Filling the sovereign gap

Activity in the international bond market has been surprisingly frantic so far this year. Even allowing for the January spurt that, as expected, followed the lull at the end of 1997, volumes of issuance are unusually high. “We have seen a staggering amount of issuance in the market place” says Paul Richards, managing director of investment grade syndicate and secondary trading at Merrill Lynch. Says Jerome Lienhard, corporate treasury manager at Toyota Motor Credit: “It is surprising how much volume there has been, even though a lot of issues were withheld in the last quarter of last year.”

Up to February 17, bonds worth $155 billion had been issued in 599 deals this year. This compares with $126 billion in 780 issues during the same period in 1997. Growth of almost 20% is surprising given market uncertainty since October last year.

While conditions are more favourable than at the end of 1997, “it continues to be a relatively challenging market for any issuer”, says Linda Knight, senior vice-president and treasurer at Fannie Mae. She attributes any anxiety to “the ongoing effects and changing nature of the Asia crisis, and thoughts of the onset of Emu”.

The Asia crisis and its knock-on effects still prey on the minds of borrowers and investors alike. Although a source at the Korean Development Bank claims to be confident that spreads will narrow “close to normal trading” if market conditions stay as they are, many people in the bond market are pessimistic. Knight at Fannie Mae feels the worst is yet to come: “The situation in Asia will play out over a period of time, we’ll see peaks and valleys.” Lienhard at Toyota Motor Credit agrees. He is positive about Japan’s financial restructuring and general recovery, but feels that “Indonesia is in denial,” he says. “This is a critical situation and the most likely source of problems. It seems that long-term problems don’t get solved overnight, and Asia will be a choppy environment over the next year.”

“Asia changed quite a few things” says Gumersindo Oliveros, director of treasury finance at the World Bank. “There was a flight to quality, a flight to liquid issues, and a flight to safe-haven currencies.” The other emerging markets of Latin America and eastern Europe are feeling the effects of wider spreads and investor caution. Few bonds have appeared from these regions since October, but business is beginning to pick up again with recent sovereign issues including Brazil, Argentina, Colombia, Turkey and Ukraine. “Asian contagion is still having an impact on these countries” says Lienhard.

While many have praised the Brazilian government for its effective response to the crisis ­ raising short-term rates to slow down the economy – some fear that in the run-up to the elections later this year the austerity measures may be abandoned. Stephen Abrahams, chief of capital markets at the Inter-American Development Bank, thinks that recovery in Latin America will be gradual. “While I expect that the region as a whole will continue to recover, recovery will not be without temporary setbacks,” he says.

Riccardo Pavoncelli, managing director and head of debt capital markets (Europe) at Morgan Stanley, has similar feelings about central and eastern Europe. “Eastern Europe is slowly creeping back into the market, but they felt burnt by the sudden widening of spreads,” he says.

In this changed environment issuers have had to reassess their borrowing strategies. Sovereigns, supranationals and corporates are trying to tap the opportunities and avoid the pitfalls of the unpredictable market. Sovereigns in Asia and some other emerging regions are still finding life in the capital markets difficult, while sovereigns with a higher credit rating are benefiting from investor caution.

The most striking difference in borrowing this year is the growing size of issues, which largely accounts for the increased volume. So far in 1998, issues worth $2 billion or over have come from Fannie Mae, the World Bank and Canada among others. On February 12, Italy announced an unprecedented deal of Ecu4 billion (almost $4.4 billion), the biggest euro-fungible bond to date. The 10-year superliquid bond was well received and is expected to remain the 10-year euro benchmark even after the onset of Emu.

There seems to be a competitive aspect to the bigger issues, a feeling that a large deal confers kudos, especially among sovereigns. “Size [of deals] is important, especially in terms of competing for name recognition,” says Pavoncelli at Morgan Stanley. Low interest rates in many countries are also a contributing factor, but the major reason for the growing issuance size is concern about liquidity. “The biggest theme of this year is volume, an enormous focus on large liquid transactions,” says Lienhard at Toyota. Borrowers need to convince investors that the difficulties of the Asia crisis are over by providing liquidity for the secondary market. A hunt for yield characterized the first half of 1997, but when the markets plunged into chaos investors had problems reselling their bonds. A liquidity crisis and a retreat to the most trusted issuers followed, mainly sovereigns with high credit ratings. This left other borrowers finding it much harder (and more expensive) to raise sufficient funds on the international debt markets.

Disappearance of the sovereigns

Many sovereigns, including the US and also European nations working to comply with Emu criteria, are trying to slow their borrowing and reduce their national debts. Between 1993 and 1997 sovereign borrowing has roughly halved, from $73 billion to $33 billion.

As sovereign debt decreases, investors are looking to supranational organizations and larger government agencies with good credit ratings for large, liquid deals. Fannie Mae, the US mortgage agency, aims to give investors an alternative source of liquidity. “We have been very successful at capturing liquidity, the biggest theme of the year,” says Knight. “We have tried to determine what it is that investors want and deliver this liquidity in our benchmark note programme.” Fannie Mae has raised over $8 billion this year with two issues. “Fannie Mae has been able to extract value from the market by issuing very large, very liquid transactions,” says Pavoncelli at Morgan Stanley.

Other supranational bodies have been busy this year with large global deals, including a rare $1 billion issue from the Inter-American Development Bank (IADB) in February. As the IADB has a relatively small borrowing requirement of $4 billion to $5 billion a year and a record of smaller issues, its $1 billion deal underlines the 1998 trend of increasing size. The bank obviously felt market pressure to change its strategy. “We focus on making sure we remain competitive and retain the loyalty of investors,” says the IADB’s Abrahams.

But the World Bank, though “once at the forefront of the global concept” as Pavoncelli at Morgan Stanley puts it, had been avoiding large global benchmark issues, fearing spread compression. Instead for the past two years it focused on new markets and new currencies such as the South African rand and the Czech koruna. “We diversified tremendously, both in our products and our markets,” says Oliveros at the World Bank. However, the last couple of months has marked its return to the mainstream. In early February the bank issued a

$2 billion Eurobond, its biggest in the Euromarkets so far.

Much interest surrounds an upcoming dollar benchmark deal by the World Bank, rumoured to be due this month and worth between $3 billion and $5 billion. This deal would set new standards in the trend towards superliquid issues, but Oliveros plays down the predicted impact. “There is a strong bid for large liquid dollar issues, but we don’t go for transactions just to do the largest or to win awards. We try to be in touch with the buyers, and it is critical that certain performance standards are met,” he says. Oliveros confirms that the maturity of the bond will be either five or 10 years and hopes the deal will be ready soon, but stresses that there must be flexibility in both the price and the timing. “We will tailor the price according to market conditions nearer to the time,” he says.

Oliveros agrees that the decline in sovereign issuance leaves “more room for borrowers like ourselves”, but adds that competition is emerging elsewhere. Agencies previously based within domestic markets, like the German Landesbanken, are becoming more international in scope. “The panorama has changed and new players have come into the market, but increased competition is welcome and good for the market in general,” says Oliveros.

Kreditanstalt für Wiederaufbau (KfW), Germany’s leading development agency, is one of these new players in the international market. Its recent issues include a Dm3 billion ($1.7 billion) two-year bond, launched at the end of January. The deal filled a maturity gap in the market to become a Bund proxy, and met with great customer demand. In mid-February KfW issued a $1 billion five-year bond. According to Dieter Glüder, head of money markets and domestic capital markets at KfW, this was “much larger than our normal issues”, a response to investors’ demands for liquidity.

The drive for liquidity is generally advantageous to supranational organizations and quasi-governmental agencies. They issue large amounts of debt successfully and are more able to compete in the market with sovereigns. Not surprisingly, these bodies are upbeat about their positions in the international debt markets. “The market is working quite well from our point of view,” says the World Bank’s Oliveros. Says Abrahams at the IADB: “Given all the turmoil most institutional investors become cautious and want security, which serves our interests”.

Paying the price

Whether sovereigns are finding borrowing more troublesome this year depends largely on their credit rating. In the first week of February the Ukraine announced a DM750 million three-year Eurobond, its second approach to international markets, but had to pay the price for its lack of credit rating and offer a coupon of 16%. This very high yield was a hit with customers and may help to cultivate a following with institutional investors.

Greece, higher up the ratings scale at BBB, is finding that it is more attractive to investors than those sovereigns that have been downgraded. Greece is rated lower than most EU states but still not seen as highly risky, so customers buying government bonds can combine a certain amount of security with a higher yield. Spyros Papanicolaou, director of international banking at the Greek central bank, says that “even at the peak of the crisis last year, we had no problem accessing the market”. The main strategic change for Greece has been to move away from loans towards bond finance and large liquid issues.

The Greek central bank is currently working on a long-term global fixed-rate dollar bond of about $750 million, expected early in March. JP Morgan and Lehman Brothers are the lead managers. Papanicolaou is entertaining the idea of a euro-denominated bond issue in the next month, in keeping with sovereigns such as Italy and Spain. He feels that the bond markets are moving away from the dollar and the yen in favour of the euro and its constituent European currencies, in preparation for Emu. But Greece is “not going to undertake the deal unless satisfied with the price”, says Papanicolaou.

The trend towards large super-liquid bond issues is not necessarily good for all borrowers. Size of deals seems to be growing for corporates as well, meaning that each issue represents a much larger portion of their annual borrowing requirement and they can come to the market less often. Consequently, the timing of a corporate’s issue has to be immaculate – more money is riding on each deal and there is no room for mistakes in liquidity and interest rate management.

Lienhard at Toyota Motor Credit feels strongly that they have been forced by market pressure towards bigger issues. “For large frequent issuers it is relatively easy and efficient to access the capital markets in sizes of $1 billion plus, but for corporates whose needs are not as large it is all their issuance in one shot. Historically, high-quality corporates have been successful in issuing in smaller sizes – about $300 million – and focusing on retail,” says Lienhard. “Everybody talks about liquidity as king, but this excludes a lot of people” he adds.

African approaches

Louis Musasike, chief of capital markets and financial operations at the African Development Bank (ADB), agrees that liquidity is overrated. “The concept of liquidity comes and goes,” he says. “For smaller organizations like ourselves it doesn’t make sense to target liquidity as the main borrowing issue.”

The ADB’s annual borrowing requirement ranges from $700 million to $1.5 billion and is driven specifically by how much it needs to lend to its member countries. This year Musasike’s strategy will be very different to that of much larger supranational borrowers. “We will concentrate on smaller transactions, which we have found to be cheaper, and look at emerging currencies such as the rand and the Egyptian pound as well as the dollar,” he says. “We are keen to take part in the development of the capital markets in Africa.”

But other borrowers feel that the markets are moving away from the more exotic currencies of the past couple of years and towards the safer currencies of the US and Europe. According to Richards at Merrill Lynch “the dollar market was choppy at the start of the year, but is now a friendly source of finance and deep in terms of funds available”. There is also a move towards the euro, but “the next few months will show us whether this is a broad and deep market,” says Glüder at KfW. Structurally, global bonds are thought by some to be gradually taking over from the traditional Eurobond structure, as sovereigns, corporates and supranationals aim for a wider range of investors.

In terms of maturity, borrowers are taking advantage of the current lower interest rates by issuing longer-term bonds and locking in lower-than-normal coupons. “In the first part of this year issuance has been concentrated on maturities of five years and beyond,” says Knight at Fannie Mae. “We have never before seen so many issues in the long category,” says Glüder at KfW. Abrahams at the IADB agrees: “We are trying to focus on longer maturities”.

Investor caution is also a contributing factor to the lengthening of maturities. As spreads begin to tighten on previously high-yielding paper, investors have been shopping around for bonds with higher coupons. This could come from the emerging markets, but many investors are still viewing these borrowers as too risky. “The other option they have is to buy longer maturities in better-known credits,” says Roman Schmidt, head of syndicate at Barclays Capital.

This year the Eurolira market has been swamped by long-dated deals of up to 30 years. Italy has one of the largest retail appetites for bonds in Europe, and is fertile ground for new products, especially those with attractive coupons. “It’s no surprise that fixed reverse floaters, Libor-based structures, and 30-year Eurobonds are having a field day in lira,” says Schmidt at Barclays Capital. Unusually the Deutschmark sector, well known for its rigid adherence to five- and 10-year maturities, has broken new ground. In January Morgan Stanley and Barclays Capital brought a successful 30-year Dm1 billion domestic issue for the German state of Baden- Württemberg.

A turbulent phase

Lienhard at Toyota Motor Credit believes that we are entering a new and turbulent phase in the debt markets. He feels that “the role of the European retail investor – household names, smaller transactions – is diminishing” in favour of institutional investment. Also, investors may have an increased level of power in that they can demand more liquidity and transparency, and can ultimately “vote with their money”. Credit ratings have become much more important in the light of the Asia crisis, causing borrowing problems for the many unrated or low-rated corporates. “The changes are not necessarily all good, but you have to move forward and react to it,” Lienhard says.

Pavoncelli at Morgan Stanley believes there are still too many players in the Euromarkets. This competition between banks pushes fees for bond deals down, to the advantage of borrowers.

However, Pavoncelli warns borrowers not to take lower fees for granted. After Europe’s current phase of consolidation and mergers and acquisition activity, fees and therefore the overall cost of borrowing will rise again. Complacent borrowers will be penalized when investors decide not to buy. These changes seem to have made the debt markets a more perilous place for borrowers. Large issuers who have high credit ratings and can provide the liquidity desired by investors have every reason to be confident. But the new trends of increasing size and competition could spell trouble for corporates and sovereigns further down the scale. Oliveros at the World Bank is decidedly bullish: “Asia has forced people to change their strategies, but if borrowers are nimble-footed the new environment can be rewarding.”