Monday, 20 November 2017

Non-Core Bond Markets Roundtable 2007: Part three

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IFR: There is a wealth of difference between some of the currencies we are talking about. Australian and Canadian dollars, for example, are going to be far more liquid than the smaller currencies, are they not?

Michael Gower: I would not classify – either internally or publicly – Canadian and Australian dollars as niche currencies any more. I would call them the tier two currencies compared with euro, US dollars and yen – and sterling, we can discuss. But certainly, the markets are now mature enough domestically. Canadian dollars are a bit of an unusual scenario because they have not quite matured in the way most Triple As hoped, but there is enough development internally in those markets for them to really be non-niche now. They are of a size whereby you can raise US$500m to US$1bn of real money in one go, so I do not think you can classify them as niche, either in terms of volume or the way people originate transactions. They are simply more sophisticated and more mature, and they are just bigger.

IFR: So they truly are mainstream now?

Michael Gower: Yes, I certainly think the Aussie is now a mainstream currency and Canada, in terms of volumes, has become so. But I think that market still has a way to go. We have been notably frustrated by it: it took us a year to get another transaction out there, and relative value is still developing in that market.

David Smith: I guess those markets have grown in the sense that it is the domestic investor base that is the driver, as opposed to the offshore appetite when you are in niche markets. Whether it is Australia or Canada, they are being driven by domestic investors who make the decisions in terms of the credit curve and valuation. You still have international distribution, but they are sophisticated domestic investor bases that you do not have right now in the local emerging markets.

The Turkish offshore market is greater than the domestic market away from the government's issuance, but those things will grow, and, eventually, I am sure the domestic investor base will be more important for the Turkish market than offshore investments.

IFR: What has been frustrating about the Canadian dollar market? We actually have a curve all the way from senior to Tier 1 now, so why is that disappointing?

Michael Gower: It is relative to how it started two or three years ago. We very openly had big expectations of how it would develop when we first executed a C$1bn deal in 2003. A lot of the institutions there were very surprised, one because they did not really know us as a credit, but more in terms of being able to do a deal of that size that was that liquid. For any large borrower, that is good news. But since then, since the markets opened up and the pension funds have been able to buy international assets in a way they were not before, there really has been a lot of pushback in terms of how the domestic investor looks at highly-rated credits that are non-domestic. And while the likes of KfW would probably have been slightly less frustrated than us, it is very frustrating how investors view things relative to Ontario: they simply do not pay up because they cannot perceive a credit can be any higher than the domestic provinces. That is a pretty common phenomenon in domestic markets as they mature, but I think, once you start looking at us as a bank, or KfW with the guarantee, there has to be an acceptance at some point as the market grows and asset demand becomes bigger.

IFR: How great is the resistance to pricing through Ontario?

Moti Jungreis: I am sure that people will accept it over time, mainly because of the level of demand. But if you are a Canadian investor, you will have a hard time going to your committee trying to convince them to buy something that is yielding less that Ontario. It is easier to convince them when it is yielding higher: you do not need to do any work, so why not just continue to buy some of the high-grade domestic issuers? But I think this will change this year. There are a couple of things that are forcing it to change: first of all, we are slowly creating indices including Maples. This is key, because most managers are benchmarking against an index. When Maples were not included that index, why bother buying them? So now we are slowly changing and people feel more comfortable buying foreign issuers.

The pension plans are growing at a very fast pace and they are running out of things to buy in Canada, so I think they have to get over the mental hurdle and say, "Okay, I am willing to accept a Triple A issuer through Ontario, if it is 1bp, 2bp or 3bp”, and not worry about it too much.

But when that happens, you are going to see another wave of demand, and that will be a problem. The other problem is that the basis market has been somewhat illiquid, and as soon as we saw the big flow of activity over the last two or three months, it went basically right down to zero, and every trade is now effectively a marginal trade. It is hard to make them as attractive to issuers as they were before. And the situation is similar in Australia.

Petra Wehlert: The question of basis swaps is a big issue in these markets, no doubt about it, although Canadian corporates can issue more outside, which will hopefully help.

And you have the question of the local Ontario benchmark curve, but you have that in nearly all markets. If you look at the US dollar market, it is always a hurdle to price through agencies, regardless of what discussions there are and whether you are Triple A. This is something we have to cope with. If you have a local market like in Canada, it is an especially difficult hurdle to get over. In the US dollar market there are a lot of buyers outside the US, so you can do transactions with 10% or 20% US participation and they can still perform well. But if you go to local markets, to the emerging markets in Asia, there you come back to the problem of having to price over the local government curves. So we have to price over the local Chinese government curve, we have to price over the local government curve in Thailand, regardless of the fact that we are a Triple A borrower.

Things should change in Canada because investors really like the credits, they like government-guaranteed low credit risk. But if Ontario is too cheap, it makes our life difficult.

IFR: So you maintain presence in Canada to make sure it does actually happen, but it seems to be more of a constraining factor in other areas, particularly Asia. Does that hinder what you would like to do?

Petra Wehlert: That is not the only obstacle in those markets. Emerging markets are at an early stage, so it is not just a question of basis swaps. First of all it is about overall swap and hedge markets. So if you see an emerging market like Peru, for example, you discuss issuing a bond but you are constrained by the swap market because, although there is demand from local investors to buy the bonds, you cannot do the transaction because you cannot hedge it. It is similar in Thailand and other emerging markets: these markets are not yet completely developed.

Michael Gower: It is interesting you mention South America because that is somewhere we have seen a lot of potential. The hurdle is not actually getting demand for a transaction, it is the pricing over the government curve and the lack of swaps that are prohibitive. We did execute a small Chilean peso domestic issue through our branch out there, which was sold domestically in pesos, but of course it was not swapped. It was priced significantly over the government, which caused head office quite a problem conceptually. But we took the view that we had use for the currency in small size – US$50 million equivalent – and we thought maybe it was a way of opening up the market and getting people familiar with the name.

IFR: It is also something you have to keep doing. You cannot do a one-off, otherwise the costs are never going to come down, are they?

Michael Gower: All borrowers have to keep looking at sources of liquidity. At some point in time, some of these markets that are currently niche are going to become lot bigger and provide more liquidity. Our view is you have to be in there now and try and develop them, so as they grow, you can take advantage.

IFR: What about some currencies that were not niche but now seem to be? You mentioned sterling and more to the point, there’s yen.

Michael Gower: As an Englishman, I cannot call sterling niche.

IFR: But in terms of relative importance, I would have thought that Canadian and Australian dollars play a larger role than yen at the moment.

Petra Wehlert: The yen market is a great example. It is the same story, actually, because you can do yen Globals and they are bought by investors outside Japan because they have an interest to have yen exposure. But you can only sell into Japan if you price significantly over JGBs, which does not work for borrowers at the moment. If you look globally, it is always the same story: you need to attract local demand together with international investors.

But the yen market is coming back. Last year was a very good year for Global transactions after a long break, so I am a bit more optimistic on that one. And the sterling market is definitely not a niche market, because it is not driven by the UK only. In addition to the local demand, it is driven by Asia and very much by Europe.

Sterling is the number three currency in international reserves. There was a shift between yen and sterling some years ago, so that yen now ranks number four and sterling has gained a lot in the market and its importance is higher.

Michael Gower: There has definitely been a lot more central bank interest in sterling over the last couple of years. And yen for us has been very frustrating because to place it domestically has become challenging. We have executed Uridashis into retail, which has been good, but Samurais are really not a Triple A market. There has been a lot of Single A and Triple B corporate issuance there, but to price significantly over JGBs has simply not worked for us from a cost perspective. Will that change? It is possible. We saw some hope last year that we were getting close, but that seems to have moved away slightly. I think it is fairly cyclical, but the challenge of placing yen domestically remains.

IFR: Much of recent sterling deals has been sold to European investors. Is what distinguishes it from a number of other markets that domestic investors are not looking at the government benchmark in quite the same way?

Petra Wehlert: Yes, the UK is a bit different and the sterling market is very international. So, you have demand from the UK mainly at the longer end of the curve, and in the shorter end, it can well be that there is no UK demand at all involved. It is the other side of the story compared with markets like Australia, where they do not want to have the transactions driven only by international demand without local demand.

Sterling is also a tap market: people feel familiar with taps and they like to have liquid issues. It is a market you can really not compare with others in terms of professionalism.

IFR: Apart from maybe the resurgence of the yen market, where should we be looking for our next currency? What is the next Turkish lira: where is the convergence play?

Michael Gower: People talked of Icelandic kronor for a while, but I think the volatility in that economy is such that it has taken a little bit of the shine off it. It is difficult to say: is it central European? Possibly. It is difficult to say that things like Botswanan pula are going to be euro convergence plays, but some of the Eastern Bloc countries, once swap markets develop, could go down that route. But at the moment we certainly feel things are not developing as quickly as we hoped in these countries in terms of swap liquidity. Turkey became mainstream niche, if you like, very quickly and suddenly volumes became quite large. I have not really seen an equivalent, away from Icelandic kronor, which has been very much concentrated at the short end, save a couple of longer-dated zeros.

Moti Jungreis: There are always a few currencies on the go where you can do a couple of opportunistic deals. If I look for the next Turkish lira, actually, it is Turkish lira. It is the one currency that slowed down just before the blow-up last year and then re-emerged as a very strong currency and a very active business.

I think if Brazil tomorrow morning said, "We are really floating", it would be a great market. And there will be other currencies like that, that provide some sort of a yield and a good economic story. But at this point, you are really running out of places where the market is liquid enough from an underlying swap market perspective and that has enough pick-up to get people excited. I thought Russia would be one of those, but it is proving slow. Maybe a back-up in Russia would be helpful.

One other currency that has been a very positive surprise to us is Romanian lei. There is definitely a healthy demand for Romania, but the underlying swap market is very illiquid and still at a developmental stage.

IFR: The EIB is looking to go up to seven years in Romania, which will be the first issue further out than five years. Is it a currency that KfW has been looking at?

Petra Wehlert: We have looked at the currency in Eurobond format, and have issued several times so far. But we have no interest to go into the local market directly at the moment. There are recommendations to go there, but we are not yet convinced because, at the end of the day, we think, with European integration, it is the question of whether it makes sense to have access to too many local markets in Europe. Asia and in South America might be a different issue, but it is not yet on our highest priority to go into local markets there either. But the Eurobond market, whenever the possibility is there, yes.

Holger Kron: Basically, it is really a question of investor appetite: who is interested to take bet on which currency and why. Certainly for the high-yielders, the question is easy to answer: people go for yield. But in most of Eastern Europe, the levels are relatively low, and if you look at the local inflation levels, they are relatively high. So it becomes purely an appreciation game: you need currency appreciation to make money on your investments. But it is a difficult task to teach to investors en masse.

I doubt we will see a lot of growth there very soon, because the arbitrage has been happening for quite some years now and probably the big wave for Eastern Europe is over due to the comparatively low yields.

I see a lot of opportunities in Asia: there is a lot of investment demand and interest to diversify to find arbitrage. So, from both a borrower and investor viewpoint, I think Asian currencies will become much more interesting. The different time zone makes things difficult, however, because you only have a few hours a day, so it is not easy to arrange things: you always enter the market at the end of their day. And obviously a lot of people are not aware of Asian currencies, having no natural closeness to this area, whereas Eastern Europe is something at least every European has some idea of.

In Latin America, I see a lot of interesting things coming out. I look at Argentina, where we have double-digit yields, and there is possibly an interesting window opening soon. I do not know whether the story is as good as Brazil’s, but I definitely see interest in certain Latin American currencies.

If you look at Africa, most yields are pretty low bearing in mind what is actually happening on this continent. Relative to risk, my personal perception is that we will see some transactions, but it will not become a market like Turkish lira.

We have been through a big phase of positive development overall in niche currencies, and we are now entering markets that have historically been regarded as emerging markets. Five years ago, people were looking at Norwegian kroner, now we are talking about Turkish lire. How much deeper can it go? I do not know. It has to do with asset competition: at some stage maybe the equity markets are offering a better bet than fixed-income markets. The initiator will be the investor. When the investor comes and says he wants some exposure in that area, I am sure the banks will look at this in greater detail.

David Smith: The biggest factors are settlement and currency issues. In Turkey, decimalisation reinvigorated that market, obviously held by high yields.

I think Brazil has strong investor interest. We are seeing issuance in excess of US$3 to US$4 billion a year over the last three years in Brazilian-linked products. Asian currencies are all very interesting to investors looking to diversify, but most of them are non-deliverable. Institutional investors have access to those markets through synthetic structures but, if they became settlement currencies, you would see another kind of growth there.

I think in terms of the really big markets, those that have longevity invariably have relatively sophisticated banking markets. South Africa has been around for a very long period of time and has a very sophisticated banking market and investor base. You will see the same result in Mexico and you have the capacity in Brazil and in Chile in terms of a fairly active domestic investor community that will grow and support the market.

If you look at Asia and India, that is very interesting. Obviously, a massive population base, a very big banking sector and high yields, but you also have exchange controls. So you will see strong growth out of those areas just by virtue of the sheer magnitude of the economies concerned.


Click here for Part Four.

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