Parallel lines that merge

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Issuer: Republic of Austria
Amount: Ffr5 billion
Launched: January 13
Lead managers: JP Morgan/CDC

Watch out for a lot of regular Euromarket borrowers issuing instruments called parallel Eurobonds. This January, the Republic of Austria unveiled an innovative attempt to position its borrowing programme for the pan-European government bond market that should quickly emerge following the introduction of the single currency from 1999. It sold Ffr5 billion ($902.5 million) of parallel Eurobonds to a range of French and other European investors in a well-supported seven-year issue led by JP Morgan and CDC Marchés.

The French franc Eurobonds carry coupons (5.5%) and maturity dates (January 18 2004) identical to an existing benchmark domestic Austrian Schilling Bund. The deal offers investors options eventually to merge the bonds into larger, euro-denominated issues.

Austria expects to be among the first states to participate in the European single currency from January 1 1999. It is likely to convert its domestic government bonds from Austrian Schillings into euros, although it has made no commitment to do so yet. Only France and Belgium have. Even Germany has made no explicit undertaking immediately to redenominate its entire domestic debt and Austria does not want to pre-empt it. But redenomination of both domestic debts is likely. Moreover Austria has, in a special departure, undertaken to convert the relevant 5.5% Schilling bunds due 2004 into euros. At the same time, it will have the right to redenominate its new French franc Eurobonds into euros.

Investors will then have the option of exchanging their old French franc Eurobonds for holdings of the old Austrian domestic Bund, now redenominated in euros. They can do this on each of the first two annual coupon-payment dates following European economic and monetary union (Emu). The issue size of the already well-traded domestic Bund is Sch15.46 billion (Ffr7.5 billion). Were the entire French franc issue to be exchanged, the Bund issue would be brought up to the euro equivalent of Sch25 billion. With five years remaining to maturity from January 1999, it would create a very large issue in a benchmark maturity with placement and trading inside Austria and abroad.

"In effect, Austria has already pre-placed its euro bonds with long-term French investors," says Joseph Cook, managing director at JP Morgan, "which is a very appealing thing to be able to do." It is likely that there will be intense competition between larger borrowers for investors' attention in the new euro-denominated bond markets. Most European countries rely heavily on their own domestic investors to buy government bonds in their home currencies. Come the euro, governments will try to encroach on each other's territory, placing bonds with investors that previously bought only domestic national-currency bonds. It is easy to foresee the larger European government issuers such as France and Germany establishing their bonds as the most-traded and popular euro benchmark issues and crowding out the smaller issuers.

Austria has launched a pre-emptive strike in the battle for European investors, effectively attracting foreign buyers into its domestic bond market. Other sovereigns, including Scandinavian countries, have already shown an interest in the structure.

Austria is already unusual among European sovereign borrowers in including non-resident firms among its leading government bond dealers. Following the single currency more of the smaller European countries may have to follow suit.

French investors, knowing their own government will redenominate, are already strongly interested in the euro. They proved keen buyers of French franc bonds from a country rated AAA by both Moody's and Standard & Poor's and yielding seven basis points over the interpolated OAT yield curve, especially knowing that Austria's Eurobonds have clear legal provision for redenomination.

Some investors in the deal, perhaps for tax or other considerations, may wish to hold on to their Eurobonds, in which case they have a second option. They can consolidate their old French franc Eurobonds into a new, fungible jumbo euro-denominated Eurobond which might also incorporate a series of other Emu-currency Eurobonds that Austria intends to issue between now and 1999. Obvious candidates for future parallel Eurobond issues would be bonds denominated in Deutschmarks or Dutch guilders. Following Emu, these might be redenominated into euros and combined with the old French franc bonds into a new giant euro Eurobond.

Whether or not Austria does issue such additional parallel Eurobonds partly depends on its ability to match maturity and coupons with fungible domestic Schilling issues. It must be wary of adding to outstanding debt maturing in years where it already faces substantial redemptions. "We are not intending to increase our foreign-currency debt just to provide liquidity for such an issue," jokes Helmut Eder, head of the Austrian national debt office, "but obviously this would be an interesting possibility for investors."

Such a large euro-denominated Eurobond would enjoy strong investor support in France, Germany and the Netherlands and would have dealers based in each of those countries from the original new-issue syndicates committed to making markets in it. By contrast, old national currency Eurobonds that do not carry the range of redenomination, exchange and conversion options Austria is providing on the parallel deal may suffer a dramatic loss of liquidity and sponsorship following introduction of the euro. Investors must wonder, once France's domestic government bonds are converted into euros, how interested leading French banks and primary dealers will be in trading old French franc Eurobonds. It is likely Emu sovereign bonds in the old European currencies, narrowly placed with small groups of domestic buyers and with limited market-making, will trade at lower prices than new euro-denominated bonds of the same issuers.

"We feel there will be a lot of these orphan bonds around post Emu, with only scrappy local trading," says Cook. Austria first sounded out banks for proposals on such an innovative financing last September. JP Morgan spent four months in discussions with Euroclear, Cedel, Société Interprofessionelle pour la Compensation des Valeurs Mobilières (the French clearing system), the French Trésor (state treasury), the Commission des Opérations de Bourse, lawyers and the borrower, while perfecting the legal structure. It was considered crucial that the documentation be written in English and the deal be subject to English law. "The mechanism for exchange and consolidation of future parallel bonds is now ironed out. I expect this will be replicated by other issuers," says Cook.

Whereas national governments can alter their domestic bond markets almost at will, Eurobonds are more complex contractually. Redenomination into euros of European-currency Eurobonds that do not carry similar documentation is theoretically possible. But it would be difficult, requiring approval from a significant majority of bondholders. Tracking them down and meeting them would be hard enough. Even if this could be managed, issuers would face the expense of recalling national-currency bearer bonds and issuing newly printed euro ones. To avoid this problem, the Austrian French franc parallel deal is in the form of a permanent global note.

The deal was snapped up by French and non-French investors, the latter taking 40% of the deal. Austria achieved tight pricing by issuing in a currency where absolute rates are low. But does the deal's popularity suggest generosity in the first-ever Euro-French franc deal from such a highly rated sovereign? "We never undertake an issue for purely political reasons. It must also be economic to do it," insists Eder. But investors may have taken their conversion and exchange options for free. "As these were the first such options, it was impossible to establish a value for them," says Eder. "Their value will emerge later."