hundreds of outstanding national-currency Eurobonds, hence perhaps, its determination to become the first issuer of a euro bond, two years before the currency exists.
Carlos Ferreira da Silva the EIB treasury official coordinating its euro strategy, explains a twin-track approach to preparing its debt for emu over the next two years: its direct issues of euro bonds and its issues of so-called tributary bonds in national currencies. The EIB has launched four bonds, each with a maturity of 10 years and a coupon of 5.75%, and valued respectively at Dfl1 billion ($526 million), ffr3 billion, Esc20 billion ($118 million) and Dm1 billion ($600 million). Each will be redenominated into euros when the relevant currency participates in Emu and they will be blended into one large issue. “The idea is that these tributary bonds will one day flow into a large euro river,” says da Silva.
All European currencies could be included in the EIB scheme. Theoretically, it could merge tributary issues in 10 or more national currencies into a single euro benchmark. By 1999, the EIB hopes to have prepared euro benchmarks at several points on the yield curve seven, 10, 12 and 15 years. The only limit to the process is the task of executing national-currency deals that all have identical coupons and maturity dates.
The EIB and other borrowers have to be wary of such schemes leading them into expensive or inappropriate issues. “So far the market response has been excellent and we have achieved our cost objectives,” insists da Silva. “An investor buying a tributary bond is buying prospective liquidity, so the investor may give up some yield.”
It all sounds fine in theory, but are issuers becoming so enamoured of the grand design behind these deals that they are launching poor transactions? That criticism was levelled at L-Bank when it launched a twin-parallel deal in February. It sold at the same time a ffr2 billion and a Dm750 million, each seven years with a 5.125% coupon. The Deutschmark issue was tightly priced at 10 basis points over Treuhand paper but sold well. The French franc portion was more difficult, even though L-Bank appeared to be offering a spread of 14bp over OATs slightly more generous terms than it had paid on previous deals.
Buy Germany, sell France?
With absolute yields on the Deutschmark portion higher than on the French franc bonds, some French institutions may have preferred the Deutschmark tranche. A strong domestic insurance company bid in France has brought yields on French government debt below that on German paper over the past year. But there is little prospect of the French economy outperforming the German economy, and increasingly French institutions are considering buying German bonds. Arbitrage traders may have been tempted to buy the L-Bank Deutschmark bonds and sell the French franc bonds. A larger Deutschmark new issue with a clear commitment to redenominate into euros might have been a better idea. Alternatively, L-Bank might have delayed the French franc issue and launched at a more propitious moment.
“These deals are supposed to offer value two or three years from now when they become fungible and more liquid but in the meantime the issuer is risking a poor reception for one or other leg of these deals,” says a syndicate manager. “That’s OK for someone like Siemens. [In February, the German technology company ended a 25-year absence from the public bond markets and launched three 10-year parallel deals of Dfl500 million, ffr2.5 billion and Dm750 million, carrying redenomination and consolidation clauses. These were well received.] Plus, regular borrowers like L-Bank are bunching maturities together.” Issuers are gambling on being able to refinance such tributary or linked parallel deals in a large euro market of the future. What if it never comes into existence? To date, most prudent regular borrowers have tried to reduce peaks in redemptions of their bonds falling due. Now they are piling up deals all maturing on the same dates.
Helmut Stermann, deputy head of international funding at L-Bank, is sensitive to the danger of large principal repayments falling due on the same day testing the company’s liquidity. He does not sound inclined to link in a third issue, though L-Bank has not ruled out the possibility. L-Bank intends to issue debt in euros after 1999 but sees uncertainty in two aspects of pricing its euro debt. What will be the underlying government benchmark? The German government has not yet committed itself to redenominate its domestic debt in euros following monetary union. L-Bank may have to price deals relative to French government debt, which is not a particularly good point of comparison for a German state development agency. Secondly, what comparable issues of its own could be made relevant? “We want an L-Bank yield curve in euros by 1999. We believe the size of benchmark issues will be larger than present domestic benchmarks,” says Stermann. L-Bank did not feel it could launch a Dm2 billion deal, as that would be stretching the limits of the Deutschmark market. So it chose to combine Deutschmark and French franc issues which will be converted into euros.
Differential trading
The additional reason for launching explicitly-linked parallel deals is that they should enjoy broad support from market makers across Europe, and bonds should flow easily to the strongest bid, following conversion into a single euro deal. Separate bonds of the same issuer, even once redenominated into the euro, may trade at different spreads because only one or two market makers will know where the original bonds were placed, at what levels and with what associated hedges or switches.
Sensible borrowers will have to beware of some of the wild ideas being bandied about. One bank’s suggestion to L-Bank was that it launch French franc and Deutschmark issues and then, in 1999, take out the French franc leg and replace it with additional Deutschmark bonds offered to investors at then prevailing rates. That would produce a large Deutschmark deal with an option to convert into euro. But such a structure would create unacceptable uncertainty as to L-Bank’s financing costs.
What’s certain is that there will be more such deals, especially as borrowers in the euro bloc that today rely heavily on domestic investors realize the danger of these investors being wooed away by new issuers offering diversity within an enlarged European domestic market. Belgium is a natural candidate to launch euro or parallel issues to develop more European interest in its debt. Bankers say Sweden and Denmark have also taken a keen interest in parallel deals.
Those, like the Scandinavian countries, with a large portion of their debt in foreign currencies are worried about having large numbers of orphan bonds, trading at high yields because of poor liquidity, establishing high pricing benchmarks for future euro issues.
One difficulty for sovereign borrowers such as Sweden, Finland, Spain, Italy, Portugal and Ireland in following Austria’s lead by issuing a core currency Eurobond exchangeable into a domestic issue, is the high coupons on their domestic bonds. One solution would be to issue Eurobonds at a price well above par to produce a lower yield on high-coupon Eurobond debt. But many European institutions dislike buying bonds at well above par, no matter what the compensation of the higher coupon. The alternative is to sell domestic debt at a deep discount permitting a lower coupon. Sweden has already done this and Spain is sounding out its primary dealers about selling low-coupon domestic debt at discounts and strippable bonds. It’s a sign of sovereigns re-designing their stocks of unappealing domestic debt, with a view to funding strategies for the coming euro market.
Perhaps the simplest idea of all issuing in euros is the best, despite the obvious element of hype involved. Paribas was a bookrunner on both the EIB and Italy euro deals. Ardalan tacitly acknowledges the marketing element of calling them euro bonds, when they will remain Ecu deals until monetary union takes place if it ever does. “There is a big psychological difference here. We were able to bring a lot of new money into these deals, from UK investment management groups and German investors, which we might not have done if we had called them Ecu deals,” he says. “It shows these issues are looking to the future not the past.”
The past of Ecu bond issues is unfortunate. The Ecu new-issue market was frenetic in the early 1990s as investors became convinced that monetary union would happen, but it fell into decline following the exchange rate mechanism crisis of 1992 and 1993, and the Ecu became a relatively obscure retail currency sector.
Whether investors in the EIB and Italy deals fare well depends on the timetable of progress towards monetary union. Spreads between Ecu bonds and other core currencies will vary as concerns over achieving monetary union grow and recede. Since launch, they have widened amid talk of a delay to Emu. At least, the euro deals achieved broad distribution in France, Germany, Italy, Switzerland and the UK. Placement of parallel bonds denominated in national currencies remains centred in single national markets.
And within the universe of Ecu-denominated bonds, these deals have performed well. The EIB deal was launched at a spread of 2bp over French Ecu OATs, before tightening to 6bp below OATs. A euro 300 million tranche was added at 1bp through OATs and the enlarged deal traded at 2bp below OATs six weeks after launch. The Italy deal also tightened from 18bp over Ecu OATs to 17bp over shortly after launch.
“The good thing about these Ecu/euro deals is that they are plain vanilla. They eliminate conversion risk. They demonstrate a commitment to the euro. And they don’t contain gimmicky or elaborate structures,” says the head of syndicate at a leading Eurobond firm that has so far led neither a euro nor a parallel deal. “Some bankers seem to think that European investors are very keen on monetary union and love all these ideas. The investors I talk to mostly think it’s an enormous pain in the neck. They want to take views on it in ways that are simple and clean.”
