Non-Core Bond Markets Roundtable 2008: Part 3
IFR: So the emerging markets have become the core markets. But how about the liquidity of these markets: is that holding up fairly well with respect to market commitments being honoured across the Street?
Moti Jungreis: In fairness, there has been very little selling: there has been no exiting. With the Icelandic krona depreciating so much, you would think that it would be driven by international investors getting out, but there has been no real selling. There have been bits and pieces here and there, but there has been no stress on the liquidity.
Horst Seissinger: Does that mean that in these types of currencies the share of buy-and-hold investors is different compared to other currencies?
Moti Jungreis: Absolutely. I think they are definitely buying more now.
Horst Seissinger: Which is a big advantage.
Isabelle Laurent: But much of that comes from the fact that the investor base is actually now much broader with very different dynamics. We are not just talking about the same kind of investors that we were talking about back in the 1990s.
Holger Kron: What we experienced last year was that sometimes you have one investor group leaving the market, but at the same time you have new investors coming in and saying: “this is very interesting, we want this stuff”.
We have especially seen that in the Scandinavian currencies. You had one investor group selling, and you had a new one coming in, picking up paper and even demanding more than was sold. So, from this perspective, the global environment for niche currencies has really developed in three dimensions. You have one dimension, which is market depth, the sort of maturities you could trade, the sort of size you could trade and the sort of market-makers that would give you prices.
Then, you have the second dimension with the trading houses, in that now you can get 18 or 20 prices on a Turkish lira bond. If you look two years back, you would find five to seven prices, and even those would not work: now you have 20 people competing on a trade. The third dimension is definitely the investor base. You have it expanding globally, you have Asia coming in to emerging market currencies, you have US investors and you even have Latin American investors reinvesting their dollars in other currencies to diversify themselves. You also have the Middle East with petro-dollars, and they are really going in for different markets now.
So, the entire community in niche currencies is expanding, which is really supportive for those markets in the medium term, because some will find interesting points to step in, while others will step out — if there is no key crisis in the background.
Paul Johnson: And there has been a relative absence of hot money as well: you haven’t got the leveraged players there. It tends to be real-return, real-money investors. So there is not a push for the door at the moment.
Holger Kron: Apart from ISK.
Paul Johnson: There are certain pockets, perhaps.
Moti Jungreis: But we do not even know who is pushing that right now. It looks more like it is the local banks. There hasn’t really been any push from the international investors.
Holger Kron: I wouldn’t say it is the ISK investor, I think it is the ISK credit-holder who is pushing indirectly via the banks.
David Smith: The benefit that emerging markets have is that it is a growing asset class. But it is not a mature asset class, so you are seeing net inflows into the sector. Over the last two years, there has probably been US$30bn–$35bn a year, of which last year 55% is going to local markets. So, there are no real outflows from emerging markets and any little bit of selling is going to be dwarfed by the inflows into the sector. So, the liquidity bid in the Street is from new investor money coming in, whether it be from Asia, Japan or the US.
But also, historically, if you have held out through the crisis, you have emerged making money: those people who have cut have always suffered worst. So, right now, people are banking on history repeating itself along with the new inflows, and saying: “if I get out now, sure, things can get worse, but equally, history is going to suggest that if I bail out, then invariably I am crystallising losses as opposed to weathering some short-term volatility”.
IFR: We have mentioned greater US account involvement. Are those US holders in the buy-and-hold category of investors, or have they looked to turn it around?
Moti Jungreis: With the US investors, the one thing that we have to understand is that they are buying diversity out of the dollar. So, they are buying Turkish lira or Icelandic krona, or whatever is, because they are looking for high-yielding currencies away from the dollar, and I do not think, at this point, any one of them will panic at corrections. Even the Icelandic krona with the sell-off of the last month or two depreciated 30% against the euro, but only about 10% or 15% against the dollar, so, I think, for them, it is all about diversity out of the dollar.
David Smith: But you also have a bigger investor community of dedicated emerging market funds who are benchmarked against GBI-EM, so Turkey will be a 10% weighting in their portfolios, and sure, they can be underweight on it and hold 5% positions, whether they be local government bonds or benchmark issues like the World Bank 17s, but they fundamentally invest in these markets for the long term and they are not going to day-trade them or even trade week to week.
So, yes, you are always going to have bonds being recycled, and the market is developing in the sense there are more dealers quoting hopefully more of the same deals, but, to be fair, liquidity hasn’t really been tested because these investors can fine-tune on the margins, but, fundamentally, they are buy-and-hold investors because they have seen more inflows into those [emerging markets] funds. It would be very different if everyone decided to get out of emerging markets completely and you saw mass redemptions in terms of funds, but, right now, we are, a long way from that scenario happening.
IFR: With regard to the liquidity and the increase of prices available, to what extent have new players such as JPMorgan made an impact?
David Smith: I think new players will always make an impact. I guess the question is whether they are there for a short-term impact or the medium or long term: and only time will tell. Clearly, for investors, liquidity in markets, or, probably more importantly, the perception of liquidity, is increasingly more important because of how they make their investment decisions. Certainly, as a dealer you have to justify to your manager positions that you hold on your own books, and I think there is the same pressure on the investor community, given events over the last six months. So I think investors will always want more entrants into the market and they would like them to be there for the long term as opposed to here today, gone tomorrow.
As far as JPMorgan is concerned, we have been not in emerging market Eurobonds for a very long period of time, but emerging markets has been a core part of the JPMorgan franchise. So it is a new sector for us, but I don’t think anyone is going to question JPMorgan’s commitment to emerging markets in terms of derivatives or local markets, and, certainly, we think we will add long-term liquidity to the market. Clearly, some entrants will be more short-term players and more opportunistic, and you have to rely on issuers and investors to differentiate in terms of how they spread their business out.
IFR: We would not dream of questioning your commitment: we can leave that to your peers! But is institutions like JPMorgan coming into the market a good thing?
Moti Jungreis: Yes, and I think that any bank that has, on the one hand, access to investors and, on the other hand, appetite to take some risk can do well in these markets. So JPMorgan and, if you like, ABN/RBS, could add value to this market. There is no reason to think that we should question their commitment.
Holger Kron: I think the major question arises when the markets become stressed. Experience says that out of 20 houses who quote in normal times, you probably have three to five quotes left. And they would rather focus on liquidity where they promised to deliver liquidity, which is in the bonds they led themselves. So, liquidity is not a question of the size of bonds, it is just a question of timing. When there is stress, people will really have to see how they can cope best with this environment.
Obviously, with the stress test in the core markets, we saw how liquidity faded in jumbo Pfandbriefe: one of the biggest European markets suddenly suffered a liquidity drain nobody even dreamt of. Suddenly, you are long €50m, which was a usual quote on two ticks a while back, but is now nearly unsellable because nobody will put a price on it. This is not true for every trading house, obviously, but if you look at the market, liquidity has nothing to do with size, it really has to do with the stress test at the moment, and how the individual trading houses can cope with this.
I have had the experience of there being three of us left in our market – and two of them are here today. Whether the new ones can really stand the crisis, we will have to see.
It is probably also a question of economics. At some stage, certain banks will run numbers to see whether this step into new markets makes sense economically. And they might decide at some stage that maybe they should pull back rather than keeping on playing the game. This is what we have seen very often: people disappear, and once the markets run fine and smoothly again, they come back. And prices are all over the place in between.
IFR: So, you are basically saying that this is artificial liquidity?
Holger Kron: Yes, in the end, liquidity comes down to the formula; can the individual house make a price on this asset and would they really take the bonds on the balance sheet?
Moti Jungreis: It comes down to infrastructure with the underwriters as well. If you have one person who is going to be the underwriter, the swap trader, the sales guy, everything, you are not going to last. If you have an infrastructure with risk limits, underwriting limits and swap pricing abilities, then you show commitment, and then I think you can actually survive the stress, and you actually may see opportunities in a crisis.
If your job is just to be long a few bonds of KfW, you are not going to survive. If your job is also to take risk around it, you may make money in times of crisis. You can actually really make it work to your advantage. It doesn’t have to be that every time there is a crisis, you as an underwriter have to suffer. The opposite is true.
Holger Kron: I remember the crisis in the rand markets: often you had just two prices on the system, or maybe three or four. In good times, everybody traded it, and in bad times suddenly nobody wanted to. You could even call good houses and sometimes nobody picked up. It is just a reality that financials have to secure themselves at some stage and one of the ways of doing this is pulling back and waiting for things to level out before the next stage.
Alexander Liebethal: For an issuer like KfW, it is also important to have a mutual monitoring of the houses. It is also about diversification when it comes into intermediaries. So, all in all, it is a good thing if there is a broader base of banks we can work together with. However, it is sometimes difficult to find the right lead manager.
Paul Johnson: Banks have to be committed to markets and all markets get stressed. For an investment bank with the right infrastructure, a stressed market is a great opportunity. There is no doubt about that.
Isabelle Laurent: I think it is an advantage when people start dipping a toe in the market with one of the more liquid issuers, because it is very easy for an issuer, for instance, like EBRD, actually to improve the levels at which they are prepared to buy back bonds during the crisis: we cannot always rely on investment banks having the liquidity to buy back all bonds at all times. It is not really appropriate to assume that that is going to be possible, so it is important for us to be able to ensure that our investors can get out if they want to by being able to underpin markets.
In fact, last summer we improved the levels at which we were prepared to buy back our bonds to allow investors, if they really needed to sell, at least to be able to get out of them. We saw almost nothing for the first six months and when the crisis deepened we started seeing little bits; nothing majorly significant, but I think that it only goes to show how difficult it has been to sell many of the instruments that hitherto they thought were sellable. And size is not an issue.
Horst Seissinger: It is even more interesting for KfW having more market participants and liquidity in the markets. It is not our policy to buy back bonds: our major task is to fund. And if you have to fund a large sum, then, of course, the major task is not to buy back bonds. That is a task we happily give to the investment banks!
What we have seen over the last one to two years is an increasing number of banks coming into these markets, and I share the view that there are differences in quality, with some banks being on track, while others still have to develop and show commitment in difficult situations. But, overall, we believe that the competition has increased over the last two years and that is to the benefit of the market.
IFR: What you have to do is believe that those new players are serious about it, but the investment banks must have their own suspicions about who is likely still to be standing when the market becomes stressed.
Holger Kron: There is a check-list of how often certain names have disappeared during crises over the last 15 years. In a number of cases you can say: this is a name which will definitely disappear once times get rocky.
Paul Johnson: I agree with that, but I think it applies to other markets as well. I think it is core to this discussion. Sustainable price-making for investment bankers also has an awful lot to do with sustainable markets, larger markets’ infrastructures.
Holger Kron: That is why I mentioned jumbo Pfandbriefe, because it was probably one of the most efficient European asset markets, and, suddenly, you saw this market being stressed so much that some of the market-makers pulled back. This just shows that liquidity is a question of timing: it is not a question of size of bonds or active market-makers, it really is a question of timing. Can the houses really cope with the stress? This basically goes back to the question of infrastructure.
Isabelle Laurent: Also, there is the question of whether it is an arbitrage play for an investment bank, or whether they have investors that are going into the market. Are they researching the market, are they doing business in the domestic market, where, if you pull out suddenly, the country itself is going to be very upset? I think those are aspects that really change. We used to see emerging markets as being something that a lot of people did on the side. They were doing it more for their own arbitrage books than being active in the sense of having a whole infrastructure. I think that has changed, partly because the investor base has changed and broadened. It is their investor base that is now looking at that, whereas historically they saw emerging market debt as being dollar debt with emerging market names on the top. Now, what they are seeing is emerging market debt as local currency debt and, therefore, their commitment to those markets has significantly increased, which is not to say that we might not see stresses if the market pulls back. But I think that that has changed things fundamentally.
Sjaak-Jan Baars: In the last few years, we have seen 10 or 12 banks trying to be active in those markets mostly for arbitrage reasons. Now we have moved to a situation where we have maybe one or two banks leaving the pack, with four or five others definitely committed to those markets. That is, from an issuer’s perspective, a healthily competitive environment, because too small a group is not healthy enough in terms of competition, but too large a group does not give enough critical mass or size to the banks to actually to be able to have that commitment to the markets. In that way, I think we are now in a healthy environment, where the banks have commitment and are able to help investors out in times of trouble.
IFR: As an issuer, would you reward one of these newcomers that you are not entirely convinced will be around if the market became stressed? Would you award them a mandate to lead manage one of your bonds because they are offering you a good deal, or does their commitment to the market have to go a little deeper than that?
Sjaak-Jan Baars: It is very dependent on the type of transaction, of course, but we would give them the benefit of the doubt and try to establish a new relationship to try to grow the market. On the other hand, we are cautious and we want the banks to commit and to be able to show liquidity to investors as well.
Horst Seissinger: For KfW, it is also important to have these banks that support us in the emerging markets, and who support our marketing and help us to diversify our investor base. They also become partners for other currencies, which therefore helps them to improve their overall reputation with issuers like KfW, which is definitely a benefit for them. That is also a reason why some of them are active in these markets.
IFR: So, it is possible to break into the underwriting world?
David Smith: I think it is possible to break into it, but investors could do more to police short-term new entrants in terms of how they spread their business. In a bullish market environment investors are happy to trade with anyone, issuers are happy to print with anyone, and then suddenly it goes wrong. If an investor comes and asks for liquidity on Lehman (led) deal or a Bear Stearns deal, then it is pretty hard for them to really expect Deutsche Bank to show them a quality price.
They probably will, because of the investor relationship, but, fundamentally, I think investors and issuers can all do more on both sides of the fence to figure out if somebody is really a short-term player, or what their plan is regarding emerging markets or non-core dollars. It is interesting that you see a lot of bonds being recycled from lead managers who are no longer involved in these kinds of markets. But you always want to question the investor and say, hopefully, you have learnt your lesson this time and you should be awarding your business to people who are a bit more credible and have a sustainable kind of business.
Holger Kron: Isn’t it funny that the investor seems to forget all the problems they’ve had with certain lead managers? Things pan out, markets go normal again and, suddenly, they pop up again and they have their investors lining up for new deals. So, investors are no elephants: all they remember is the loss but not why and how it developed.
IFR: How frustrating is it, being a house that will be there in good times and bad times?
Holger Kron: Sometimes we believe that clients really come back and reward you for liquidity given in bad times, but this is a fairy tale: reality looks different. In good times you have to fight for the business against broader competition and in bad times you fight for survival in a difficult environment. This is just the name of the game: that is what we are paid for, and that is what we do very well. As to whether investors or issuers have a conscience, it is generally much better with issuers. The investor base is focusing on a new investment, and whoever is going to give the best price for what they want is going to win the bet in good times.
Isabelle Laurent: I think most issuers are fairly responsible in trying to balance out the ability to allow other people into a market with trying to look at the rationale for why they are there and whether or not they have the infrastructure. I think issuers have a responsibility to try to find that out, particularly ones that are not necessarily so liquid and therefore would not be able to support their debt if the investment bank were suddenly to step away, which would leave them with reputational risk. However, you do not want to block out new entrants.
I remember when we started to do many of these emerging currencies, we were doing them with TD Securities in the 1990s. TD had no historic position in those markets: they were the newcomer on the block. So we went, and we saw, and we understood the rationale of what they were trying to do and the business model they had.
Now, they could have pulled out, but they did not. They had decided that that was what they were going to do, and now they are a significant player: nobody is questioning their role in those markets. RBC similarly came from a background with Hambros and other retail investor bases, so there was a long history of dealing in many of these kinds of exotic markets. So, there was a rationale. Deutsche has been there right from the start and has many local presences.
But many people pulled out during some of the crises we have seen, and they are not always the ones that you would predict. So, I think issuers try to be fair-minded and try to allow markets to develop, but, at the same time, they need to balance out exactly what the rationale is, and I think most do that successfully.
IFR: So, it appears that issuers take this into account but investors don’t. Is that a real worry?
Holger Kron: Once you figure out what you want to do, as an investor, you generally tend to go for the cheapest price in good times because you probably do not really think about Plan B. Plan B is something you don’t really expect when you invest in something and if you really expect it to happen, you should think about whether you should do this investment in the first place. So, in that respect, I think it is a very natural thing that this happens. Obviously, I would wish it to be different, but this is just the way it is.
Isabelle Laurent: Maybe we will see things change going forward. We have had other crises and people have pulled out, but it is often the sort of people who are not in the core, they are on the side, and they were caught in some particular crisis that was very localised. Right now, what we are seeing is a real meltdown in so many different markets that people are focusing far more on these issues about who has liquidity and credit, and going back to Plan A. It is not something that is affecting the boys who are at the other end of the dealing room: it is affecting everybody, and, to that extent, investors themselves are focusing on these exact issues, whether they are in emerging markets or mainstream markets. So, maybe it will harder for people to forget, although I don’t know if that is being too optimistic.
Holger Kron: Maybe you are right, but the reality of the past proved different.
Isabelle Laurent: Yes, but I think a lot of people were replaced very quickly, so a lot of them did not have the institutional memory resulting from difficult experiences. People went, people came, people went. But right now you would have to get rid of everybody that is involved in the markets to lose the memory of what this has meant in terms of what liquidity is, where demand is and who is making prices. I think this is very fundamental.
Horst Seissinger: If you look at the bigger picture, that is definitely true. What we saw in the past was cycles in the emerging markets and in the consequent interest of investment banks. Now it is obvious that these markets are in regions of growth where investment banks try to maintain a sustainable interest. Therefore, I think we will not return to these cycles, and we will have more focus from a broader community of banks that are active in these currencies.