With hindsight, Deutsche’s foray into the unknown – a joint venture with Fannie Mae to market an inflation-linked bond to institutional investors – seems as if it could not have failed. But it did not always look that way. Sophie Roell reports.
When Jeanmarie Genirs, managing director for US agency trading at Deutsche Bank Securities in New York, left for work on the morning of February 4, she did something she never does: she asked her husband to wish her luck. “I need good luck, because today is either going to be a really good day or a really bad one,” she told him.
Deutsche is no newcomer to the US agency market – it ranked top of the league tables in 2003 – but on this occasion had persuaded Fannie Mae, the AAA-rated, government-backed mortgage colossus, to try something a bit different: a large-scale bond issue linked to the consumer price index (CPI).
The deal, initially planned for $500m, would be Fannie Mae’s first linker in seven years and did not fall neatly into either of two distinct categories: the inflation-linked bonds issued by the treasury known as Tips (which have a specialised, largely institutional audience), on the one hand, and the swathe of corporate bonds linked to the CPI issued in recent months, on the other.
The latter have tended to be relatively small in size – the largest was a 10-year deal by SLM Corp, a provider of student loans, for $225m – and aimed at retail investors.
Rather, Deutsche was aiming for a first: a large-sized agency linker appealing to institutional investors.
Breaking new ground
It was a jump into the unknown. “I don’t want to say we were issuing into a black hole, but there were not a lot of comparisons in the market,” says Sarah Salih, director, debt syndicate.
As sole lead, Deutsche had structured a deal it thought would appeal to a broad range of investors – offering a spread over Tips but doing away with one of the main disadvantages of the treasury issues: principal accretion. Instead, the bond would pay a coupon, removing the problem, among others, of phantom tax liability – paying taxes on income that has not been received.
Yet the early response was not overwhelming. In about 350 conversations with clients, there was some enthusiasm about the bond but not a single investor committed to buying.
“It was something new; people are always sceptical,” says Ralph Segreti, director, US government trading.
For Deutsche, the deal was a natural culmination of its success in the agency market combined with its efforts to develop a global inflation franchise (also helped by the development of a CPI swap market in the US). But just because the team could do the bond, it did not necessarily follow that there would be any buyers.
“It had not been done before so it was really just a group of people saying – we know we can create it – but can we sell it?” Ms Genirs says. “From Fannie Mae’s standpoint it had to take a bit of a leap of faith. It’s something we all believed in collectively but the truth was that until we brought it to the market we really didn’t know if it was going to work.”
The risk was that, instead of bridging the gap between two types of market, it might end up falling between the cracks.
According to Mr Segreti: “Typical treasury investors were telling us they felt the deal would be viewed as expensive – because Fannie Mae trades at 35 basis points over Tips, so why should Fannie Mae inflation-linked trade at 20 over treasuries?”
Flying start
As it was, the deal, announced at around 9am, was sold out within two hours. “By noon our book was fully subscribed at $500m,” says Ms Salih. “Even some of the accounts we were talking to, who were sceptical or even negative on the transaction when we were sounding them out before announcing, came in right away when they saw the momentum gathering around the deal.”
Orders were still being taken until the end of the following morning on a subject basis – with no guarantee that they would be filled. Then Fannie Mae gave the go-ahead to upsize the deal to $750m. By then Deutsche had more than $1bn in the orderbook. Says Ms Salih: “I think it could have been much more had we left the book completely open.”
About 140 investors bought the bond – including corporate bond funds, money managers, central banks and insurance companies, as well as some retail investors. Demand has remained high in the secondary market. “We have traded between $75m and $100m and right now we are short [of] the bond,” says Ms Genirs, which the team says is not entirely surprising, given the novelty of the product.
Tight timing
Mr Segreti says that a lot of the investors to whom he spoke said they needed time to analyse the structure because it was new to them. “And by the time they got it done, the books were closed – and they wanted the paper,” he says.
Some dedicated Tips funds even had to rewrite their covenants to allow them to buy the bonds – something that cannot be done overnight. “We still have some accounts that are rewriting their internal guidelines,” says Ms Genirs.
In retrospect, the deal’s success seems almost inevitable. Inflation is the current watchword and, as demonstrated already in the strong performance of the Tips market, that is bound to benefit any inflation-linked product.
“A low rate environment with a reflationary monetary policy is a recipe for success for the Tips market and so I think people are looking at inflation-linked products as either defensive bearish plays or, if you believe that rates are on hold for quite a long time, they’re going to be an excellent carry trade,” says Mr Segreti. “And [the Fannie Mae deal] has fed on the success of the Tips programme: deals like this were bound to happen.”
New world on offer
He argues that the deal will break open the inflation market to a whole new universe of institutional investors – and set a benchmark: “It really did open up the world of inflation protection and inflation hedging, and asset liability matching, to people beyond the treasury world.
“I think we’re going to see an inflation credit curve developing, whereas before there wasn’t one; there were these kind of spotty deals out there – there were deals coming and if people had an interest they were getting done – but this definitely marks a sea change in the investment community.”
Says Ms Genirs: “It’s kind of set the benchmark going forward. It used to be Tips or you could look at these retail structures. Now we have something new that kind of bridges the gap.”
Sitting in the bank’s gleaming new offices at 60 Wall Street, the team argues it was not a surprise for them to get the sole lead role – given what they see as Deutsche’s strength in agency, inflation and derivatives markets. “Without all of those pieces working together you can’t bring a transaction of this size and this complexity,” says Ms Salih.
“And that’s also why it’s so important on a deal like this to have a sole manager role. Because there are so many different parts to the transaction – both in terms of marketing the product to managing our potential inflation risk – you need to have complete control of the deal.”
Sigh of relief
Ms Genirs says timing was all. “With hindsight, you need the moon and the stars, everything, to line up; now, it’s a little bit easier to breathe. But at the time it was a big leap of faith.”
And it is not just Deutsche and Fannie Mae that are breathing a sigh of relief – it is also Ms Genirs’ husband: she is eight months pregnant. “I told him, if this deal doesn’t go smoothly, the baby is going to come out early,” she says.
