Although deeper and more liquid than anyone had dared predict, the nascent euro-denominated bond market in 1999 had one weakness: it was failing to secure may US issuers. However, during the first eight months of this year the costs of issuing in euros narrowed for a great many US borrowers, and increasing numbers of them began to recognize the attraction of the euro market.
The prospect of investor diversification beyond the traditional base was always an attractive one for American end-users. Moreover, the cost of borrowing in the euro market is generally lower than in the domestic dollar market. But these advantages were not sufficient to overcome one big disadvantage for US borrowers that needed dollars as an end currency: the cost of the basis swap from euros to dollars.
The cost of swapping from five-year floating euro exposure to floating dollar exposure currently costs the borrower up to 4 basis points; at 10 years it is 4.25bp. In the early days of the euro-denominated bond market, this cost was even more prohibitive and ran to 6bp or 7bp at 10 years. “The basis-swap cost did put a lot of people off,” agrees Paul Richardson, treasurer of scientific publishing house Reed Elsevier.
At the outset it was thought that the appreciable cost of swapping euro debt to dollars (and, conversely, the pick-up from the opposite trade) would narrow as the market gained maturity. However, although it has narrowed by several basis points, it has remained prohibitive for end users of dollars. The basis-swap market functions purely on supply and demand, and as there has continued to be greater flow from dollars to euros, so the market has continued to be well bid.
The basis-swap market also tends to move suddenly and capriciously when supply hits it. It is not the most liquid sector, and big debt issues can move it several basis points in the wrong direction. Issuers that have wished to move large-scale exposure from euros to dollars have seen the market quickly spike up by several basis points, raising their borrowing costs commensurately.
However, for much of this year, the euro market has allowed much more favourable pricing of debt than the dollar market. Indeed, the scale of the differential has been such that for many US borrowers it has been cheaper to issue in euros and swap to dollars, the basis swap notwithstanding. “Until very recently, the euro market up to seven years was so much better in pricing than the dollar market. Even after the basis swap it was still cheaper for US dollar borrowers,” explains Richardson.
Robin Stoole, syndicate official at JPMorgan in London, agrees. “The currency basis swap has become less of a problem. It is smaller than it was, and the euro market has been on fire. There is a screaming demand for credit,” he says.
The front end of the curve has seen the most significant difference, but substantial savings have even been made in the three- to seven-year area of the curve. At its widest point in March of this year, a double A-rated borrower could issue five-year debt up to 15bp cheaper in the euro market than in dollars and a single A-rated borrower could secure a 10bp saving, estimate syndicate bankers.
The favourable treatment afforded to borrowers in the euro market was a result of simple investor demand and differing pockets of liquidity. Traditionally suspicious of weaker credits, European investors have become increasingly prepared to reach down the yield curve in search of greater returns. According to the Salomon Smith Barney Euro-BIG Corporate Bond index, triple-B credits provided returns that were 50bp better than single-A credits in the first six months of this year. Meanwhile, single-A credits provided returns that were 90bp better than double-A credits.
“The euro market is still relatively immature and the depth of the dollar market is still greater. But it is increasing in depth all the time, and European investors are getting more comfortable with lower-rated credits,” explains Stoole.
| US corporate issuers euro-denominated bonds (Jan-Sep 2001) | ||||
| Rank | Issuer or group | Amount (emn) | Issuances | % share |
| 1 | Ford Motor | 9,940 | 12 | 42.13 |
| 2 | General Motors | 5,287 | 9 | 22.41 |
| 3 | General Electric | 1,325 | 9 | 5.62 |
| 4 | MCI WorldCom | 1,250 | 1 | 5.3 |
| 5 | Hewlett-Packard | 750 | 1 | 3.18 |
| 6 | Baxter Travenol Laboratories | 650 | 1 | 2.75 |
| 7 | KPNQwest | 500 | 1 | 2.12 |
| 8 | Toys ‘R’ US | 500 | 1 | 2.12 |
| 9 | HJ Heinz | 450 | 1 | 1.91 |
| 10 | Liz Claiborne | 350 | 1 | 1.48 |
| Total of issuances used in table | 23,594 | 52 | 100 | |
| Source: Capital DATA | ||||
Enormous demand created pools of liquidity that were not apparent for US borrowers in the dollar sector. The pricing differential between dollars and euros clearly varied considerably according to credit profile, maturity and timing, but one investment banker estimates that it was sometimes as much as 20bp. Clearly, the dollar market has seen very strong demand for credit product as well – it is just that the euro market has outperformed it on a relative basis. Both fixed-income markets have been aided greatly by the lamentable performance of equities worldwide this year.
According to Bloomberg data calculated in mid-July, since the beginning of the year the average yield on 10-year A2-rated euro-denominated debt had fallen to 6.2%. In contrast, the average yield on 10-year dollar bonds issued by A2-rated borrowers had contracted to 6.98%.
At the end of July, Reed Elsevier brought to market a three-tranche dollar and euro offering that exemplified these trends. The deal consisted of a 6.75% $550 million 10-year note, a 6.125% $550 million five-year note and a 5.75% e500 million ($480 million) seven-year note. The lead managers were Lehman Brothers, Salomon Smith Barney and UBS Warburg.
The five-year dollar tranche was swapped to floating dollars and the 10-year dollar tranche was kept in fixed dollars. The seven-year euro tranche was swapped to a combination of fixed and floating dollars, as Reed Elsevier had no need of dollar exposure. But it chose to issue in euros and swap to dollars partly because, at this maturity, it was more cost-effective for it to do so despite the basis-swap cost.
The euro tranche was priced to yield 106bp over the 4.75% Bund due 2008, or 5.825% semi-annually reoffered. This was equivalent to 72bp over mid-swaps, and the basis swap to dollars added 3bp to costs. Thus the borrower may have achieved a reoffered cost of around Libor plus 75bp, and this was several basis points – “in the single digits” – better than would have been achieved in the dollar market, says Richardson. Part of the deal was swapped to fixed-rate dollars, and the equivalent fixed-rate cost was around 165bp over treasuries.
The five-year dollar tranche achieved an after-swap cost of around Libor plus 67bp – only 8bp cheaper to the borrower than the seven-year tranche for a shorter liability and with no basis swap to consider.
Richardson stresses that a joint euro and dollar offering was also attractive in that it allowed the creation of “pricing tension” between the differing maturities and currencies, which furnished more attractive pricing in each. The seven-year tenor is in fact the point at which the steeper euro market and flatter dollar credit curves intersect, notes Stoole. In a two-tranche issue, euro-denominated debt can be placed at this maturity without prejudicing pricing of dollar debt at different parts of the curve. When WorldCom brought its $10.2 billion equivalent multi-tranche, multi-currency jumbo in May via JP Morgan and Salomon Smith Barney, it offered dollar debt at three years, 10 years and 30 years while placing euro debt at seven years.
Nonetheless for some borrowers the basis-swap cost remains a formidable impediment to greater participation in the euro market. Toyota Motor Credit Corporation, which swaps all debt to floating dollars, seriously considered the prospects of issuing in euros in the early summer when demand was at its greatest, but the basis-swap cost was still prohibitive, says treasurer Lloyd Mistele. “The costs of issuance are very competitive with the dollar market but the basis swap makes it unattractive relative to dollars,” he says.
TMCC has issued smaller, retail-targeted issues in euros, and in these sort of transactions pricing can be squeezed. But for the larger, institutional transactions the dollar market still makes more sense. Mistele adds that basis-swap costs for TMCC have been at least 5bp and at times have been as high as 10bp.
Through the first four instalments of its EuroReference Note programme, Freddie Mac has discovered that it has been impossible to match dollar funding costs in the euro market. Though the triple-A rated US agency had at first hoped to secure comparable costs in the euro market, the programme – though a success in every other way – has consistently produced funding up to 10bp more expensive than would have been the case in dollars.
Neither can US borrowers place long-dated debt in the euro market. Issuers that wish to contract 30-year debt must do so in the dollar sector. Moreover, some US borrowers have little chance of placing debt successfully in the euro market, despite the increasingly cosmopolitan nature and readiness to accept lower-tier credits of the latter. “Some issuers have got a cat in hell’s chance in the euro market,” adds Stoole.
The luckiest US borrowers – and there are growing numbers of these – are the ones that can keep euro debt fixed in euros and have no need to navigate the spiteful waters of the basis-swap market.
These names can take advantage of the ferocious bid for credit and have a natural hedge to this exposure from European operations. For these end-users, the tribulations of the basis-swap market are a glorious irrelevance.
