Last month Freddie Mac did something that solid, dependable US agencies are not supposed to do: it took a gamble. It announced that it would start borrowing large amounts in euros.
The agency will issue what it calls eReference Notes, bringing to the euro sector the trend towards government-style borrowing programmes by frequent issuers which has swept the dollar market in the past three years.
It’s a gamble because the euro market is neither as deep nor as liquid as the dollar sector. Freddie’s European counterparts – triple-A-rated borrowers such as the European Investment Bank (EIB) and Kreditanstalt für Wiederaufbau (KfW) – have to pay more to borrow in euros than the US agencies do to fund in dollars. And Freddie will face the added cost of swapping euro proceeds back into its home currency.
Given prevailing swap prices and the spreads of comparable issuers, Paul Hearn, head of European debt capital markets at JP Morgan reckons it would cost Freddie Mac seven or eight basis points more to fund itself in euros than in dollars. That’s a huge amount of money for a price-sensitive borrower.
Freddie’s hope is that massively liquid euro bonds will cause that price difference to vanish. Liquidity can certainly make a huge difference to pricing. “Compare Italy and KfW,” says Hearn. “In dollars they trade side by side. But in euros, where Italy is large, liquid and trades on EuroMTS, KfW trades some 15 to 20 basis points back from Italy.”
The problem is that nobody is sure how liquid the new eReference Notes will be because nothing on this scale has been attempted before. “None of the European agencies have really done a benchmark programme in euros,” says Hearn. “With its Earns programme, the EIB has tried to do something similar to the US agency dollar programmes, but it has not been on the same scale. Freddie Mac’s decision to role out a benchmark programme in euros is an interesting and bold move.”
Freddie Mac’s chief investment officer Greg Parseghian points out that it is unprecedented for an issuer to have large, liquid issues outstanding in two different currencies. “We expect that our issues will trade at a comparable level to our dollar reference notes on a swaps basis,” he says, reckoning that arbitrage will quickly bring prices in the two currencies into line.
Several features should, in theory, make the notes more liquid than previous euro agency paper. The First is the sheer size of the e20 billion-a-year programme. Second, the pattern of borrowing will follow a predictable calendar – Freddie promises to issue e5 billion every quarter come rain or shine, either in new bonds or re-openings of old bonds. “We have not committed to the precise level of specificity that we have in our dollar reference notes programme,” says Parseghian. The annual calendar for the agency’s dollar reference notes programme spells out which maturities will be issued on which days throughout the year and in what size. But Parseghian expects the euro calendar to get more detailed over time.
But what should really give Freddie’s new euro bonds liquidity is that they will trade on EuroMTS, the electronic trading platform for eurozone government bonds. That should give the issuer access to a whole new class of investors.
Admitting mere agency paper is something of a U-turn for EuroMTS. Earlier this year, the organization responded to lobbying by Pfandbrief issuers who wanted to trade on EuroMTS by setting up a separate platform for non-government bonds. Known as EurocreditMTS, it admits only large, triple-A bond issues, but the eligibility criteria are slightly less stringent than for the main government bond platform. EuroCredit was seen by many as a poor substitute for EuroMTS.
“We are trying to achieve some degree of government surrogacy with the Freddie programme,” says Philip Brown, managing director in debt capital markets at Schroder Salomon Smith Barney. “So we were extremely enthusiastic that the securities should be traded on the benchmark EuroMTS platform.”
In early September, the board of EuroMTS is expected to agree a change in the rules. This will allow non-government bonds to be traded on EuroMTS provided they meet the standard eligibility criteria for government paper, notably that an issue must include e5 billion or more of outstanding.
The question now is whether European agencies such as the EIB and KfW, both of which have borrowing needs running to some e30 billion, will switch strategies. Last month the EIB announced that it would issue a global bond of at least e2 billion from its Earns programme, but that would still not be big enough for either a EuroMTS or a EurocreditMTS listing.
