Non-Core Bond Markets Roundtable 2007: Part one
IFR: Issuance in non-core currencies has historically tended to be dominated by large, generally supranational and agency borrowers. Will they continue to dominate, or is there a possibility that banks or issuers lower down the scale could begin to investigate the opportunities to a greater degree?
Michael Gower (Rabobank): Speaking as a bank, a non-supranational or agency borrower, I have to state that it is not purely an agency and supranational market. That being said, it is clearly a market that has been developed and dominated so far by the Triple A universe. I think the reason for that is that the Triple A borrower base is able to execute and take advantage of arbitrage a lot quicker and be a more appropriate swap counterparty in certain niche currencies than many of the lower-volume, lower-rated borrowers.
That being said, as a lot of these currencies become more mainstream, such as the Turkish lira and a lot of the central European currencies, the number of lower-rated, lower-volume borrowers that have become involved has increased.
I think it is something that could continue going forward. But, having said that, it is still likely to be dominated by the Triple A universe purely as a result of the desire to find new pockets of liquidity and new currencies and new markets in which to operate.
IFR: Petra, would you welcome new borrowers coming into the market?
Petra Wehlert (KfW): In general for us, for obvious reasons, it is great that names like KfW, explicitly guaranteed by their governments, are very deeply involved in that market. It is a great market for us and we are relatively quick in execution because we know this is one of our advantages, but after a while investors will look down the credit spectrum. This is a quite natural development and when we see more names, we have to look for new markets. Then again, I also think that at the beginning, when markets are still very volatile and not very well established, people do not care so much about 10bp or 20bp pick-up for a Double A name, and therefore they go to the SAS sector. But after a while, yes, they will look down the credit spectrum, and this is something that we appreciate and we will look for new markets where we can be first again.
IFR: Is there a battery of new borrowers looking to get involved in the market?
Holger Kron (Deutsche Bank): Obviously, every borrower is sitting there and looking to diversify its investment base. It is interesting to tap new markets because there are values to be gained. On the other hand, you have a perception of credit and currency risk that the investor has to evaluate. The bottom line has to do with a lot of market functions, such as why people buy lower-scale credits in any curve. But the less developed a market is, the more you have to go for Triple A borrowers and the more the market develops, the more other borrowers will try to come in and take advantage. The more liquidity and transparency growth in a market, the more investors will take on credit risk.
And today, with new instruments like credit default baskets and credit default swaps, it is easier to enter credit in all sorts of structures. So the universe becomes broader and wider, as the tendency of the market is that credit becomes less of a risk. This might change as the direction of the market changes and credit risk becomes more of a concern, then, obviously, people will step back from credit risk and return to Triple A borrowers.
So, in the end, it will stay a Triple A market: after all, we see this in euros and US dollars, with the basic funding done by Triple As. But everybody will try to do their funding as cheaply as possible, and as soon as you get the opportunity to do it in a niche currency, you will do so.
IFR: Is it fundamentally a ratings-driven market then?
Moti Jungreis (TD): Generally speaking, yes: definitely from an international investor perspective. If you are an international investor, you are looking mostly at the currency and rates play. I think where the opportunity will come is from domestic investors. We see it in Australia and Canada, where people have been slowly willing to go down the credit curve, and there have been some great trades on that front.
If you are looking at the more exotic currencies, be it Turkish, Mexican or Russian, they will have to come from the local investor and the local pension funds, how they are regulated and what kind of diversity they are allowed to have in their portfolios.
I think the big opportunity will be that investors in those countries will come and say, "Okay I want to go down to the Double A or Single A space, but I do not want to have currency exposure, so bring me paper that is denominated in my currency." That is the opportunity. I think it is still at an early stage. We have definitely seen it in Mexico, and if you look at Russia and what people buy in Russia, it is very low-grade product, but they have not really gone outside Russia to look for those types of names, because they are not really allowed to. That is where I think it needs to change for us to see a significant number of issues down the credit curve. There have been banks issuing, but the easy trades are still in the Triple A space.
IFR: Could it be said to be becoming more of a name recognition market?
David Smith (JPMorgan): Name recognition is one factor, but I think, fundamentally, if you are buying a Eurobond it is generally because you do not have access to the local underlying market. Once you have made that decision, you really want the greatest liquidity possible, and the reality is everyone will trade, buy and invest in a Triple A name. Whereas if you go down the credit spectrum road to Single A financials, you will have fewer people market making, fewer investing, and therefore less liquidity for the end investor. When you are looking for credit diversity, you are either going to see people look at the Triple A space, or going to the end of the spectrum buying local emerging market credits, such as Russian and Kazakhstan banks in the local currency, because that is where you get your real credit play rather than buying an investment-grade financial.
IFR: It seems that in some of these currencies, such as Russian roubles, it is the Triple A sector that has made some sort of imprint on the market, although often with not very much by way of follow-through. Is it a completely different investor base that is interested in local credits and that will be active in the lower end of the credit spectrum, rather than international investors looking to diversify into those credits?
David Smith: I think you have a bit of both. The supranational Triple A names will always make the first in-roads into some of these local markets, often because they have ties with the government agencies in the domestic markets. Also, in some cases they have liability matching, where they may have on-lendings in Russian roubles, for example. So it makes sense for them to lead the way in innovation. And in terms of the investor base, it offers an access point for a very significant number that cannot buy local credits settled domestically.
IFR: Do you expect the amount of borrowing in niche currency markets to continue to rise or is it stabilising at the current levels?
Petra Wehlert: It has definitely been rising. For us, it also compensates for the weaker structured bond market. We used to do a lot of structured bonds in the US dollar and euro markets. That is now quieter, but it is more than compensated for by the interest of investors in exotic currencies. For us, if you exclude US dollars and euros, one-third of all our funding was in 21 other currencies last year, so it is quite a substantial part of our business. But I would also exclude the sterling market, the yen market, or even markets like Australia and Canada, which are well established. Apart from that, we cover the whole spectrum: Turkish lire, Botswanan pula, Egyptian pounds, Russian roubles. These are more the currencies that we sell internationally, where we can be very quick at execution and where we are very flexible. If investors change their view on a currency and want to have new one, then we can react quickly and can print bonds under our note programme. On the other hand, we have access to local markets, especially in Asia, where we have specific relationship with the central banks and the authorities. That is why we have established an MTN programme in Malaysia and are in discussions in China. China is very difficult, but nevertheless it is a big market. If you think about Japan, where we started more than 20 years ago, we assume that a market like China will be very important in the future. So we are putting our efforts into those markets.
When we look at local markets, then our wish would be to combine local and international, a little bit like it is in Australia, where you have a well established local market and where, after a while, investors have an interest in participating
internationally so you can develop a global market. In Hong Kong and Singapore we have very good local markets, but at the moment they are very local, the global route is not yet really there. It also depends on the yield level, because the high-yielding markets tend to attract more international demand. But as an international borrower, our wish would be to have international markets combined with local markets. This is something to work on: it is not only about funding levels.
If you exclude sterling, Japan, Australia and Canada, it is 10%–15% of our funding, but there is a lot of investing in strategic projects for the future and markets are constantly changing.
IFR: Do you think it will stay in the region of 10%–15%?
Petra Wehlert: No, I would expect it really to play a larger role in the future.
Michael Gower: I think Petra has raised two particularly interesting points, both of which I agree with. Firstly, on the overall amount we have borrowed recently, niche currencies and non-core currencies represented a dramatically growing percentage: 2006 was around 10% or 15% of the total €25 billion we raised. Whether that continues to grow remains to be seen. In terms of overall volume, I would expect it to remain fairly static, although I think the composition of those currencies is likely to change. With dramatic amounts of Turkish lire over the recent period, that still seems to be flavour of the month, but a lot of the Eastern European currencies, the Hungarian forint and some of the Scandi currencies have dropped a little bit and have been replaced by other ones. In terms of the international and domestic markets, we have also tried in certain areas, and Australia is an example where there is already a relatively mature Kangaroo market as well as the international Aussie market.
A lot of the niche currencies, certainly in Europe and Africa, are very much in their infancy. They are very separate in terms of their international placement vis-à-vis their domestic placement.
Being a bank, as opposed to an agency or a supranational, the process is a little bit more arduous to try to establish ourselves as a perceived risk-free credit to offer to investors domestically in their own home market. But it is something we are working on.
China is clearly something for the future that I think any large international borrower cannot avoid focusing on. It takes time, it takes effort and a lot of negotiation, but that is something we firmly believe will reap rewards in the long run.
And overall, any large borrower has been suffering from the lack of fizz in the structured note market. Certainly, the cost and the relative efficiency of niche currencies to a large borrower is very attractive, and I think most people will continue to focus on that for a period of time.
IFR: So is it a question of diversification and arbitrage. Are they equally weighted?
Michael Gower: Arbitrage is always important for any large borrower to keep average costs down. Diversification and new sources of liquidity are equally attractive.
Petra Wehlert: Regarding the relation between arbitrage and diversification, diversification is the more important product because arbitrage changes. The Australian and Canadian dollar markets have historically been very good arbitrage markets, but the relationship has changed somewhat because we have seen euro spreads widening. Funding has to offer good diversification, and overall costs must be attractive.
IFR: I assume the amount you have to pay up diminishes over time, as you break further into the market.
Petra Wehlert: Yes.
IFR: What is the cost of the kudos of being first into a market, and how much are you willing to pay? Is it sometimes not better to be second into the market when someone else has already done the groundwork?
Petra Wehlert: It is not our intention to be first in every market. There are institutions that develop markets, and who put really a lot of money into it. But it is not our intention to be first. To be early, yes; not to be first.
And as for paying up, that is a strategic question. There is no fixed amount that we would pay to enter a market. We have to fund €55bn, which is a large amount, so we cannot think only for this year; we look for stable funding in the foreseeable future.
Michael Gower: The future is a very important point. If you look at what has happened in the core currencies over the last two or three years, the oscillation between the efficiency of euros and dollars has changed dramatically. A lot of the niche currencies that are providing relatively small amounts of liquidity at the moment are certainly set to build over the next three to five years. And while 10%–15% is the number in our overall portfolio right now, there are certain currencies that we feel may grow dramatically over time. And finding key investors who will provide you with ongoing large amounts of funding is very important for the long term.
IFR: So the growth is going to come from the maturation of existing markets, albeit small at the moment, rather than brand new markets.
Michael Gower: I think that is a fair statement, yes.
IFR: Is there a similar desire on behalf of underwriting banks to be first into a particular currency?
Holger Kron: There is an obvious advantage in being first in the market. But there is another point that is very important for the issuer. Look at the publicity and the virtuous cycle it can create. If you enter new markets, you are regarded as innovative and modern. So, for the issuer, being in the first wave is very important. Being in the right currency might be the second choice.
We have gone through a phase where nearly every niche currency investment worked out in the end, although if you enter the wrong market at the wrong time you could really harm your name and reputation. Rather than innovation, you could create bad sentiment around your name and bad feeling. It is very important for me, as a banker who helps to arrange bonds, that the timing is right about when to enter which market.
Possibly we will see the market change into basket trading, where risks are combined, so that the issuers see another structured level on top of the fundamental pure markets.
IFR: Presumably the Icelandic market was one where there was the potential for it to perhaps grind to a halt, and yet it did not. Have all the markets recovered from any shocks there may have been?
Holger Kron: If you draw a bottom line on your portfolio performance of high yielders, in the past, there are only a few which really make money for the investor. Obviously this depends on when you got in, but a lot of people got in during the wrong phase. Before it started to tumble, Icelandic kronor was a very big market. And since then, we have seen even more banks becoming active, so it is growing, although it went through this rocky phase. It is the hunt for yield that is the current theme.
Moti Jungreis: If you look at Mexico, it was very hard two years ago. It almost ground to a halt because rates were too low. People were saying, "I want to have a seven handle on Mexico", and I think Turkey and Iceland managed to go through those cycles of sell-off, new investors coming in, high rates: that is why those two markets are still active. If Iceland went below 10% tomorrow, I do not think people would really care. I think those markets are here to stay, but there is cyclicality to them. Sell-offs tend to bring new investors, new opportunities, and that is what you need. You need to keep them on the radar screen and be active with them for when the opportunity comes. When it comes, it tends to be there for about a year, but you never know when it is actually going to come. But there are also markets that do not work out.
IFR: Which did not work out?
Moti Jungreis: One example is Israel. There was not enough pick-up to European and US rates and there was no follow-through of demand after just one deal. There was just not enough interest to build it further, simply because rates were not high enough. But if rates in Israel went to 9%, you could guarantee that everybody would be all over it. That’s just the way it is. What is driving those markets is the hunt for yield and the pick-up: it is just another carry trade.
Click here for Part Two.