Cracking into sterling

Gordon Brown: has put off a decision on the UK’s entry into the eurozone for at least a year

THE STERLING CORPORATE bond market is a strange beast. It is small, quirky and dominated by a cosy group of investors and the banks whose traders and sales people have befriended them. One banker goes so far as to describe it as a cartel. It is certainly a tough nut for the outsider to crack. Yet since June, when UK finance minister Gordon Brown deferred making a decision on the UK’s entry to the eurozone for a year at least, several brave continental European and US banks have decided that they want to increase their push into the sterling bond sector.

The drive to find new lucrative revenue streams in an ever more competitive European bond market is laudable, but it is not at all certain that they will be able to infiltrate the clique, let alone make any money.

The banks that are successful in this market already are dominated by UK players that have lending relationships with sterling customers to snap up the primary market business and or historical expertise in sterling sales and trading.

Royal Bank of Scotland, HSBC, Barclays Capital and UBS fall into this category, the latter by virtue of the former SG Warburg’s sterling business. Morgan Stanley is the notable exception. The US bank has earned a place at the high table largely on the back of its trading strengths – it hired arguably the market’s best euro sterling trader, Darren Bowler a few years ago and hasn’t looked back since.

Looking at the primary markets, at the end of last month, Barclays Capital, RBS and HSBC had done almost 45% of the business year to date between them. On the secondary market side, Morgan Stanley, UBS and Barclays Capital have the strongest franchises.

“HSBC and RBS have the sterling primary market sewn up because they are big sterling loan houses. But they haven’t really converted deal flow into secondary market strength, which can be a huge cash cow,” says one competitor. For all-round strength in trading, origination and research, investors bring up these same names.

Banks such as JPMorgan want to change all that. In June, in response to Brown’s statement, it hired sterling experts Ray Sykes, a UBS trader, and Michael Leonard, a portfolio manager at Aegon, one of the key sterling fund managers. Both joined to trade sterling industrials and utilities.

On top of that, JPMorgan is carving out a separate sterling department within the European debt capital markets team, with Jonathan Hoyle appointed to a new position as head of sterling credit in addition to his job as head of European corporate syndicate.

The bank also added one person to its UK bond sales force and appointed Jonathan Todd within the credit research team to coordinate its sterling research effort. “The Brown decision was coincidental,” says Hoyle. “At the beginning of the year we decided that sterling was too significant a market not to be a market leader. The primary objective is financial but it also completes our credit picture.”

JPMorgan was already top of what Hoyle terms the second division of sterling banks before this effort, but ABN Amro and BNP Paribas, the other two banks that are making a big push into sterling, come nowhere in the sterling rankings, either for trading or origination. The task ahead of them, faced with such stiff competition from established players, is even more daunting.

The rationale is pretty clear. Not only is sterling a hot market to be in right now, but if and when sterling joins the euro, these investors will be long euro buyers and will count for a significant proportion of euro turnover. It makes sense for the banks to get to know them now. Niall Cameron, global head of credit markets at ABN Amro, says: “We think that it is important whichever way the decision goes. If sterling doesn’t go into the euro, we will need a large stand-alone sterling business. If it does, as a large euro house we will be set to benefit from this.”

Unfriendly to newcomers But many banks have tried to make their presence felt in this market before and quickly disappeared again. Are the newcomers going to see much of the investors’ business?

It is relatively easy for banks new to the sterling scene to make headway in the primary market and, in the case of BNP Paribas and ABN Amro, capitalize on their strength in euros and the issuer relationships they have developed as a result.

The fees on sterling issues, which are typically much longer dated and often highly structured, are also appealing. For example, BNP Paribas has done three or four index-linked sterling PFI bonds – high-margin business for the bank, with lots of structuring fees. And, according to David Ovenden, head of global credit products at BNP Paribas, there’s a lot more demand from issuers: “We have numerous clients on the issuer side wanting to do something in sterling.”

The addition of some specialist sterling syndicate officials to a debt capital markets team is generally an asset. The sterling market, having been around a lot longer, has produced specialists with much more experience in credit analysis than counterparts in the euro market and a better understanding of the value of covenants in bonds, for example. Indeed, both Anthony Barklam, head of corporate syndicate at Morgan Stanley in London, and JPMorgan’s Hoyle come from a sterling background. And if the UK does adopt the euro, bankers think that there will still be demand for these types of long-dated, covenanted assets from funds, whatever the currency.

Sterling investors generally welcome the idea of more new issues coming to the market as more banks get in on the act. “The more guys in the market can only improve the liquidity. The broader the origination, the broader the universe of issuers, with some new names,” says Stephen Snowden, investment manager at Aegon. “The European banks have been well received in the market and that’s probably because of the diversity they offer.”

Yet this is still a small market, with not that much business to go around. “At £46 billion of issuance year-to-date, the sterling new-issue market is a lot smaller than the euro market, with e608 billion of issuance year to date, and the deal sizes tend to be smaller, typically £200 million to £300 million,” says John Winter, head of European investment banking and debt capital markets at Barclays Capital. Recent large-scale sterling deals like those done by the BBC [see BBC tunes in to securitization, this issue] and Southern Water are in the minority. “The investor base is growing but remains limited because these deals are usually sold to a select group of institutional investors, with virtually no retail participation,” says Winter.

Some non-UK institutional investors have invested in sterling deals, and non-UK issuers have also done some issues, tapping into the longer-dated investor demand available in the sterling market and creating some price competition with any of their outstanding euro issues. General Motors’ recent two-tranche £600 million deal issued in June by Barclays Capital, Goldman Sachs and Merrill Lynch is a good example. But this still only accounts for a small proportion of the business and has not taken off in any big way. “Banks will go on about leveraging their European client franchise but the fact remains that 90% of sterling business is transacted by UK-based investors, so it’s a limited pie,” says JPMorgan’s Hoyle.

The main problem is that investors put much more value on banks being good liquidity providers and market-makers than they do on those just offering a pipeline of sparkly new issues. “New-issue supply is important, but most important is secondary-market trading ability,” says Snowden at Aegon. “Usually guys with a big secondary-market presence have decent new issue businesses anyway. We’ve seen flurries in primary issuance from certain institutions that have not invested sufficiently in the secondary market to back this up, but these institutions don’t tend to stay on the scene for very long.” In particular it is some of the US banks that have been deemed guilty of this in the past.

Investors find this practice frustrating. “It’s the most infuriating thing,” says Rebecca Seabrook, investment manager at Isis Fund Management. “They take the fees off the primary market but then don’t consider how much they will have to invest in secondary trading. There is room for more players in this market but they have to be serious about it.”

Winter agrees that succeeding in sterling trading requires long-term commitment. “In the sterling market you have to make markets in good times and bad – credibility with investors can take a long time to establish.”

But this presents something of a vicious circle when the trading side of the business is even more of a closed shop than the rest of the sterling business. “We use four key accounts that will see the majority of our business,” says Snowden. “This doesn’t mean we shut the others out and any one of those four can change at any time as banks come up and down in favour but we will deal mostly with them.”

This is pretty much standard among all the key accounts. “Sterling turnover is concentrated in a much smaller number of hands – unless you’re on an investor’s core list, you are not going to get the business,” says Barklam at Morgan Stanley. “You cannot buy your way into this sector. It’s a relationship thing.” Another banker’s view is that sterling investors are just unnecessarily “sniffy”, but he concedes: “Like all cartels, the only meaningful barrier to entry is the lack of inside knowledge.”

Sometimes, investors can refuse to deal with a bank, even on a new issue, unless they have a counterparty relationship with it. “We are limited in the number of counterparts we can deal with simply in terms of how many we can know thoroughly,” says Seabrook at Isis.

Comfortable in the inner circle So if you’re among the inner circle of traders and see a lot of volume, it can be very profitable. On the outside it can be miserable. If banks don’t see the flow of business, the illiquidity of the market means that sterling trading desks can be costly to run. “The main reason that we have been more cautious in the past is because you can make too much liquidity and end up not being able to offload the bonds,” says one banker.

As Barklam points out, this means you can easily get stung if you do not see the volume. “It can be dangerous to be in the sterling secondary market, because it is relatively illiquid. In dollars or in euros, you can close out a trade with the street for just 2bp to 3bp of loss, in sterling it can be more like 10bp to 15bp if you don’t have the end investor deal flow.”

BNP Paribas and ABN Amro, like JPMorgan, have attempted to access investors’ preferred counterparty lists by recruiting industry heavyweights, particularly on the sales and trading side of the business. These are the people that already have the relationships with the key accounts and therefore can act as gatekeepers to the banks getting these investors’ business. ABN Amro has hired Dan Broderick from Goldman Sachs to head its sterling credit trading division. This was done to complement the hire from CSFB of Stuart Bell, another former euro-sterling trader, into a new role of head of sterling credit markets as well as European corporate debt syndicate to lead the bank’s push into the primary sterling market.

BNP Paribas has been selectively hiring key sterling specialists over the past year. Nick Tudball, a senior and well-respected sales manager at UBS, is now sterling product manager for BNP and will head the bank’s sterling efforts. Simon Towler has also been brought in from Deutsche Bank as a senior product manager.

Ovenden says the plan is to source talent from within the bank to support these senior appointments. “We think the shotgun approach of hiring a team of 12 in one hit is outdated. You need a limited number of key specialists to start the process off but there is too little confidence in banks’ ability to build a business internally.”

Sterling credits trade very differently to euro credits, which often means that banks have to carry the expense of separating out sterling trading from the rest of their debt-trading functions. Then they have to dedicate balance sheet to sterling trading.

On top of that, the traders and sales people with the specialist skill sets and contacts books are in high demand. There is an elite band of sterling specialists who have the market knowledge and reputation to open doors and they certainly don’t come cheap. As one banker points out: “There is a small universe of real specialists that are widely overpriced. When they’re in fashion, as they are now, people will pay a lot for them.”

Bankers believe there are other ways of building a sustainable trading business. Hoyle at JPMorgan points out that the bank’s derivatives business allows it to manage its positions better. “We have such an integrated credit trading team that the sterling specialists have many more options to off-set risk. Traders can hedge inventory in euro credit or derivatives, which means that we can be much more aggressive in pricing than our competition.”

Differentiation counts Ovenden points out that committing the balance sheet, producing good research and generating innovative ideas wins brownie points with investors. “If you have the ideas and the product, people will deal with you,” he says. “It’s only if there’s little differentiation between you and your competitors that the problems can arise. What you can’t do is cold call investors and say ‘hey, we’re in the sterling business, how can we help?’ because they’ll tell you to get lost.”

It does seem that what investors really want is expertise across the board. Laurent Frings, credit analyst at Morley Fund Management, says: “We look for three things from banks – how good their sterling new-issue business is, their ability in the secondary market and the strength of their sterling research. The three or four top players can do this. The rest of the banks are coming to the market with one or two of these three.”

Frings adds that, in this context, the others will find it challenging. “If it’s hard for a bank like JPMorgan, it will be very difficult for the European players to successfully develop their franchise in the period before euro entry. The new entrant banks may be better off focusing on one specific area in sterling, like proprietary trading.”

Unsurprisingly, the banks expanding in this area are pretty confident that they can do it. Hoyle says: “We are committed to becoming a top three dealer. We have seen a threefold increase in our trading volumes this year and a huge concurrent increase in profitability, even though the sterling market itself has remained static.”

“We have no ambition to become a top-three player anytime soon, but we think we’ve now got the self-confidence in the institution to begin to win more sterling business,” says Ovenden. “It’s amazing how fast you can build a franchise. We did it with our hybrid capital business, for example.”

He may be right, but a senior banker at one of the established sterling houses reckons that anyone who thinks that sterling is going to be a fantastic revenue generator just because the margin on the new-issue business is attractive is deluded. “If people think this is a very profitable business, they’re in for a shock. IPOs are profitable if you ignore all the infrastructure around them. We have invested heavily in sterling trading and research, as well as our new-issue platform. The perception that the sterling market is just about sleepy companies paying bankers juicy fees to sell these bonds to sitting-duck investors is just not true.”

Even if these banks manage to break into the inner circle, it could prove a costly business to stay there.