Battle of the currencies
The sovereign debt crisis in Europe has cast a cloud over the euromarket in recent months, with even European companies often gravitating to dollar financing. But while international borrowers have hitherto been powerless to resist its allure, there are signs the golden era for dollar corporate bond issuance may be drawing to a close. David Rothnie reports.
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The US economy may be teetering on the brink of a double-dip recession; bond bears are predicting a spike in Treasury yields. But the story so far in 2011 has been one of European corporate borrowers continuing to flock to the dollar market.
“Since the fall of Lehman Brothers, it has been a golden era for the dollar as a financing currency, but the question is whether it is going to last,” said Marco Baldini, head of European corporate syndicate at Barclays Capital.
Yankee bond issuers have tapped the US markets in their droves in 2011, breaking the all-time monthly record in January as they found a near-insatiable demand from US credit investors.
Unlike their European counterparts, US credit investors have ploughed into high-grade debt in the search for superior returns as Treasury yields continued to fall to record lows. “From a liquidity standpoint the US on a like-for-like basis packs a bigger punch in terms of what it is willing to deploy in credit,” said Baldini. “By contrast European investors have deployed less in the credit markets as a result of the sovereign debt crisis.”
As Ireland and Portugal were forced to follow Greece into a bailout from the International Monetary fund, casting the euromarket into the shadows, the dollar market continued to glisten. The euro-dollar basis swap worked in favour of the dollar market, making it cheaper for European borrowers to issue in dollars then swap back into euros, than issue in their native currency.
In March, Bill Gross of Pimco, a leading dollar bear, announced that his fund had sold down its US treasury holdings in anticipation of a big sell-off. According to Gross, the completion of the quantitative easing programme at the end of June would lead to a massive overhang of US Treasuries that would send prices tumbling and yields soaring.
He was not the only one predicting Armageddon. Investment banks were warning their clients that ten year Treasury yields would surge and advising them to sit on the sidelines.
Short-term, both have been proved wrong. “US borrowers are much more yield driven than European counterparts,” said Baldini. “Banks had been telling issuers that 10 year Treasury yields would exceed 4% so when they dropped again to 3.25% there was another mini-explosion of issuance as borrowers jumped at their second chance.”
The result was another bumper month for US investment grade issuance in May, with US$99bn worth of deals done. But now there are signs of investor fatigue. Most deals done in the last month have underperformed in the secondary market and investors are asking for bigger new issue concessions.
One type of trade currently popular in the dollar market that may hint at a weakening of sentiment is the floating rate note. The heavy demand from US investors has perplexed analysts that view it as a bet on the collapse of short-term treasury yields. Others see it as a place for bond investors to park cash – without index constraints – and earn more than 0%, while retaining the flexibility to shift it quickly into longer duration bonds or out of the asset class altogether.
The dollar market has reached an inflection point. US borrowers have saturated the market. “Because of the low rate environment, every dollar borrower that can tap the market has done so. They’ve brought forward funding plans, refinanced. I can’t actually think of anyone else who could tap this market,” said one head of US debt capital markets.
By contrasts, the euro market is showing signs of life. May was a record month for issuance so far in 2011, as investors began to make clear distinctions between core markets and the periphery. “It’s like the headlines have got so bad, investors have almost decided to plough on regardless. It’s like the reverse of the capitulation trade,” said one syndicate head.
Meanwhile, the basis swap has come back into line following the sheer volume of Yankee issuance in the early part of the year, eroding the short-term benefit of international borrowers looking to arbitrage between the two currencies.
“The basis swap is not really a good enough reason for corporate borrowers to choose the dollar over the euro,” said Steve Barrow, chief currency strategist at Standard Bank. “At the moment, both are good currencies to borrow in because they are unattractive. Rates are very low and likely to stay that way, so the cost of borrowing is not likely to soar.”
A host of advantages
While short-term fundamentals may persuade international borrowers to favour the dollar over the euro, on a longer-term horizon there are other factors at play. International companies want dollars because that is where the action is. The commodities boom is largely funded in dollars, because the balance sheets of oil and gas companies are in dollars. European banks are beefing up their operations in the US, which also requires dollars. This demand exists despite the fundamentals of the credit market.
Big-ticket M&A activity is also skewed towards the US, meaning bidders need dollars. For example, in March Franco-Belgian pharmaceuticals giant Sanofi-Aventis tapped the market for a US$7bn six-part issue to take out a US$15bn bridge loan to finance its acquisition of US rival Genzyme.
Bankers predicted a big uplift in Europe’s M&A market in 2011, however, which could start to redress the balance, with knock-on benefits for euro debt issuance. However, big-ticket deals within Europe have not yet materialised. Activity has been confined to smaller bolt-on deals funded by cash on balance sheet.
The European markets have largely been closed to some borrowers, including banks, but that has had unintended benefits in the shape of a boom in euro covered bond issuance (see separate article). Moreover, it is only a matter of time before big borrowers return to euro markets, given their need to diversify funding over different durations, and for a capital structure comprising a variety of instruments. While low rates attract opportunistic borrowers, corporates take a more balanced view and look to both markets for their relative merits beyond the short-term technical differences.
Aside from its deep liquidity and sheer size, the US bond market is characterised by its vanilla maturities. It offers longer duration, with 30 year paper currently a favourite among pension funds seeking to match liabilities and borrowers looking to lock in low interest rates for an extended period. Conversely, it is difficult to go beyond 15 years in euros, though the market has developed in terms of off-the-run maturities, enabling borrowers to fill in the curve between 10 and 30 years.
While the post-Lehman era has created a vintage epoch for vanilla corporate bond issuance, the euro-market has gone in the opposite direction, with big European names sitting on the sidelines. “Post credit crunch big borrowers [in Europe] pre-funded so aggressively that they don’t need to access the bond markets,” said Baldini. “So instead, we’ve seen the growth of cross-over credits and unrated issuers turning to the bond markets to finance themselves, and filling the vacuum left by the blue-chip borrowers.”
There has been an explosion in assets perceived as low risk, such as covered bonds, which have often provided the only source of euro financing for the region’s banks. Otherwise they have turned to the dollar market for their financing needs. By contrast, US banks do not issue covered bonds, and nor do US borrowers issue hybrid structures.
Meanwhile, a strong month for European corporate issuance in May has lent confidence. “We are seeing anecdotal evidence of European fixed income investors returning to the fray and putting more cash into the market,” said Baldini. “There has been a lack of supply of European corporate paper and the recent pick-up is a source of encouragement.”
This month, there were reports that Siemens, one of the biggest borrowers to shun the European bond markets since 2009, is mulling a return.
The rally in Treasuries could even have further to run. After a stream of poor manufacturing and jobs data out of the US, the debate has moved back to the prospect of a third round of quantitative easing, or at the very least, a benign interest rate environment. The outlook for higher US rates in 2011 faded in June when reports showed manufacturing for May expanded at the slowest pace for 20 months, unemployment rose to 9.1% and consumer confidence fell to a six-month low.
“When QE2 finishes, the Fed’s monetary stance moves from easing to neutral,” said Barrow. “With the signs of a deteriorating economy, expectations of a rate rise are being pushed back into the future.”
That means that Gross and the bond bears could be in for another few months of pain. Borrowers face a choice: do they leap back into the dollar market to lock in financing at near record low levels, or hold off in the expectation that the dollar’s post-Lehman gilded era will finally come to an end?