Reigniting the debate

IFR Top 250 2012
9 min read
philip wright, Natalie Harrison

Opinions are divided on the EFSF’s decision to offer a five-year bond deal through auction rather than syndication. While there has been a noticeable lack of enthusiasm in some quarters, others point to the UK as an example of how the two processes can co-exist and even enhance each other.

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In May the European Financial Stability Facility took the unusual step of using an auction process for its €4bn May 2017 2% issue. While the use of auctions is nothing new for sovereigns – indeed, the syndicated market has all but been consigned to history as far as some are concerned – it was the first time a European agency had used the tool for something other than short-dated funding.

The auction produced a successful outcome, with the bid-to-cover ratio at 2.7 on the €960m raised. However, some SSA bankers were up in arms about the loss of fees they would have received if the issue had been syndicated, and because they had dedicated sizeable teams to advise the eurozone rescue fund over the past two years.

“We announced some time ago that we would look to tap existing bonds via auctions, and it is just another tool in the basket of the EFSF to increase its flexibility to access markets”

They warned that the EFSF, which had proved a tough sell at times, risked undoing all the hard work in winning over investors if future, and potentially larger, auctions did not proceed as successfully.

Critics say that the investor base for auctions – the dealer community – is much more volatile because banks have limited capacity to hold inventory on books.

“It takes time for dealers to sell on those bonds to investors, and the risk is that the market turns, dealers panic and everyone hits sell at the same time,” said one SSA syndicate official.

“Long-term, you need to build momentum,” said the head of public sector DCM at a UK-based bank. “This is especially true of credits with noise around them, ones that are in the middle of the storm.”

Another string to its bow

It does not appear, however, that this marks a fundamental shift in strategy as far as the EFSF is concerned, but merely offers another string to the facility’s bow. Indeed, the week after the tap, the EFSF returned to the syndicated format for its €3bn three-year new issue, in line with the approach promised by its CFO and CEO, Christophe Frankel, at the time of the auction.

“We will continue to use the syndication format for new and large transactions but from time to time we will use auctions. For the moment, we do not plan to use auctions for new deals,” he said. “We announced some time ago that we would look to tap existing bonds via auctions, and it is just another tool in the basket of the EFSF.”

A lot left to do

And with more than €30bn still needed this year for bailed-out Greece, Ireland and Portugal this year, it is hard to criticise the fund for investigating all the options available to it.

The borrower, rated Aaa/AA+/AAA, had made great strides in efforts to diversify its investor base already, having launched a short-term bill programme in December, as well as venturing out to the longer end of the market with a 20-year bond.

The auction, therefore, was just another step in that direction.

“They have a lot to raise and they need to be able to understand which products work,” said one SSA origination banker.

“The T-bills have worked well and the syndication process is well established. The auction was an experiment to see how deep and well that vehicle can go because they need to know whether they can hit the market like a sovereign.”

The benefits

The debate about the merits of syndication versus auction is nothing new. Although sovereigns use both, agencies have never tested the market before. One reason for that is that agency bonds tend to be less liquid, making it more difficult for dealers to position themselves.

The biggest benefits for the issuer of following the auction route rather than syndication are cost and time.

“I don’t see why there has to be a hard-and-fast rule that auctions can only be done by sovereigns. Sovereigns use syndicated transactions to compensate banks that have supported them but also for riskier transactions that require a bookbuild process,” said one of the bankers.

One asset manager shared the view that, as a quasi-sovereign issuer, the EFSF should have further success with auctions.

Triple A issuers such as the EIB and KfW have considered auctions in the past but concluded that the benefits of not paying fees were not enough to compensate for the risk of losing some key investors, one of the bankers said.

On the other hand, the biggest benefit of syndication is that it gives lead managers and issuers more flexibility to navigate choppy markets and to gauge investor feedback. The issuer also has the comfort of knowing where its bonds are placed, which is not true of auctions.

“There are a lot of tools that can be used in a syndicated deal if markets turn sour. Lead managers can move the timing, the guidance and will underwrite deals, but a failed auction might be something an issuer would not be able to shake off,” said one of the bankers.

“My impression is that the EFSF is not going to be doing billions via auctions. But if that’s the case, why would they risk doing them in the first place?”

Betting on banks

The EFSF is making a pretty good bet that banks, which really have their hands tied, will support its auctions, market participants said.

“No one is forcing us to take part in the auctions, but there’s a pretty transparent incentive to support them,” said the second banker. “Do I like it? No. But that’s the game.”

The EFSF added more salt to some bankers’ wounds the day after the auction, when it sent out an RFP for a new syndicated euro deal to selected banks, rousing suspicions that it had picked only those that had provided the most support for the auction.

“Banks that have a long position or no client for such a bond at that time may stay on the side, while banks that may be short or have identified demand will put in larger orders,” Frankel said.

The EFSF will consider banks that have bought a minimum of 2.5% of its last two auctions, either bills or bonds, as eligible candidates for a syndicated deal mandate, he added.

UK shows balance can be struck

Sweden and Denmark have recently demonstrated that US dollar investors are willing to entertain European names, while near-neighbour and eurozone member Finland has managed to attract demand for bonds issued in US dollars, euros and sterling at various points of the year.

But it is perhaps the UK DMO that can offer a useful insight into the combining of the two approaches. Despite being a domestic currency-focused initiative, the issues are the same, and with the DMO being a largely auction-driven borrower venturing into syndication – the other way round from the EFSF – it shows that a balance can be struck that suits all parties.

The DMO made its first syndicated Gilt foray in 2005, using the process to kick off its ultra-long index-linked programme. The thinking behind the approach was to create as seamless a price discovery process as possible in an unknown area and create a result that left investors feeling that optimum pricing had been achieved.

Now, with a much larger programme to be funded, up to a fifth of its needs are accommodated by syndicated deals, the benefit being that this “takes the strain off the main distribution channel”, said Jo Whelan, deputy chief executive at the DMO, referring to the auction process.

“This gives us direct through-put to the investors and is a useful diversifying mechanism, particularly at the long end,” she added.

The success achieved by the DMO in combining the two approaches demonstrates that not only can they survive together but can also prove mutually beneficial rather than internecine as some had cautioned as far as EFSF was concerned.

One thing is almost certain, however: they will get further opportunities to put their views to the test.