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Saturday, 16 December 2017

DCM 2007: Icing on the cake?

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With many historical avenues of funding all but shut to borrowers, the non-core markets have been tipped by some to step into the breach. This may well prove to be a triumph of hope over experience, however, with risk aversion not purely the preserve of the more developed markets. Philip Wright reports.

While the US dollar and euro markets continued to be the source of cheap funding over recent times, there was little incentive for most borrowers to investigate the potential of the non-core markets. A limited number of issuers accounted for much of the supply in the more exotic currencies, and they remained an un-navigated backwater for the vast majority of international borrowers.

The world is a much-changed place nowadays, however, and the opportunities available in this arena will be something that will be closely scrutinised by a much larger constituency of fund-raisers. But there is one major question that arises again and again, and that is whether there would be sufficient liquidity to support an influx of new borrowers and, more importantly, whether investors have any great appetite for such product.

“If you have a substantial amount of funding to raise, it may not make the difference,” says Michael Gower, head of long-term funding at Rabobank, one of those institutions that has historically associated with spreading its wings wide when borrowing.

“It’s beneficial to do and it can be aggressively priced,” he continues, “but ultimately it’s not going to fundamentally change your profile.”

Rabo is, in fact, one of the few banks that pursue this course of action on a regular basis, the non-core markets more generally being dominated by supranational and agency borrowers, such as the EIB, KfW, Rentenbank and BNG, with whom Rabo shares Triple A status. It has continued to tap a number of smaller currencies from the Nordic countries to Australasia via Eastern Europe, South America and Africa and has built up a strong brand name in doing so. Its recent visit to the New Zealand dollar market, where it raised NZ$900m of Tier 1 capital in a transaction upsized from an initial NZ$400m target bore testament to the esteem in which it is held by investors. The simple truth is that without years of groundwork, it would not have been able even to contemplate such a move.

“Name recognition is of the utmost importance,” says Gower. “Anyone who doesn’t enjoy that is really going to struggle,” he added when considering the possibility of new borrowers looking at previously untried markets.

“It is very name specific,” says Moti Jungreis, managing director, currency trading and international fixed income at TD Securities, “but not only that, it is also country and sector specific.”

Holger Kron, head of niche currency Eurobonds and corporate credit retail at Deutsche Bank, is of similar opinion when it comes to new names trying to break into the sector. “To start now is not the smartest move,” he said. “Basically, issuers needed to have done it before. Investors are undertaking a great deal more credit assessment than was the case before: while some of them would have looked at a Single A before the summer, they are now more likely to give up 20bp or 30bp of spread to stay with a Triple A.”

Potential buyers are also now more willing to shoulder a greater degree of responsibility than previously, as highlighted by David Smith, executive director, EM local currency Eurobonds at JPMorgan. “Whereas before they would have focused on the ratings agencies’ views, they now conduct more standalone work. They assess credits more closely and compare the returns with what is on offer in their home markets,” he says.

The generic term non-core markets covers a multitude of currencies and jurisdictions, all of which display their own idiosyncrasies. The sector can more easily be split into two, however, these being the local currency markets and the more developed international areas such as Australian and Canadian dollars, although the volumes emanating from each category remain have remarkably in step with each other in recent times (see table). Because the latter category shares many characteristics with the euro and US dollar, the reaction of the two areas to the mid-summer volatility was rather different.

“In Canadian and Australian dollars there was a virtual buyers’ strike,” says Jungreis. “They moved in tandem with the US and Europe and credit spreads widened.” In the local currencies, where FX strategy plays a far more prominent role, however, this was not the case. “You might have expected the local currencies to have had their own little crisis, but apart from a week or two this didn’t happen,” continues Jungreis.

Whereas the crises of the late 1990s had an emerging market flavour to them in the guise of Asia and Russia, the current setbacks were generated in the US and exported to developed nations such as Germany and the UK, be it through direct exposure or knock-on effects.

“The effects on the non-core market have been relatively small,” says Kron. “The funding opportunities are the same as they were before, especially in the higher-yielding currencies.”

“If anything, [local currency] investors are looking to buy more,” suggests Jungreis. “There has been relatively little impact. It is not as busy as February or March but things like the Brazilian Real, Icelandic krona and Turkish lira have been among the least-affected markets. There is no funding crisis, there is no sub-prime crisis.”

Demand notwithstanding, the obstacle that often limits the viability of many of the smaller currencies is the lack of a developed swap market in those markets. Taking Botswanan pula as an example, Rabo’s Gower sums up the situation. “If you do a US$50m trade, you can knock out the market for anyone else for the next few months,” he says.

Much for this reason he sees no obvious new currencies breaking into the markets, although he does see opportunities for issuers in areas where they have not been overly active previously. As far as Rabo is concerned, one market he highlights is the Mexican peso (although Rabo has before been present in the Europeso arena), the large number of cash-rich Mexican pension funds the major attraction in this case.

So for any new credits hoping to break into the markets as a way of diversifying their funding pools, there appear to be a number of significant, if not insurmountable, obstacles. The small scale of many of the local currency markets is one and even in Australian, New Zealand or Canadian dollars, the depth pool of liquidity is only so deep, although appetite has increased in the first two as repo-eligibility rules have been relaxed.

“Risk appetite has waned significantly,” says Gower. “What you are often asked to do is pay up, offer an attractive coupon and tempt in retail. You have to embark on extensive marketing and make sure that potential buyers are confident with the credit. Investors will to look to eke out as much as they can at the moment.” And it is difficult to argue anything apart from the fact that that the power currently lies in buyers’ hands.

With equity markets close to all-time highs, it will be a difficult task to attract them to bonds, points out Kron. “A few houses have found some new buyers,” he says, “but does this mean that these markets are open for new issuers? Generally no, but maybe individually yes. If you are a financial institution that suffered in the crisis, you won’t be able to issue unless you pay up noticeably, but if you are a corporate that was not affected, you could go and try at higher levels too.”

He does not think this is a realistic outcome, however, seeing the trend very much towards the maintenance of the status quo, in that the sovereign and quasi-sovereign credits will continue to dominate.

“Double A is really about as low as we go,” confirms Jungreis, “and we are still seeing good demand for sovereign supply.”

Indeed, with the outperformance that has been evident across the non-core currencies throughout this year, there is little incentive for issuers to add extra layers of credit risk on top. Aided in no small part by US dollar weakness, currency appreciation and coupon payments have seen the sector’s best performer, Turkish lire, returning 35%, with Icelandic kronor and Brazilian Reals not far behind. Numbers in the high-teens are fairly commonplace and even the lowest earners such as Argentinian and Mexican pesos and Chinese renminbi have yielded 4%–5%.

“[Non-core] has been the strongest-performing asset class at a time of caution,” says Smith. “It rallied through a crisis, but the outperformance has been so strong that a pull-back may be expected,” he cautions. “In the near term it could stall, but the medium term looks constructive.”

Potential profit-taking aside, it looks as if the non-core sector will continue to offer future funding opportunities. As to whether this will extend to issuers that have not previously is less certain, however. Investors are unlikely to feel the need, or indeed have the desire, to further complicate their portfolios with previously untested credits so soon after the recent volatility. The winners will be the market stalwarts, for whom it looks like being a case of business as usual at worst and increased appetite at best.

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