Pricing themselves out of the market

Return of the Viking raiders

Nordic borrowers have been moving into a period of consolidation over the past six months to a year and this does not make for happy international underwriters. The four Nordic countries – Sweden, Norway, Denmark and Finland – are achieving levels of financing they could not hope to obtain in the international capital markets and, as one London investment banker testily puts it, in the next two to three years “they will gradually disappear from the radar screens”.

Lars Norup, head of northern Europe derivatives marketing at Greenwich NatWest, says the big Nordic sovereign borrowers have been repaying debt for a couple of years. “Most corporates are in the capital markets but there is not much tradition in corporate bonds,” he says. “The exception would be Sweden and its domestic MTN programme. It has reduced its debt quite dramatically over the past couple of years, especially in 1996. Norway, because of its oil revenue, has been debt-free for about 18 months and they’re now building up the petroleum fund to finance the pension liabilities that will come their way within the next five to 10 years. Denmark has reduced its debt sharply in the past four to five years, while Finland has been through a very rough patch and has had to accept quite high unemployment for an extensive period. The Finns have cut back on public spending by slashing the civil-service payroll and reducing social state benefits. The public deficit has shrunk from a bit more than 4% to around 2.7% or 2.8% currently.”

What all this means is that the debt raised by what would be traditionally regarded as frequent issuers in these countries, the three kingdoms and the Republic of Finland, as well as institutions like Swedish Export Credit, has dropped sharply, and their funding targets have gone up. Kingdom of Denmark, for example, is an AA1 name with a funding target of about Libor minus 30 to 35 basis points. By contrast, an AAA rated entity such as DSL Bank in Germany has a funding target for the same maturities and the same kind of size of around minus 13bp. On paper, DSL Bank should have more aggressive funding targets than the Kingdom of Denmark. This would also apply to most of the other Scandinavian names.

Finland was probably the most active borrower until recently, but Helsinki is reducing its debt levels for 1998. Bankers fear the market will be lucky to see one or two private deals in the next year. The rest, they say, will be Finnish markka in the domestic market.

“This filters down to the banks that do provide the liquidity but at highly expensive levels,” says a London banker. “There is simply no money in these deals. The only developments we see are on the corporate side where we are actively pushing the arrangement of EMTN [Euro medium-term notes] programmes for corporates with government links, explicit guarantees or partial state ownership. Again, these companies are going to pose very aggressive levels.”

This has led to interest from specific investor interest areas, such as Asia and particularly Japan where big Nordic corporate names are being used as a proxy for sovereign debt, albeit at extremely aggressive levels. Indeed, a major driving force behind the Nordic markets this year has been the Japanese retail market where there has been some very structured activity at extremely low levels. Japanese investors have shown themselves to be prepared to take on additional risk in order to get a higher return. They try to build in as much as possible of foreign-exchange and interest-rate expectation and then gear the entire structure of the issue toward what the Japanese public believes will happen.

A greater number of EMTN programmes are being set up in the Nordic region by corporates which in the past did not see much requirement to use medium-term facilities. “They are no longer really EMTNs but rather debt shelves for their whole domestic market which, with the introduction of the euro, will stretch from Stockholm to Lisbon,” says the London banker.

Domestic focus

The fact is that Nordic sovereigns have been cutting back on their international borrowings to focus more on the domestic market which has been very friendly to them. Norway, for instance, hasn’t been active since 1993 and is currently buying back bonds. This prompts bankers to voice complaints that the region is repeating past mistakes and is living up to its reputation of borrowing in peaks and troughs.

“They’re not borrowing and the banks which are the main issuers out of that region are doing highly unprofitable deals for underwriters,” says a debt trader. “They all trade at the full fee level so underwriters, as well as syndicate people, traders and sales people, see nothing in it. As the Nordic banks are the only ones in the market a level of ignorance is being built up. If you are not doing business with these people over a period of time you lose touch and find that you know very little about them. The result is that the only time the market looks at them in an intelligent manner is when they’re in trouble and that is when they pay more than they need to.”

Increasing opportunism

For Eirik Winter, head of Nordic debt capital markets at Salomon Brothers, the region’s borrowers are becoming increasingly opportunistic. “I would say that perhaps 60% to 70% of the issuers today determine the appointment of their lead managers on the basis of continuous dialogue, but they are also very much led by price and by opportunities that might occur from specific investor-driven requests,” he says. “We’ve seen a couple of very large transactions by Nordic banks that were entirely price-driven.”

Winter cites ratings as another factor behind this approach. “Bank ratings have improved based on these countries’ economic outlooks,” he says. “Norway’s Den norske Bank was the first in that country to have its S&P rating reinstated and this changed the outlook of investors who require two ratings. This of course has driven the market towards tighter spreads and has pushed issuers to become a lot more opportunistic and price-driven than was the case a couple of years ago.”

If Nordic borrowers largely ignore the international debt market during good times, they have been equally quick to jump back in during the lean periods. International borrowing, bankers say, is not part of their strategy. “It is more of an emergency stop,” says a Swiss banker. “They take the view that they don’t tap the capital markets on a consistent basis during the good years. Because they don’t have any meaningful presence during those years in terms of the borrowings they require, when they come back it tends to be with a vengeance.”

Some underwriters are willing to put up with this erratic approach and are quick off the mark to reap the pricing rewards.

“Nordic customers are easy to work with and give fast answers, which is crucial in structured deals,” says Javier Alarco, director of capital markets and treasury at Spain’s investment bank Banco de Negocios Argentaria. “We have done large matador issues for Nordic issuers. We issue pesetas and swap them into the currency they want, which has been Deutschmarks and dollars. It is an opportunistic financing for them, taking advantage of an arbitrage opportunity in Spain. We have preferred the Kingdom of Sweden because of the name.” So far this year Argentaria has been bookrunner for eight Nordic issues totalling $243 million, seven of which were for the Kingdom of Sweden with one Pta10 billion ($67 million) issue lead-managed for Sweden’s Venantius.

One of the perils of excessive price-focusing is that with the approach of Emu, credit will become the main driving force in the market as opposed to arbitrage. “It will become a credit market like in the United States, and credit and investor diversification is an important factor,” says Salomon’s Winter.

“If you only hit the tightest bid every time you end up with lower-quality buyers, such as street buyers and funds who will not care about the paper in the secondary market.” Winter argues that issuers should look more towards performance and quality of new issuance instead of pricing. “Some issuers already understand the importance of this,” he says. “The last five or six issues that we lead-managed in Scandinavia were not only won on pricing. In fact two or three competitors were tighter than us and this is encouraging.” Salomon Brothers’ two most recent deals were a $250 million FRN for Svenska Handelsbanken and a Dm350 million ($198 million) FRN for Norgeskredit. As of mid-September the bank had acted as bookrunner for 17 Nordic issuers, placing it third in the international league table with deals valued at a total $2.49 billion.

UBS European economist Philipp Paulus says Emu and its impact on the capital markets is the biggest issue facing the Nordic countries in the immediate future. “We can see quite a divided picture in the region,” he says. “Norway’s membership in either the EU or Emu is clearly not going to be an issue until 2002, possibly even beyond. Sweden seems set to meet the Maastricht criteria sufficiently to join in 1997 but the ruling Social Democrats are unwilling to alienate anti-Emu voters ahead of next year’s general election so they will play down the issue. Denmark is not going to join in 1999. They will probably adopt the UK position and join at a later date if Emu is a success. Finland is the most pro-Emu country. The government promotes Emu despite a divided public. Finland ranks with Luxembourg and Ireland as the only countries to have fulfilled the criteria.” Paulus points out that, like Germany, the Nordic countries are faced with the challenge of reforming their state pensions which now operate on a pay-as-you-go system. “If they went for a funded pension system, something which the Nordic governments are largely trying to circumvent, it could create a more liquid capital market,” he says.

As Emu comes on stream and Europe turns into a huge credit market there is likely to be more room for, and a greater understanding of, Nordic borrowers, as well as their municipality market. “Local lenders such as Holland’s Bank Nederlandse Gemeenten (BNG) and France’s Crédit Local will be bidding for debt issued by some tiny municipality in Sweden and Denmark, for instance,” says a banker. “All these people who fund their own municipalities in Europe in their own countries will be pursuing these municipalities in Scandinavia as well.” This, he says with regret, is a whole new business line which investment banks, unlike these big buyers of local debt, will largely miss out on. However, the international investment banks can put more resources into credit research and do ratings advisory for municipalities to get them on the road with their first deal. “They’ll sort themselves out after that and the market will determine what they can and cannot do,” says this banker. One of the trends as credit becomes the crucial issue will be the role of the investment banks to put new borrowers on the map. “This can also be laid across the fact that as we move through the next few years we will see greater and greater privatization of state assets, and they will be able to fund themselves more efficiently through a mix of equity and debt than they ever did in the past,” he says.

Debt dynamics

But the banker highlights the problem of barriers of entry to local and municipal debt markets. “Taking France as an example, Crédit Local knows the borrowers in France intimately and what is value,” he says. “So the only way a company like BNG or any other municipality funding bank can win market share in those regions is by underpricing. If other people come in, Crédit Local, BNG and the rest will bring their margins down. As margins come down the cost of government debt will average lower, and equally important is that the local authority municipal financing public entity cost of debt will also fall with greater competition for that debt.”

Thorsten Soderhielm, a director of fixed income at Credit Suisse First Boston, says the development of Tier-1 products apart from pure equity for the financial sector has been a feature of the Nordic region this year. “Nordic banks will take advantage of this, as Finland’s Merita Bank has already done,” he says. Merita issued non-cumulative step-up perpetual capital securities that create regulatory Tier-1 capital.

“This instrument is tax-deductible,” points out Salomon’s Winter. “I think this will be followed with great interest. Finland is where it started in the Nordic region and this is due to the fact that banks issued so-called state capital notes during the banking crisis and these notes are stepping up next year to 150bp over Helibor. The notes are currently at Helibor plus 50bp.”

Another trend has been the so-called 4% issue, a Danish tax-driven structure that has turned into a major market. At the start of the year it was about Dkr20 billion ($3 billion). Everyone thought the market would become saturated when it hit Dkr35 or Dkr40 billion. At the moment it’s at Dkr65 billion and still going strong. Because there is a tax advantage built into the bond, investors can achieve spectacularly low targets, so this has been a major source of finance for Danish public entities and a whole range of other Nordic public entities, as well as quite a few German Landesbanken.

Corporate beginnings

The Nordic region has seen the beginnings of a commercial paper market for some time as well as some sort of corporate bond market. CSFB’s Soderhielm cites the fact that corporate borrowers in the Nordic region have had easy access to cheap financing in a very competitive bank market. This, he says, can be seen in the number of revolving credit facilities. “Now when they look at their liabilities they find that most of it is bank debt.” More and more corporates are therefore looking to diversify away from the bank market and they are looking at longer maturities. “The yankee bond market is the obvious choice,” he says.

Nordic corporates looking at their liabilities find that more than 95% is bank debt. Margins for weaker, BBB rated corporates have shrunk at a considerable rate, hence premiums are lower. Nordic corporates are also buying back equity and replacing it with long-term debt. Sweden’s Volvo, for instance, started a share-redemption programme not long ago and is now looking to the debt market to replace it. The international investment banks have largely been left out of the picture. The Nordic banks are obtaining cheap capital which they use to fund the corporates. Whereas the securities market in the rest of Europe regularly beats the bank market, this is not the case in Scandinavia, which foreign investment bankers say is underrated by Moody’s and Standard & Poor’s.

“If these companies were somewhere else they would be better rated,” says a UK investment banker. “Therefore the securities market does discriminate against them.” With these ratings the Scandinavian banks are effectively betting that they know these companies better than anyone else and believe they are AAA. The market may rate them AA3 but they lend the money at AAA levels and charge that cost of capital as if they were lending to a AAA borrower. “This is of no interest to international investment banks,” says this banker. “We can go around the UK, Germany and France where there are good deals and money to be made.”

House-bank philosophy

The Nordic corporate sector is basically built around the German house-bank philosophy of banks owning large chunks of the corporate sector that normally turns to these specific financial entities for their funding requirements. Whereas a UK or US corporate treasurer would normally go to the equity markets to raise capital through a rights issue, that is not the case in Scandinavia.

“Instead you contact your house bank and typically do some sort of revolver or, if you’re slightly bigger, a Eurobond,” says Greenwich NatWest’s Norup. “The crucial factor is that it’s like a multilateral deal, where you borrow the money at a low margin and you then give your group of house banks the business. This is a major limitation, because buying companies like Volvo for seven years at a rate of Libor plus 10bp, given the fact that it’s a 100% weighted asset, is not a great way of investing your money.” Norup says the gearing for Scandinavian corporates will always be higher than that of a similar US or UK company because of the difference in the way they are set up and the closeness of their treasuries to the respective house bank. “The reason for this is that the equity markets in the Nordic countries are not nearly as well developed as in the UK or the US,” he says. “There has also always been a much closer relation between banks and corporates in northern Europe.”

Bankers say the party may not last much longer, since the advent of the euro will create a major debt market where most of these issuers will have to change their ways.

“A liquid euro issue is bound to be a lot bigger than a liquid Swedish kronor or Finnish markka issue,” says one banker. “Entities like Nordic Investment Bank may run into a major problem, because they will suddenly lack a raison d’être and could easily find themselves forced to merge with someone like EIB which is doing the same thing. There is likely to be a lot of structural change in the Nordic market.”

The feeling is that many Nordic banks will have to reinvent themselves and focus more on the second-tier and third-tier corporate market. A lot of mergers are expected over the next few years, since Nordic banks with a dominant presence in their home markets will not have the same critical mass with the coming of the single currency. Such countries as Sweden and Denmark are already using the euro as a benchmark and to that extent they see themselves in Emu at some point down the road.