Fear of the orphan bond is stalking Europe. This is the fear that, after the introduction of the euro in 1999, bonds in the national currencies whose exchange rates are locked will lose liquidity. They will have no benchmarks to trade over.
With the elimination of exchange and interest rate differences, investors will gravitate towards the biggest euro benchmarks. Market makers will lose interest in classes of bonds destined sooner or later to disappear. By 2002 all payment of interest and principal must be made in euro.
A foretaste is given by a City of Munich bond still denominated in wartime Reichsmarks. This 4% bond of 1944 was never redenominated but is being serviced at a rate of Dm1 to 10 Reichsmarks by the government debt agency the Bundesschuldenverwaltung – an orphan to beat all orphans.
To keep investors loyal, governments of euro states, especially the smaller countries, will want to redenominate their benchmark national currency bonds into euros “as quickly as possible”, says Kari Nars, Finnish executive director at the European Bank for Reconstruction & Development.
The bigger member governments will also want to redenominate to give their own financial markets maximum opportunity to maintain or increase trading volumes. Paris, Frankfurt, Brussels, Amsterdam are vying to be centres of trading in euro securities. None of these cities wants trading volume to be sucked away to continental rivals, or London.
Under the Maastricht Treaty, wholesale markets have three years from 1999 to switch their instruments to euro – according to the principle of “no compulsion, no prohibition”. Competition is the driver, liquidity is the goal.
The French government has said it will redenominate all its government bonds into euros from January 4 1999. Germany is expected to do the same, at least to redenominate its Bunds (government bonds), but probably not its federal savings certificates (Bundesschatzbriefe), mostly retail, or its rarely-traded Schuldscheindarlehen.
But the cliffhanger for the financial markets is, how will the redenomination technically be done? Only when the French and German governments have decided, will the markets be able to see the legal and economic implications clearly enough to shape their own response. Paradoxically, the governments appear to be waiting for the markets to come up with a model for redenomination first, although German finance ministry sources says they expect a decision from their minister Theo Waigel in early July. The French finance ministry and the smaller French banks cannot agree on a method.
Non-government issuers are waiting for a market practice to be established before committing themselves to one method or another. Time is slipping away. “There’s very little project management about the whole thing,” says one participant in the European Commission’s informal working group. “There are big gaps between meetings, we’re now looking at October 4 for the next one.” The longer the protagonists dither, the less chance there is of creating a large body of tradable euro securities in the first few trading days of 1999.
So, how do you turn a Dm1 billion or ffr5 billion bond issue into a tradable bond denominated in euro?
First, the obstacles. Many market practitioners argue that, unless you’re a government with a political axe to grind, it will be simpler, and cheaper, to let your bonds run to maturity in their original currency. After January 1 1999 the currency becomes a fraction of the euro, and coupon and principal payments can be in euro. After January 1 2002 all coupon and principal repayments must be in euro, but bond trades can still be done in nominal amounts of Deutschmark, francs, guilders or whatever. The bonds will be orphaned, but they will still have value. According to article 109l (4) of the Maastricht Treaty, after that date all national currencies will be “read as” euro, although nit-pickers wonder what exactly “read as” means. Under these circumstances, why not leave existing bonds alone and concentrate on new issues? The hassles of redenomination outweigh the benefits, many market practitioners warn.
Certainly redenomination will bring a cost, to the issuer or the investor, or both. There may also be legal problems. If the economic nature of the bond is affected there may be grounds to call a bondholders’ meeting.
If the issuer is determined enough to overcome these two obstacles – either to demonstrate its commitment to European economic and monetary union (Emu), or because it sees liquidity as vital – then the challenge is to find the best and simplest method of conversion.
Experts have identified six or seven possible ways. They first distinguish between three basic approaches to redenomination, which could be called “the three Rs”. (These definitions are adapted from the Bank of England’s Practical Issues Arising from the Introduction of the Euro, April 1997.)
1 Redenomination. A change in the currency unit in which the nominal value of a security is expressed at the conversion rate, rounded to the nearest euro cent (ie preserving exactly the economic value of the security).
2 Renominalization. After redenomination, a change in the minimum nominal amount in which the security issue is held and traded (to simplify trading and clearing). This may be achieved either by a reduction in the minimum nominal amount to one euro cent, or by the repackaging of an odd amount, to achieve a round amount in euros (eg E53.23 might become E50). The process of renominalization creates rounding errors, especially when the rounding is to the nearest euro rather than the nearest euro cent. These differences could be compensated for by cash payments.
3 Reconventioning. A change in the terms of a security issue to reflect the different conventions (eg frequency of interest payment) prevailing in the market for securities in the new denomination (to make the securities more comparable with or fungible with new euro securities).
In early March, because so little seemed to be happening at the official level, a group of trade associations calling itself the Forum – noting that there were fewer than 500 business days to Emu – published some recommendations on redenomination. Recommendation number one was: don’t do it. The Forum warned against the possible legal obstacles, and the fear that redenomination might reduce rather than enhance an issue’s liquidity. If redenomination was considered absolutely necessary, then, the document urged, “the minimum denomination should ideally be 1,000 euro to facilitate liquidity in the secondary market. However, the minimum denomination should in no event be lower than one euro, in order to avoid the use of decimals in the nominal amounts”.
This was like a red rag to a bull. German and Austrian officials had already decided that redenominating – or strictly renominalizing – in units of 1,000 euro or even one euro would too radically change the economic nature of the bond. On the other hand renominalizing the bond in units of one euro cent would mean practically no loss or gain through rounding up or rounding down. Having bonds expressed in euros and cents might seem absurd, but it might avoid the need for bondholder meetings, cash handouts and repackaging. In German law, it seems, any change to a bond issue must have the approval of all bondholders. To avoid having to seek that approval, the renominalization must either have negligible economic impact, or, according to some lawyers, there must be a change in German law.
The Forum document, designed to clarify some issues and push on the debate, seemed to deepen the rift between three camps: German, French and Anglo-Saxon.
The Austrian government sent a furious fax to the Forum group. “Borrowers hadn’t been asked what they wanted,” complains Helmut Eder, head of the Austrian national debt office. German bankers insisted heatedly on a euro cent solution. Their anger was fuelled by a suspicion that the Forum was only offering a solution that would save time and money for the clearing agencies Euroclear and Cedel. Euroclear and Cedel cannot handle securities denominated in decimals. They would have to change their systems to cope with bonds in euro cents, at an estimated cost of around Dm30 million; so would a number of French banks. “The French banks are not unanimous about this,” says Dominique Hoenn, board member of Paribas and chairman of the European Bank Federation’s working group on the euro. “It depends on the bank’s custodian system flexibility, the interface with the stock exchange and reporting to customers. Paribas incidentally can handle euros and euro cents.”
Cent consensus
The big German banks and their bond clearing system, the Deutsche Wertpapierzentrale (DWZ) have no problem with cents. The Anglo-Saxons – predominantly the UK-based investment banks – are indifferent to the technical problems of euro cents rather than euros. But the bond-traders’ lobby groups – Ipma and Isma – initially favoured the euro or 1,000 euro solution as the cheapest and simplest way of redenominating. Their preference reflected the reality that bond dealers are hardly likely to trade in cents.
However, the consensus is swinging in favour of the euro cent solution. The Forum’s original view is becoming increasingly untenable. Even Euroclear and Cedel affirmed last month that, if their members wanted a euro cent solution, they would naturally adapt their systems. Since 60% of German Bunds go through Euroclear and Cedel – and Bunds are likely to be redenominated in euro cents – it seems the clearing agencies have no choice. But “how can you make the systems changes if you don’t know how [redenomination] is going to be done?” asks Geoffrey Wakem, director of product management at Cedel.
The Bank of England’s working committee on the euro, which publishes a quarterly report, in April still appeared to be in favour of rounding to the nearest euro, but that is mainly because participants couldn’t reach consensus. The quarterly report is widely regarded as the best working material for interested parties across Europe. Some contributors to it are a little resentful of giving ideas to the competition: “When I take part in a debate in Europe I find we’re streets ahead,” says one Brit. “I think ‘Why should I share our stuff with them?'”
The arguments are amassing in favour of the euro cent. The International Swaps & Derivatives Association (Isda) is distancing itself from the March conclusions. “At a recent Isda meeting nobody voted in favour of the one euro method,” says one member. “Nobody had thought about the cost on the banking side.” Isda’s carefully neutral position is that it would like redenomination to be as exact as possible, to be done in as few different ways as possible (for systems reasons), and that it should respect the rights of bondholders. Rounding bonds too far away from their previous value could create a mismatch between a swapped bond issue and the nominal amount of the swap to which it is attached, say swap dealers. While small discrepancies might be dealt with by cash settlements, that might not be possible if the issuer is inflexible about its hedges, for example if it is a special purpose vehicle (SPV) with a fixed principal amount, or a repackaged bond attached to an asset swap. “A lot of bonds are repackaged,” says Clifford Dammers, secretary general of the International Primary Market Association (Ipma), “so there’s nobody around to step up with new cash – especially with SPVs, which are almost invariably swapped.”
The German Private Banks Association (Bankenverband) attacks the one euro method, arguing that it “violates existing law, is fiscally questionable, hampers the derivatives market and greatly increases redenomination costs”. As an example the association calculates that redenomination by euro cent will cost the federal republic about Dm3 for each holding of German Bunds, while redenomination by euro will cost it Dm16. Since there are about 40 million individual portfolios of Bunds, the cent method would cost around Dm140 million to implement, but the euro method would cost the republic Dm640 million. With the euro method, the value to the right of the decimal point, which is not included in the new bond, must be paid to the client, calculating the net present value of the interest payable on it over the life of the bond. “However you calculate it there is likely to be a legal problem,” says Thomas Weisgerber, managing director of the Bankenverband, “you’re taking the property of the client”. If the Germans have a “domestic legal problem, that’s their effing problem,” says Isma chief executive John Langton in his usual forthright manner. “They should change the law.”
The European Commission’s informal working group, chaired by Alberto Giovannini of Long Term Capital Management, is due to publish its recommendations in early July. It is expected to favour the euro cent, and rounding by each holding of bonds (bottom up), rather than rounding each individual bond (top down). This means that each portfolio’s maximum gain or loss through rounding, on any bond issue it holds, is half a euro cent – hardly a cause for litigation. The Giovannini group is looking at other issues which may be even more crucial to the success of the euro money-market and securities markets. They include the price sources for variable interest rates, and harmonizing market conventions governing interest accrual.
There is another French/German/Anglo-Saxon clash over the future fixing of euro money-market rates. The French want a pan-European interbank offered rate (Euribor) fixed by selected banks in different European centres, while the British Bankers Association (BBA) has already announced that it will publish a euro Libor rate fixed by banks in London. The London and Frankfurt futures exchanges have said they will stick with London-fixed Libor rates when they redenominate their short-term interest-rate contracts. The French futures exchange, Matif, has “already announced it will fix on Euribor without knowing what it will be”, says a euro Libor supporter. “If we let things go, there may be two sets of references, suggests Hoenn at Paribas, “one domestic and one international. The European banks should agree on one standard to avoid confusion.” Isda and the Bank of England working group have each urged that an early agreement should be reached on pricing sources, perhaps even this month.
Interest accrued daily on bonds is calculated by different conventions in different European centres. The accrual is either calculated crudely, assuming every month has 30 days and every year has 360 days (30/360) or 365 days (30/365), or it is calculated precisely using the actual number of days run, divided by 365 (Actual/365) or by the actual number of days in that year (Actual/Actual). Now that computing power can handle Actual/Actual with no difficulty it makes sense to harmonize on that convention. However, that should only apply to new issues, argue practitioners. Reconventioning existing bonds while renominalizing them could trigger the need for a bondholders’ meeting and could affect related derivatives and repo transactions. This could concern up to 20,000 different securities in European currencies, totalling the equivalent of $800 billion, cautions Jo Van de Velde an associate at Euroclear.
There are also moves to harmonize interest intervals to either annual or semi-annual payments, and to standardize the settlement date for bond transactions at T+2 (two days after the trade) – until real time gross settlement becomes an alternative. “I’ve suggested that you should reconvention the bonds on the first interest-payment date after Emu,” says Bob Blower at the BBA. “Then the bonds are fungible in market trading terms. Otherwise benchmarks will be watered down.”
Sorting out these questions will require a mixture of leadership by governments and the European Commission, and market-led initiatives. “It’s a minefield,” says Wakem at Cedel, “but it gets worse as no decision is made.”
It is possible that much legal uncertainty can be avoided by recognizing a country’s sovereign right to change its monetary law (lex monetae). But English lawyers in particular tend to insist that the subject at issue with Emu is continuity of contracts and contract law. However, some enabling legislation may have to be passed in each state to avoid bondholders contesting every small change in a bond’s characteristics. “Investors have a right to know the economic terms of the new effect,” says Wakem. But the new effect should be minimal argues Hoenn at Paribas: “With a maximum of half a cent discrepancy, will some Japanese or US investors go to court? I don’t think so. There is no legal question; it’s an Anglo-Saxon question to keep lawyers busy.”
The view from Germany is that conversion is “purely lex monetae and you don’t have to consult bondholders”, says Dammers at Ipma. “Anglo-Saxon lawyers think that’s wrong, and I agree with them.”
Move to national law
Different treatments may depend on the governing law stipulated by a bond issue’s documentation. An interesting test case might have been the UK’s own Dm5 billion issue of 1992 governed by English law. Could the Germans redenominate it without the say-so of the UK government and UK lawyers? The Amsterdam summit of EU leaders in June decided an Anglo-German dispute on this issue in the UK’s favour: governing law prevails. The UK issue anyway matures this October. But to avoid confrontations “bond issues will increasingly use their own national law”, predicts Joe Cook, managing director at JP Morgan.
In today’s procedural vacuum, some big issuers have chosen to prepare the ground with so-called “parallel” or “tributary” Eurobond issues. Investors have bought these bonds, denominated in Deutschmark, French francs, guilders, escudos and other potential Emu currencies, in the knowledge that the issuer intends to convert them into euro bonds as soon as possible after Emu happens.
But, interestingly, no hard-and-fast formula for conversion has been offered. The best that issuers such as the Republic of Austria, Siemens, the European Investment Bank (EIB) and L-Bank have been able to promise is a fall-back formula if no best-practice is established.
Siemens, which issued Dm2 billion equivalent in Deutschmark, French francs and guilders, names a redenomination and consolidation agent in its prospectus. This agent, Morgan Guaranty, will ensure redenomination, and the consolidation of the three separate currency tranches into one fungible euro issue, on the most favourable terms, giving regard “only to the interests of the bondholders”, the prospectus says. For the sake of a successful conversion Siemens is prepared to give bondholders this “free” option, says group treasurer Christian von Ahlefeld. Siemens has calculated that if every bond holding is rounded upward “it would cost us a maximum of around E50,000,” he adds.
The EIB picked a redenomination formula that rounds bondholdings to the nearest 4 euros. Some market participants are worried that the EIB has given itself “no fall-back position” if its method of redenomination goes against what evolves as accepted practice. The EIB has issued tributary bonds in lire, guilders and French francs which are intended to create a fungible jumbo bond.
“But will they be truly fungible?” asks one market source. The true test will be if, after redenomination, Euroclear or Cedel accept a short position in the original French franc bond, for example, against a long position in the original guilder bond, the source says. Incidentally, the EIB has avoided UK governing law for its euro-fungible tributary issues. This may be to avoid possible anti-Emu rulings, market sources note.
Market participants fear that parallel bond documentation, carefully thought out and stress-tested by some issuers, has been copied parrot-fashion and misapplied by others. A possible example is a parallel bond in Schillings issued by Argentina which, investors have been told, will be fungible with Argentina’s Deutschmark paper. Another is an escudo deal by the EIB. “Can they be sure these will be fungible,” asks one market source. Ipma recognizes the uncertainty and is working on standard language for parallel bond documentation, says Dammers: “It should be out in a few weeks.”
Since the purpose of redenomination is liquidity, even these parallel bonds are something of a shot in the dark. No one knows yet how they will trade once they switch to euros. But JP Morgan, lead manager of the Austria, Siemens and L-Bank parallel bonds, notes that the Deutschmark tranches are already trading two and a half times more actively than comparable non-parallel bonds.
“Our view is that, without a redenomination clause, Eurobonds [in affected currencies] won’t trade very well after Emu,” says Cook at JP Morgan. For many issuers that won’t be a problem. Many Eurobonds have never had real liquidity, or they lose it soon after issue. “For these issues, redenomination won’t add any value,” says Velde at Euroclear. But the orphaned Eurobonds will become increasingly harder to trade as the relevant benchmark, such as a national currency government bond, also becomes illiquid or disappears completely.
This phenomenon will be an opportunity for the so-called “odd-lot trader”, and the specialist in illiquid bonds. There are odd-lot traders in the US treasury market, because citizens regularly sell bits and pieces of their holdings to pay their bills. “Why shouldn’t there be odd-lot trading in bits and pieces of euro and euro cent bonds?” says Cook. He foresees them trading the cents and odd values that investors throw out of their holdings of redenominated bonds – investors and dealers like nice round numbers. “I suspect the investors will not like to have the cents,” says Hoenn at Paribas. “At the first opportunity they will sell them to specialists who trade odd lots.”
