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Team of the monthOctober 1 2018

HSBC facilitates £1bn EIB Sonia issue as Libor fades

As the transition from Libor to Sonia begins, HSBC’s debt capital markets team has found itself with a key role to play. Edward Russell-Walling reports.
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HSBC team 1018

From left: Asif Sherani, Hector Snuggs, Dan Broderick

Fatally wounded as it is by scandal, the London Interbank Offered Rate (Libor) will almost certainly be replaced by the Sterling Overnight Index Average (Sonia) as the primary sterling interest rate benchmark for bonds, loans and derivatives. The European Investment Bank’s (EIB) recent £1bn ($1.3bn) Sonia-linked floating rate note issue may mark the real beginning of that transition in the bond markets. HSBC was a joint lead.

Sonia is not exactly a newborn, having been launched in 1997. Its use in the sterling overnight indexed swaps market has grown steadily, with daily volumes rising from £10bn to £15bn in 2010 to £40bn to £50bn in 2018, according to Bloomberg. In the bond markets, however, it has been virtually unknown.

That said, this was not the EIB’s first debt capital markets (DCM) outing with Sonia. Back in 2010 it issued a four-year £300m bond with a coupon of Sonia plus 35 basis points (bps). It was priced at par.

This had all the hallmarks of an experiment that did not quite work. There was only one lead manager (RBC Capital Markets) and the issue was small compared with the EIB’s normal funding size. It was never tapped, and another eight years went by before the bank tried it again, this time with a more decisive outcome.

Leading the way

The EIB was the natural candidate for this trade, with its long-standing commitment to sterling as one of its three core funding markets. “The UK was one of the EIB’s most important lending markets,” says Hector Snuggs, HSBC’s head of public sector DCM London. “The EIB has been the premier SSA [sovereign, supranational and agency] borrower in the sterling market for decades.”

At its peak, the EIB issued 45% of all annual SSA sterling bonds excluding the UK Debt Management Office, says Mr Snuggs. It accounted for up to two-thirds of sterling floating rate note (FRN) SSA issuance.

In addition to its traditional activity in sterling markets, the institution likes to be a trailblazer and role model when it comes to innovation and regulatory change. “As the market leader in sterling, the EIB wanted to pave the way for other issuers,” says Asif Sherani, head of HSBC’s public sector syndicate.

Given that the Luxembourg-based supranational’s own interest in sterling will plummet once the UK leaves the EU, this displays a certain degree of altruism.

A couple of developments have made Sonia more immediately germane to the sterling market. The most important of these was an announcement in July 2017 by Andrew Bailey, CEO of the UK’s Financial Conduct Authority (FCA), which regulates Libor. He said that the FCA would not compel banks to submit Libor rates after the end of 2017.

“The importance of Sonia has changed since the 2017 announcement,” says Mr Sherani. “It is now seen as the rate that will be used by the end of 2021, and the one which must be used for floaters.”

Daily clarity

Another pro-Sonia development is that its administration has been taken over by the Bank of England, which has reformed its calculation and publication.

Most daily Libor submissions are estimates, which is what allowed the rigging scandal to develop in the first place. Sonia rates are based on actual transactions. The Bank of England has broadened Sonia’s database, and changed publication from 6pm on the same day to 9am on the following London business day, allowing time to process the larger transaction volumes.

The EIB has been discussing the possibility of a benchmark Sonia issue with its advisers since 2017. The first concrete indication of what was coming was a £2m test trade in March 2018, in which a small number of investors, typically banks, were invited to participate.

“They wanted a trade out there to allow investors to buy tickets and see if systems and platforms could cope with Sonia, which is a very different animal to Libor,” says Mr Sherani.

For bond investors, Libor effectively resets every quarter. Sonia, however, resets daily. This makes it a better hedge for most investors, Mr Sherani argues, because they are exposed to an actual rate on a daily, rather than quarterly, basis. But some will need to address the ability of their IT systems to handle daily accrued interest computation.

Apart from that, and a few minor IT glitches, the test went off “reasonably smoothly”, according to HSBC’s bankers. “Most of the testing was done in the secondary market, and was dominated by bank treasuries,” says Mr Snuggs.

The Bank of England had confirmed via its website that the bonds were repo-eligible. The fact that bank treasuries were likely to provide the bulk of demand helped to build confidence that there was the critical mass for a full-sized trade.

Strong demand

The EIB awarded a mandate for a Sonia-linked transaction to HSBC, NatWest Markets, RBC Capital Markets and TD Securities. “We announced the intention to issue on June 18,” says Mr Snuggs. “We thought it would take at least a week for feedback but, given the strong investor demand, we accelerated the timeframe from that originally envisaged.” The transaction priced on June 22.

Why such appetite? Mr Sherani believes it was because investors realised they were looking at the future. “We had expected pushback on their ability to take Sonia, because it was a new product,” he says. “In fact, the only problems were where internal systems couldn’t handle the daily computation of accrued interest. Even there, some said they could manually override the system.”

Given the supportive investor feedback, a new five-year bond was announced three days later, with initial price thoughts of Sonia plus 35bps area. Sonia is compounded daily, with a five-day observation lag.

The original deal size envisaged had been £500m, but demand was unexpectedly strong, with orders of over £1.55bn from more than 50 investors, and the size of the transaction was increased to £1bn. The spread to Sonia was left at 35bps, “as this was a strategic transaction”, in Mr Sherani’s words.

Unsurprisingly, most investors were UK-based, taking 89% of the issue, with the balance from the rest of Europe, Middle East and Africa. Banks accounted for 75% of the allocation, with fund managers 21% and central banks and others 4%.

The bonds were immediately bid tighter than re-offer, according to Dan Broderick, director rates in HSBC Global Markets. “We have seen robust demand in the secondary market, where the bonds have been trading sub-30bps over Sonia,” he says. “That underlines the quality of the book. And if you sell, what do you replace it with? It’s a difficult asset to replace.”

A Sonia template

Mr Broderick pays tribute to the EIB. “It has been very innovative and generous, spending time, energy and money to get it right in a way that works for the market, and not just for the EIB,” he says. “It has set a template that works and can’t be ignored – investors will buy Sonia-based products.”

So will there be much more Sonia-linked issuance? “Absolutely,” says Mr Snuggs. “On the public sector side there is a lot of interest.”

Nonetheless, future issuance from SSAs is likely to be constrained by concerns over how to hedge risk, since many of them are not lending in the UK and are therefore not exposed to Sonia.

SSA borrowers may issue in sterling, but many will then swap back into dollars or euros. “And in the past very few have issued FRNs,” says Mr Sherani. “However, Sonia-linked issuance should be a growth area for corporates and financial institutions.”

Indeed, financial institutions have already picked up the baton, as HSBC is well aware. In September, it was lead manager alongside Lloyds, RBC Capital Markets and TD Securities on Lloyds Banking Group’s debut Sonia bond.

The three-year, £750m covered bond was priced at 43bps over Sonia, and made Lloyds the first financial institutions group issuer – and this the world’s first covered bond – to link coupon payments to the new benchmark.

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