IFR: Has the investor experience been positive as a result of involvement in the non-core markets?
Holger Kron: If you take all non-core markets together, they have had a fantastic phase. Currencies performed much better than the theoretical forwards, so they earned the pick-up plus the currency performance. But in some – Icelandic kronor and Turkish lire, for example – the yield was not enough for the risk you took. And, basically speaking, people rely on additional performance because otherwise they would not get involved in those markets.
With currencies it is a funny thing. Bottom line, you earn what the currency lets you earn: the performance of the currency is the underlying value of the whole trade. A pick-up of 5% will not be enough when the currency gets into rocky times.
The real problem is that you have two types of investors. You have the very well educated institutional investors who have research and maybe some domestic footings in those markets. They know a lot of those markets: they get a lot of information from the brokers and traders. So they know what risks they are taking and should be able to decide for themselves.
But on the other hand, you have the retail investors, who do not really know what is happening in those currencies, and a lot of these people do not have any sense of what could happen to their investments. There should be a balance between what you know of the market and what you need to know of the investment. In my view, there is an imbalance at the moment, but people really like investing in high-yielding currencies and seem happy to go on like this, even during the difficult phases, so it looks set to continue.
And if you entered Turkey at the right time, you made not only your pick-up, but you also had fantastic currency performance. But it is anti-cyclical trading that makes you money. You go into a currency when it is weak and you leave when it is trading tight. As long as you keep to this cycle, you will always perform in niche currencies. But very often we see people coming in during the wrong phase of a currency when it is very expensive, and they tend to leave when it gets cheap. And the investor base changes dramatically when a currency becomes cheap: then we see the educated investor coming in on a much bigger scale.
Michael Gower: In fact, that crosses over from the investor and underwriters' side to the issuers' side, where we, as a borrower, and perhaps more as a bank are concerned about who is buying our products. There could potentially be some very serious negative reputation ramifications if you sell long-dated, non-deliverable currencies to retail investors, because, frankly, even investment banks have a lot of trouble working out where US dollar/Brazilian real will be in six months' time, let alone locking in your Belgian dentist for 10 years and his not understanding his principle is actually at risk.
While we want to develop these markets – and they are great potential liquidity providers for the future – there have been a number of occasions where we have had to say we loved the idea but were simply not comfortable with our name being associated with the risk to that particular buyer base. If a large asset manager who understands portfolio diversification, rate curves et cetera wanted to have a part of his bucket in a particular product, we are comfortable: but I think to mass-market this as a retail investment with potential high-yielding returns is very dangerous. That is certainly something that has perhaps prohibited us from taking as much advantage of some of the arbitrage funding as we could have done.
Petra Wehlert: Obviously we care about the products issue, but on the other hand, we are such a large borrower. Last year, we issued about 500 transactions, and the year before it was around 600. It is not only a question about the non-core markets but also the structured market. At the end of the day, our target investor group is institutional investors, and we assume they are familiar with the risks they take – they are professionals, they should be – and to the extent our products are sold in the retail market, we talk to our banks and trust them to explain the products to the clients. Nevertheless, there is always a small is risk that there will be some clients, some retail buyers, who are not aware of the risks they are taking. After the Turkish lira and Icelandic krona depreciation in May, I was expecting that perhaps there would be some complaints. But I have not heard anything, which makes me feel comfortable that people know what they are buying.
IFR: Do you worry less about responsibility the more you have to raise?
Michael Gower: You certainly have to take more risk. As our borrowing profile has grown over the last three or four years, the types of product we look at now compared to five years ago has changed. The structured note market is really the one where we spend the most time discussing internally whether we want a product sold into retail.
Petra Wehlert: We do not issue credit-linked notes, for example, and there are other products, especially in the structured market, where we are not willing to show a price if we think it is really hard to oversee any risk there. Nevertheless, the more products you offer, there remains a small risk that people are not completely aware of what they are buying. In that case, the banks have to better educate their distribution people, because that is how we distribute our bonds.
IFR: Is it difficult to know whether liquidity has been provided to a retail customer who wants to sell KfW bonds denominated in whatever currency, perhaps in a very long maturity? You may not necessarily have targeted retail investors, but they might be involved and you do not know what liquidity problems they might encounter in trying to sell positions in the event of a depreciation of a particular currency.
Petra Wehlert: I have not heard any complaints so far, so I would say the bid liquidity is quite good. I do not think that there is a lot of product sold in the secondary market but, normally, people should get a bid. In certain situations, the bid/offer spreads might be wider, but this is a risk you take if you invest in exotic currencies.
IFR: Is it the underwriting banks who should shoulder responsibility?
David Smith: Obviously, it falls to us to articulate the risks. The beauty and simplicity of level currency markets means they are very easy to highlight and transparent. But when you overlay that with the kind of structure, with this optionality, it is harder to explain. If it takes more than two minutes to explain to a salesperson, then there is no chance that the end investor is going to understand the product.
Holger Kron: I think the key question is the one of liquidity when it gets difficult. The market has become more professional and people provide liquidity even in difficult times. Compare this to five to seven years ago, when liquidity was poor as soon as markets became difficult.
Moti Jungreis: You have to support the market, and you have to support the investor base: it is not just about underwriting a deal and walking away. If you do that, you are out of the game fairly quickly. People do notice and do remember.
IFR: But it does happen, though.
Moti Jungreis: Yes it does. Banks change strategy: people in the bank change. A bank might be involved in a market, then three months later it loses some money in a correction and suddenly there is no commitment. But over time, you really see who is really in and who is not.
Michael Gower: Also, that flows over into structured products. For example, if you take the popularity of CMS over recent years and its relative underperformance, from a borrower's perspective it has been very clear, having travelled round and seen lots of investors, which banks are consistently quoted as providing liquidity in those types of deals, and where those investors will go repeatedly to look for their new products.
That is extremely important for us, because if you are in the business of needing to raise more liquidity and looking at higher-risk products, you instinctively return to the people who will provide liquidity to the investor if there is a market jolt. The number of banks who do that on specific products is actually not as big as people would think and that holds true in the niche currencies as well.
IFR: That has often been the case with structures that have involved equity indices, such as Hang Seng-linked notes. When the market is performing well, everything is rosy, the bids are there: when the market turns, suddenly nobody wants to know about it. So, perhaps not everybody who appears to be supporting the market is there in reality under certain circumstances. Although this is not something that is restricted to the non-core and niche markets: it is just clearer to see in the smaller markets.
Micheal Gower: You could argue that in a lot of smaller markets, such as Icelandic kronor and Turkish lira, volatility is much greater on a day-to-day basis relative to a lot of the long-dated structures. After a 12 or 18-month period, you may see that the structure was actually the wrong bet, and therefore the market has underperformed. Whereas, if you take a spot check in the middle of January, Turkish lira may look fine, take another spot check in March, and it may also look fine, but the intervening period may have been horrendous. People may have wanted to get out and there might simply have been no bids.
IFR: Is there anything obvious that can be done to improve liquidity?
Michael Gower: Talking as a borrower, the question is do you provide liquidity yourself? We, as a bank, do have a trading operation. There is a capital markets business, and our traders will always be there with a bid. One of the reasons that we are popular with the retail investor base is they know that there is always liquidity in our issues. No matter how technical they go, there will always be a bid, and we are fortunate with that. We are a bank, and we have that ability. Some of the supranational borrowers have thought about this concept in the past, but ultimately it is really up to the investment banking community to provide that service as part of the deal.
Petra Wehlert: The initial bid comes from the banks, but we do the same. If there is a situation where someone needs a bid for a bond, we will make a price, there is no doubt about that. And there may be cases where we have a specific interest. For example, when we issued large Australian dollar-denominated Uridashi bonds in Japan, the paper came back after a while. So we had an interest to buy it back, rather than see it sold cheaply in the market. So, there might be a situation where we have specific interest, but in the new non-core currencies in general, this is really the job of the banks.
There will never be an investor who cannot sell the bonds, because we will make a price, but if that happens we might have to have a discussion with the banks about their policy and how they manage transactions. It is something that goes together: primary and secondary markets are more or less one package.
Moti Jungreis: And in this cycle there was a sell-off last year, although not anything like Turkey in 2001 or Mexico in ‘94. But when this kind of thing happens, that is when you really see the stress of people perhaps not even knowing where the bid should be. It is all driven by liquidity in the underlying markets, so if instead of 10bp or 15bp, Turkish swaps trade 50bp or 70bp wide, even banks are going to struggle to find what the right bid for the product is.
So far, this decade has been a fairly easy experience. There has not been a real geopolitical or fundamental problem in any of these markets. I have not had a call from anyone in my bank saying, you should not trade in Iceland, or don't trade with Turkey. Those calls will happen at one point when a market gets really distressed because of a geopolitical event and when senior executives of the banks are feeling uncomfortable with the exposure that they have with to certain market. It has not happened, and hopefully it will not, but this is where you really get tested. I do not think that in the last five years we have really been tested in any of those markets. At this point it is a fairly easy game.
IFR: JPMorgan is a bank without the primary track record. Is the secondary market a way that you can break in?
David Smith: You cannot walk in as a newcomer to these markets and say, buy my issues but I am not there to support the market. You have to provide a track record in terms of secondary support, not only in your own issues but other people's transactions. Then you have to back it up with research. It is more than just saying, “mine is the cheapest transaction in Turkey this week”. That is not good enough if you do not think the person who brings that transaction is going to be around in six months' or a year's time. Certainly, for JPMorgan, emerging markets are a very core part of the franchise. Non-core is an extension to that as opposed to being a new house with no involvement in emerging markets. We are committed to emerging markets as a house and therefore providing second liquidity in all assets classes. So we will trade in local government bonds, local swaps and now local Eurobonds. For us, we have to offer the same kind of liquidity to all investors across all product lines.
IFR: Is a major selling point in terms of trying to get a primary issuance?
David Smith: We are not a niche house saying, "we have no involvement in emerging markets, we do not trade local rates for local governments, but we are very good at Eurobonds", or, "we were not in the market last year, but we are in it this year”. The liquidity we provide in terms of local rates and local governments will be extended to local Eurobonds, and that should be a competitive advantage.
There are some other newcomers to this market who thought of it as a chance to make an economic return in a short period of time. But I think investors will realise, if they take an opportunistic approach and deal with those counterparties, then, when you go through a liquidity crunch, you have to know who your core counterparties are in terms of the people who will provide liquidity or longevity in the markets.
IFR: After the development of a swap business, the natural extension is to go into the new issue business. The JPMorgan swap business has been in existence for some time, so is it just now that the bond market is considered of sufficient importance to make that step?
David Smith: Different institutions have different growth strategies. Certainly, JPMorgan has been deeply involved in developing derivative markets and cross-currency swap curves for the emerging markets: that has been the focus. We now realise there is a natural fit between the rates business and the relationships with frequent borrowers, and that we should try to marry up both capabilities. Having said that, distribution is key in all this, and we have to develop the same kind of investor franchise that a lot of the niche houses have developed over many years.
IFR: And presumably develop the trading capability as well.
David Smith: Electronic platforms have made things more transparent for investors and allowed banks to provide greater liquidity across more currencies and instruments. But, like all these things, there has to be consistency and reliability, and that is something you can only build up over a period of time.
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