Building a euro market

A SUPPLEMENT TO EUROMONEY – MARKETS 1997

With the introduction of the single European currency less than two years away, borrowers and intermediaries in the international debt capital markets will focus more and more on this huge impending change. “This year and next are very major turning points that will shape the capital markets for 10 or 15 years to come. One is hard pressed to think of a more important development over the last 20 years than the euro,” says Carlos Cordeiro, managing director at Goldman Sachs.

Within Europe, the old national capital markets will be replaced by one huge domestic European market. How this will operate, no-one is yet sure. But participants are already trying to anticipate its workings ­ witness Austria’s euro-French franc bond deal in January which can be re-denominated into euros when Austria’s own domestic schilling bunds become euro-denominated. It is essentially an attempt by Austria to win over a French institutional following for its domestic debt, in advance of the single currency. Other major borrowers may be tempted to establish their credit spreads in major European markets, to establish themselves with new investors.

This is but the first sign of an enormous change to come. What may soon become clear is how major international investment banks have neglected the national domestic markets. “The major London-based investment banks give the impression of having a strong presence in and knowledge of each of the major European countries. But often the reality is that they do little more than trade the major benchmark government bonds and operate on the periphery of domestic debt markets,” says Manfred Schepers, head of debt capital markets at SBC Warburg in London.

To survive and thrive in the large new domestic euro-denominated market will require firms to go out and develop much stronger contacts with borrowers and investors which previously confined their activities within national boundaries. “For example all major investment banks cover the Kingdom of Belgium because it potentially borrows internationally,” says Schepers, “but very few talk to the state borrowers for Flanders or Wallonia because now they fund themselves domestically.” But in future their bonds could easily flow to Holland or Austria. The Belgian banks don’t know many Austrian investors and the Austrian banks don’t know the Belgian borrowers. So who is going to intermediate that flow? Schepers adds: “In the last three years, all the leading investment banks have grown used to talking to the likes of Depfa, Credit Locale and BNG, but not to the local municipal and provincial borrowers.” He concludes: “Very few banks are even moderately well positioned to cope with this change.”

But in each country, there is exciting potential. As sovereigns borrow less, investment bankers will have to visit the next tier down of municipal and local government borrowers. The Basque country is already quite well known from a couple of international issues. There are another 16 or so Spanish provincial borrowers which might in future fund beyond the local Spanish bank market.

And on the investor side it’s the same. Banks will have to re-think the way they cover large accounts which previously they had ignored because, either for reasons of innate conservatism or regulatory restrictions, they played only in national markets. One banker says: “Take a country like Finland. Many large fixed-income investors there have bought almost exclusively domestic government, bank and mortgage bonds. In the future they will be allowed to buy Italian municipal bonds. We have to get to know these investors better.”

Life is going to be tough for European fund managers. No longer able to secure performance by anticipating interest-rate and currency moves in different national markets, they will have to grow more adept at taking credit risk. This will require much more than the ability to take positions in various euro-denominated government bonds for the few basis points that might distinguish the credit of France from that of Germany. Increasingly, investors will have to take on more corporate, bank, emerging market and structured debt.

“In a homogenous market, the emphasis will increasingly be on credit research rather than interest rates and currencies,” says James Garvey, managing director at UBS. “In anticipation, UBS has established a team of 18 credit analysts, 6 in London and 12 in new York, who staisfy our clients’ growing requirements.”

Last year, there were already strong signs that the low interest-rate environment was compelling more and more fund managers to seek new investments in the search for yield. Emerging market sectors have grown up in the Deutschmark and Italian lire bond sectors. More spectacular has been the growth of European investment in asset-backed securities, both those originated within Europe and outside. Some 30% to 50% of all American floating-rate asset-backed bond deals were placed in Europe last year. Highlight European transactions included the Cyberval deal, securitizing assets of Crédit Lyonnais, the GPA leasing deal and the Rose transaction, a securitization of UK corporate loans from NatWest.

The growth of the sector will continue in 1997. Asset-backed deals are the last remaining highly-rated ­ AA or even AAA ­ instruments that yield a few basis points over Libor, making them attractive for banks and investors. Buyers are taking structure, or prepayment, risk. So understanding deals does not require as large a number of credit analysts as might be needed at an institution building up a diverse corporate bond portfolio. Asset-backed deals are becoming larger and more liquid. There are plentiful assets to securitize. “I think rather than the attention-grabbing corporate loan securitizations, we will see more simple, consumer finance receivable-backed deals,” says Joseph Cook, managing director at JP Morgan in London. “They lend themselves to inexpensive credit enhancement.” He adds, “For European financial institutions, preparing for the onslaught of Emu-inspired restructuring, selling off collateral is more than just a means of financing. It may be a useful tool in re-vamping their capital structure in a way that enhances returns on capital.”

Investors which stay out of the asset-backed market will only find such highly-rated bonds yielding well below Libor and so will lose out against their competitors. And they may eventually lose out against the major benchmarks. “Not much structured product is included in the major indices yet,” says one banker at Salomon Brothers, “But as the asset-backed sector grows, so will pressure to incorporate it.” Underperformance may have drastic consequences. In a large borderless capital market, money should flow easily to the best performing managers, so if the French fund managers appear to regularly underperform, they may quickly lose out to better performers in, say, Holland.

The decline in importance of sovereign issuers in the international bond markets should continue this year. Many who took on substantial foreign currency debt to defend their own currencies during disruption of the Emu and to fund themselves through recession in the late 1980s and early 1990s are now committed to reducing their deficits. They will naturally concentrate on borrowing in their home markets and eventually the pan-European domestic euro bond market. Their place will be taken by municipal and local government borrowers, financial institutions and corporates.

Growing corporate borrowing will partly result from the continuing huge volume of European privatizations. Large quasi-sovereign borrowers such as Deutsche Telekom, will now lose their sovereign guarantees and enter the private sector. European companies may now be reaching a point in the economic cycle where they are more inclined to borrow. “European companies are under-leveraged,” says Cook. “Some French and German companies who are sitting on large amounts of cash could enhance their share value by more consistent borrowing. Europe is coming out of a period of low growth and near recession. Companies have been squeezing cash from their operations by cutting inventory, slimming down, closing loss-making operations and selling subsidiaries. In the process they have built up cash balances. But increasingly, with some economic expansion in Europe, these balances will be used up in investment and mergers and acquisitions. Companies will take on net new debt.”

It remains to be seen whether companies will borrow through the capital markets or from banks. Bank liquidity is high and generally for companies rated AA or better, bank debt will be cheaper than bond issues. Bank loans offer other advantages. A syndicated revolving credit is not only cheap, it is flexible. Unlike with a bullet maturity bond, the borrower can chose exactly how much and when to draw-down.

If European companies continue to seek most of their funding from commercial banks, then banks themselves will become increasingly important borrowers in the international capital markets, extending their liabilities to match growing balance sheets. A wave of privatization, consolidation and mergers among European banks will leave new enlarged banks needing bigger funding bases in the private capital markets.

Banks may yet be disintermediated. Institutional investors have shown themselves eager to take yield and duration on below investment-grade sovereign debt. Latin American countries have sold 20-year and 30-year global bonds. It would make sense for investors to diversify into speculative-grade corporate debt closer to home and many banks are setting up high-yield bond desks in Europe to manage this. What might drive these kinds of European borrowers out of the arms of the continental banks which so far have lent to many of them as if they were A rated credits or better? Perhaps cost, if institutions grow more desperate for yield and for diversification. More likely, borrowers will be attracted by the looser covenant structures demanded by bondholders. “Corporates in the US have found that the covenant packages that banks demand may hinder their operational flexibility and that has driven them to the capital markets,” says a Salomon banker.

Already dozens of European corporate borrowers have turned to the US high-yield market for funds, including Telewest and Ionica. Some growth companies have found that their need for funds outstrips what senior bank lenders and equity buyers will supply and they need to find new types of debt providers. They would be pleased to find European takers for their debt. For investors, there is the potential attraction of substantial capital appreciation ­ reminiscent of the equity markets ­ as well as high coupons from some speculative-grade bond investments. Tag Hauer issued par bonds, which now trade at 115%, following last year’s recapitalization through the sale of a large slice of public equity.

“There is no reason why high-yield corporate debt markets should not take off in Europe,” says Schepers. “Many European institutions are buying emerging market sovereigns. The truth is that they have not been shown much BBB or BB rated corporate debt. As the pressure grows on European fund managers to perform, the corporate market could become quite exciting.”

Another topic of consuming interest in the debt capital markets this year will be along what lines the euro capital market will work in detail. European domestic markets have evolved in differing ways and at varying speeds depending on the existence of a significant institutional investors base, local custom, tax and other regulations. Theoretically procedures should converge. All euro denominated government bonds should be eligible to be held as reserve assets at central banks and be acceptable as collateral for short-term funding through repurchase agreements. That should create a large liquid market with most government bonds trading close together and plenty of professional trading.

But some countries may be tempted to cling on to what one banker calls “home town rules”. Competition among major borrowers ­ and there are none larger than the sovereigns ­ for the favour of investors could become intense. That might present problems to a borrower like Belgium. Today 50% to 60% of Belgian government bonds are held by Belgian banks. Banks are encouraged to buy bonds because they are not required by the central bank to mark them to market but can carry them at cost. Will that advantage disappear or will it be extended to other euro-denominated sovereign bonds after 1999 and how then will Belgian banks behave? Might they turn to other government bonds for a few basis points more in yield? “Will we see a truly open capital market or will these kinds of local rules persist?” wonders Cook.

Another pressing question is where will the euro-denominated capital market be centred. Today most European governments insist that primary dealers in their government bond markets have large local offices. It will be difficult for the smaller countries to push for this once a huge European domestic market begins to operate. The German domestic bond market is not a particularly attractive model for this. “It is not a broad based capital market,” says one foreign banker. “Almost half the Deutschmark bond market comprises various specialized municipal- and state-guaranteed banks selling bonds to each other at very thin margins. Most Pfandbrief bonds stay on the books of lead underwriters and are not distributed.”

Frankfurt has no bill market and no efficient bund yield curve. Traders struggle to price five-year German government bonds because, the Bundesbank targets its new Bobl issues at retail investors for the first three months of their lives, only opening them to institutional buyers when they have four years and nine months to maturity and are already off-the-run. “I would be hard pressed to think of a worse way of putting out five-year debt,” says one banker. Perhaps Paris may be a stronger centre for the euro capital markets. The success of eight year fixed-income savings accounts managed by large institutions has contributed to strong non-bank capital formation.

New issue rules will have to be worked out. It would be idiotic to have three or four governments issuing large amounts of similar maturity bonds on the same day. “The question of ‘traffic management’ viz-a-viz auction schedules and taps is a critical issue,” says Garvey.

The coming of the euro market will present new opportunities for imaginative bond traders. The conversion of so many bonds into the euro will leave investors with their nice Dm10,000 or French franc 10,000 holdings altered into odd amounts of euros That may prompt new, specialist odd-lot traders to buy up inconvenient fractional amounts at wider spreads than in the conventional trading market. Illiquid-bond brokers may also find opportunities in old eurobonds denominated in national currencies.