The world paper chase

The global turbulence on credit markets has led to a flight to quality among Asian investors, who are demonstrating a strong appetite for AAA rated sovereign, government-backed and supranational paper from Europe. Some of these issuers are getting their best-ever pricing versus mid-swaps.

At the same time, lower-rated issuers such as commercial banks are finding it difficult to access the markets at acceptable pricing levels, and are waiting for the markets to settle down before going ahead with senior unsecured deals.

Price drivers

The position of Asian investors as the main price drivers on AAA deals has slightly weakened. Two years ago, if a big issuer missed out on a couple of major Asian accounts, their deal would not come at the tightest pricing. Today, there is growing distribution of bonds to central banks and sovereign wealth funds from oil-rich jurisdictions, such as Russia, Norway or the Gulf Co-operation Council countries. And in South America, Brazil has also emerged as a big buyer.

In fact, competition for paper is pushing Asian central banks further out along the curve, even for euro paper, simply to get their hands on top-quality credits.

In early January, Kreditanstalt für Wiederaufbau (KfW) sold a €5bn deal 10-year transaction. Lead managers RBS, UBS and Citigroup opened the order book on Monday morning, and strong demand in Europe was reinforced overnight by unusually strong Asian demand for Euro-denominated 10-year paper. Asian accounts eventually made up 12% of the allocation.

And in the dollar market, the $3bn 10-year global from KfW in late February was 43% placed with Asian accounts.

Flight to quality effects

“The effects of the flight to quality can be seen in overall demand and the size of individual tickets,” says Horst Seissinger, head of capital markets at KfW. “Our offerings in the first quarter included a three-year global bond with a record volume of $5bn: a €5bn, 10-year, and a $3bn, 10-year, so it is clear that new money is looking fortop credits.

“Compared with a year ago, spreads over bunds or treasuries have obviously widened a lot but the swap curves have also shifted, so our cost of funding in Libor or Euribor terms is slightly better than last year, because of the flight to quality,” he says.

“In 2006 or early 2007, we would start marketing on a Friday and look at market developments on a Monday morning, but in today’s market conditions we can take a decision in two or three hours whether we are prepared to go to market or not, based on some discreet soft soundings.

Timing is important, Mr Seissinger emphasises. “It is important to get the timing right, especially because other borrowers are also looking for opportunities to issue, so flexibility is the keyword for benchmark activity,” he says

Mr Seissinger says that the work that KfW has done in the past three or four years to improve investor relations activities is now paying off. “We talk regularly with our biggest customers, attend conferences organised by investment banks and send out regular newsletters. The infrastructure that we have built up to communicate with our investors has proven highly beneficial to us in today’s difficult market conditions,” he says.

Taking advantage

The European Investment Bank (EIB) has also been taking advantage of Asian demand. In mid-February, it launched a $1.75bn, seven-year deal, its largest ever Eurodollar transaction.

Taking advantage of a liquidity build-up after the Chinese New Year holiday period, and a stronger tone in the underlying market, EIB responded quickly with the initial announcement of a $1bn deal. Strong bookbuilding momentum in Europe in the afternoon continued overnight into Asia.

With $2.5bn-worth of orders the deal size was substantially increased, and printed at 20 basis points (bp) below mid-swaps, in line with initial guidance. Asia took 44% of the issue, with EMEA 53% and Americas 3%. Central banks and official institutions comprised 70% of the order book, banks 13%, fund managers 10% and retail 7%.

Guy Reid, executive director of frequent borrower coverage at UBS in London, says: “In difficult markets, you typically see a very strong bid for high- quality assets at the short end of the US dollar curve; and the best sovereigns, supranationals and government-guaranteed names are getting deals done at similar or better spreads than this time last year.” A number of heavily oversubscribed deals have also outperformed in the secondary market, he says.

“There has been a higher percentage of dollar deals distributed to central banks than we saw in early 2007,” says Mr Reid. “At that time, a lot more paper was going into the US, whereas today many US investors prefer to invest in domestic names, particularly since spreads on US agencies have widened during late 2007 and early 2008.”

Mr Reid says that central banks have absorbed this paper. “And we have seen deals, such as BNG and Network Rail, sell more than 90% to central banks. The rise of central bank reserves outside Asia, for example in Russia, Norway and Brazil, has been quite significant, and those accounts can be price drivers. Issuers are getting wider distribution and are not as reliant upon Asian accounts as they were before, though demand from Asia remains very strong,” he says.

Challenging space

According to Dan Shane, executive director at Morgan Stanley in London, sovereigns and supranationals have benefited from the flight to quality, achieving larger deal sizes as a result, whereas the rest of the market has declined in size. “We are increasingly seeing demand for corporate issues but the most challenging space is the financial sector, where there has been a big drop-off in activity.

“However, in the past few weeks, we have seen the start of a recovery in new issue volumes, in particular, seeing success with placement of retail deals, with some of these being specifically sold to Asian retail investors,” he says.

“Sovereign and supranational issuance is counter-cyclical to some extent, and issuance was very strong during the first quarter, with some borrowers getting half of their 2008 borrowing programmes done. Asian central banks and sovereign wealth funds are core buyers of European sovereign and supranational paper, and key drivers on pricing,” says Mr Shane.

The right groundwork

For issuers, the key is to remain flexible and hit the right part of the curve. Whereas 12 months ago, almost every deal was heavily oversubscribed, in today’s market conditions, issuers are careful to lay the groundwork and ensure that their public offerings are a success.

“Issuers are doing a lot more soft soundings of key investors, and knowing that they are ready to put in an order gives you more confidence in launching a transaction in the current environment,” says Network Rail deputy group treasurer Samantha Pitt.

Network Rail runs the UK’s rail track infrastructure and is guaranteed by the UK government. It has plans to raise about £6bn ($11.91bn) equivalent on the capital markets during its financial year, which began in April.

First quarter offerings from Network Rail included a $1bn, three-year deal, lead managed by HSBC, RBS and Merrill Lynch. It priced at mid-swaps minus 23bp, which was Network Rail’s tightest-ever dollar pricing, although given the movement of the swaps curve versus treasuries, this was 55.2 over treasuries.

A year ago, most issuers would have priced a dollar offering versus treasuries, but in a fast-moving market, most issuers tend to give price guidance versus mid-swaps.

“Our three-year dollar deal was 91% placed with central banks, and 33% went to Asian accounts,” says Ms Pitt. “Demand from Asia is strong, although the Asian allocation was slightly less than on some previous deals, mainly because we are seeing a lot more interest from investors in the Middle East, Scandinavia and central and eastern Europe.”

Asian demand

Top sovereign issuers, such as Germany and France, are seeing heavy demand for their paper from conservative Asian central banks, but they too are staying closer to the short end of the curve to take advantage of current conditions.

Agence France Trésor chief executive Philippe Mills says: “Our policy is to have a regular and predictable series of auctions, while listening closely to our primary dealers and adapting to market conditions. We are experiencing more demand for our products as part of the global flight to quality, but at the moment, investors clearly prefer the two- to 10-year segment of the curve.

“We stay in regular contact with Asian investors, such as central banks, institutional investors and sovereign wealth funds. For example, in April we will be spending a week in China, South Korea and Taiwan. In 2007, Asian accounts were our second largest group of international investors, after Europe, and total net flows from Asia on all of our securities were €42bn, which increased from €22bn in 2006.”

Price tiers

During the first quarter, and especially in March, there was growing tiering of pricing among eurozone sovereign issuers, with Germany getting the best execution.

Erik Wilders, agent at the Dutch State Treasury Agency, which has built up a sizeable Asian investor base in recent years, says: “Because of the market turbulence we have benefited from the safe-haven effect, but investors are looking for liquidity and not just the AAA credit rating and this has benefited Germany the most because they have the advantage of the Eurex Bund future.

“All eurozone government bonds are hedged versus the Bund future and if that relationship is less efficient, there is more risk for traders buying and selling securities and it is harder for primary dealers to hedge themselves,” he says.

“Issuance is trickier in today’s market, and it is more difficult to estimate at what price the bonds will clear in an auction. But we are still seeing strong demand, and after Germany, France and the Netherlands have the tightest spreads among eurozone sovereign issuers.”

Watching the points

Market making remains problematic, according to Jean Deboutte, director of strategy at the Belgian Debt Agency.

“A year ago, there might have been a 4bp or 5bp pick-up over Bunds for 10-year Kingdom of Belgium benchmark bonds, which are rated Aa1/AA+, but this was more like 30bp in January and widened out to 40bp in March,” he says. “With wide bid offer spreads, this clearly puts off some investors.”

Many investors see good long-term value in Belgian government bonds, Mr Deboutte believes. “In January, we launched a €4bn 10-year OLO [obligations linéaires] and there was very good participation from Asian central banks, which took 16% of the issue – the highest-ever figure for a 10-year deal. The total order book stood at €6.9bn.”

In late March, there was strong demand for an offering of three lines of obligations linéaires, with €3.38bn-worth of bonds sold.

The commercial picture

For commercial banks, the picture is more difficult, though AAA-rated, publicly owned institutions, such as specialist public sector lender Bank Nederlandse Gemeenten (BNG), have a clear advantage.

Bart van Dooren, head of funding at BNG, says: “In current market conditions, it is particularly important who you choose as lead managers. An issuer needs to know that a lead manager has sufficient capital to support a deal, in case the issue is not fully subscribed, because they want to avoid seeing their bonds sold onto the secondary market.

“We start off with some soft soundings with five or six key investors to see if conditions are right for a successful deal, and in today’s market we are finding that investors are looking mainly at the short end of the curve and prefer three- or maybe five-year paper.”

There is still strong demand from Asia, and investors from Scandinavia, Russia, the Middle East and South America are becoming more important, he says.

In early January, BNG launched a three-year, $1.5bn, 3.375% public-benchmark deal, which priced at mid-swaps minus 15bp, lead managed by UBS, Goldman Sachs and Citigroup. Given the volatility of markets at that time, there was strong investor demand at the short end of the curve. About 92% of the deal was placed with central banks and official institutions. The geographical breakdown was 35% Asia, 27% Europe, 23% Americas, and 15% Middle East and Africa.

A waiting game

However, looking at lesser values than AAA, demand for AA or single A paper is weak at present, and many banks are waiting for the markets to settle down.

Bart Toering, head of capital markets at SNS Bank, which over the past five years has built up a growing investor base across Asia and in Australia, says that the market is difficult at the moment. “In the first quarter, we did a five-year €800m residential mortgage-backed securities transaction backed by NHG-guaranteed mortgages, which had good appetite from European investors and printed at 12bp over Euribor. And we are planning a three-year covered bond offering during 2008, out of our newly established covered bond programme, although the market is very difficult even for covered bonds.”

But SNS has grown its deposit base. “And, having done a lot of funding in 2006 and the early part of 2007, we have significantly reduced requirements to access the capital markets this year.

“In August, we have a non-deal specific roadshow planned across Asia and in Australia, and we will update existing investors as well as talk about our covered bond deal. But for senior unsecured debt, the market needs a period of stabilisation before regular issuance gets started again from European banks.”

Down the credit curve

Further down the credit curve, in recent years, Asian high net worth individuals have had a strong appetite for lower rated issues that carry a high coupon.

Banks from Latin America with ratings as low as single B have tapped the market for small amounts. And better-known European banks with investment grade ratings have been able to do very sizeable perpetual deals that qualify as Tier 1 capital.

Even since the subprime crisis got under way last summer, there have been a number of deals. In October, Rabobank (rated AAA) did a $750m, perpetual non-call five deal. This was soon followed by a $400m deal for single A-rated Kaupthing Bank, and a $500m offering from AA-rated Credit Agricole.

The markets have deteriorated since the autumn but nonetheless, in February, Fortis Bank came to market with a well- received $750m transaction, lead managed by Merrill Lynch, Fortis Bank and Morgan Stanley. The single A-rated bonds carried an 8.25% coupon.

“The Fortis Bank transaction illustrates that sizeable, perpetual non-call five offerings can get done even in the current difficult environment,” says Ashish Malhotra, head of the Asian debt syndicate at Merrill Lynch in Hong Kong.Merrill sold the bonds to its own private banking clients and also via its institutional distribution platform, which covers private banks across Asia. About half of the deal was sold in Asia, with the other half in Europe, although there was some Middle East placement.

“Asian retail high net worth investors have historically been willing to go down the credit curve, and have even bought BB or single B-rated bonds in order to pick up yield,” Mr Malhotra says. “But the current environment is more of a high-investment-grade, high-name-recognition market, and lower-rated or lesser-known issuers may have to wait until confidence returns to the market.”