Will euro fever give the u.s. bond market a run for its money?

By Robert Hunter

On January 4, while most people were preoccupied with the birth of the euro, another major financial revolution was unfolding. The euroland bond market has been recast as a dynamic new behemoth that bears little resemblance to its neurasthenic predecessor. Now, three months later, fixed-income players from around the world are rushing the gates to position themselves in what may become the world’s biggest bond market.

January saw more bond issuance denominated in euros than in dollars—the first time in memory that the dollar has been supplanted as top dog. And in the first two weeks of February, there was more euro issuance than in January. It’s not surprising that governments of euroland countries would want to issue bonds in their new currency; when far-flung players such as Lebanon and Argentina launch massive euro-denominated issues, there are clearly bigger forces at work.

A recent Belgian government issue of 5 billion euros highlights the benefits of dealing in the new currency. The government chose two lead managers—ABN Amro, the biggest player in the Benelux countries, and Warburg Dillon Read, a subsidiary of the United Bank of Switzerland. In the past ABN Amro likely would have acted alone, and the securities would likely have been denominated in Belgian francs and sold mostly to Belgian investors. In the latest euro issue, by contrast, the co-lead managers dramatically widened the distribution channels, presenting investors throughout euroland with foreign sovereign bonds in their home currency, free from currency risk. And the broader investment base presumably made for much less volatility.

As appealing as they are, ease of issuance and distribution are not the sole reasons for the massive supply of euro-denominated paper this year—which many have called a glut. Chief among them: euro fever. Everyone wants their name associated with the euro, be they sovereign issuers, corporate issuers or investment banks trying to build their league table status. “All issuers—European, American and emerging market—are enthusiastic about establishing their name in the market and launching issues that will be benchmarks for their future issues,” says Bill Broeksmit, head of European derivatives at Deutsche Bank. “The euro is such an important source of capital, particularly for capital-needy entities such as finance companies and government agencies, that they believe it’s vital to get involved early and have large, liquid issues that establish their name in the pan-European market.”

There is some investor appetite for high yield in europe so far, but it will take time for the internal restrictions of european fund managers to change. Heinz Gunasekera

One unexpected casualty of the early rush to euroland is the euro/dollar swaps market, which has suffered surprisingly low liquidity this year. Issuers around the world are eager to remain in euros, at least for the time being, and international swaps dealers have been conspicuously inactive. “There was significant buying out of Asia in the run-up to the euro, and it hasn’t really followed through,” says Ian Douglas, head of global fixed-income strategy at Warburg Dillon Read. “It seems to us now that a lot of the world’s big money managers—particularly the reserve managers—are sitting on the sidelines and waiting to see how things unfold.”

The euroland fixed-income derivatives market began slowing down last December, in fact, as institutional investors scaled back activity to avoid the headaches associated with carrying over trade settlements in euros. In January and February, traders unfamiliar with the new currency waited for a well-defined market to emerge. Moreover, some U.S. players, eager to issue in euros at any cost, have been willing to swap back into dollars on terms that are less attractive than they could get in the U.S. market or the eurodollar bond market—a premium of 40 basis points by late February. The result: issuers looking for cheap money via the old mechanism of launching a eurobond issue and swapping into another currency are feeling the pinch. “The reason the euro has failed to provide that opportunity,” says David Gelber, chief operating officer at Intercapital in London, “is that so many people wanted to get their name onto a euro issue and the supply of bonds became so great that the swap opportunities simply were not there. When companies launch a sterling bond, they can get an attractive price on a swap of fixed rate to floating rate, and from there on into dollars. But with eurobonds, the arbitrage simply isn’t working.”

To the extent that there is activity, confusion has often attended the proceedings. “The banks are still organizing their trading desks,” says a London interdealer broker. “Some people are trading on a curve, and they’re organizing their trades into short, medium and long duration. Others are sticking with credits. We’re doing neither—we’re simply trying to serve people the best we can.”

The problem, for some, could be one of short-sightedness. “Everyone was focusing on the conversion D-Day,” says Raj Sitlani, manager of institutional futures sales at ADM Investor Services in London. “It doesn’t seem apparent that anyone was thinking about what they’d do once it happened.” Others agree. “People were expecting a Big Bang, but the explosion hasn’t happened,” says Heinz Gunasekera of Warburg Dillon Read’s relative-value analysis group. “It’s incremental money and it’s a slow process. They were building up to a climax, but it has been something of an anticlimax.”

Meanwhile, the predictions for low euro volatility were dead on—the euro has been remarkably stable against other major currencies, even while yen/dollar volatility has been breathtaking thus far this year. The result has been a dearth of spot and forward business in euros. The European Central Bank has vowed publicly to keep the euro as stable as possible vs. the dollar by intervening on both sides of the market. While the euro has declined precipitously since January, the daily swings have been small. “There haven’t been a lot of speculators playing a euro trade, because nobody knows what to expect,” says Stephen Godfrey, vice president of global risk analysis at Bank of America. “The political and economic fundamentals in Europe compared with the United States have led to weakening, but it has been a steady weakening.”

Wanted: A Trading Curve for Euro Swaps

In the three months since the launch of the euro, one question has dominated the minds of fixed-income players around the world: Can a swaps market develop without a clearly defined trading curve? So far, at least, sluggish volumes have indicated that some swappers may simply be waiting on the sidelines for a benchmark to emerge. Merrill Lynch publishes a synthetic curve it calls the Euro Spline curve, based exclusively on French and German government bonds. Not everyone agrees with this approach, and a benchmark battle is heating up across Europe. Paribas, for one, has been vocal about its preferences. “German bonds are currently seen as the benchmark for Europe, particularly by international portfolios,” writes the company. “However, the liquidity throughout the curve is higher in France, while the strips and repo markets are more sophisticated. The French market is by far a better pricing instrument.” That position is by no means the consensus. Barclays Capital seems to favor the Merrill Lynch approach. “At present, both Germany and France look best placed to compete in terms of liquidity and benchmark status...” it says. “On balance, Germany is seen to be the favorite, given the government bond market’s overall liquidity, size and previous stability. However, France does come a close second...Presently, French government benchmarks trade with the same tight bid/offer spread as Germany. In terms of products, the French government has most certainly offered a broader range for a longer time period than Germany. Consequently, it is possible that we might see French government bonds making up at least part of the ‘euro’ benchmark yield curve.” Some have even suggested that the swaps curve will become the benchmark. “The derivatives curve could become the defining curve of where euro interest rates are,” says David Gelber of Intercapital, “because it is a totally neutral curve—there’s no differential credit pricing. Bonds are effectively priced off of derivatives rather than derivatives [being] priced off of bonds. Some of that is happening already.” But one man’s advantage is another man’s drawback. Barclays is particularly skeptical. “It is widely assumed that swaps denominated in the anticipated countries’ currencies will be perfectly fungible into one ‘euro’ market, which, of course, will make the swaps market very liquid. However, although these swaps will not be subject to any sovereign credit-rating differences, there will be counterparty credit-rating differences, which leads us to believe that the swaps market will not provide the ideal post-EMU benchmark.” The evidence seems to support Barclays’ position. Since January, a number of anomalies have developed in the euro cash curve, says Heinz Gunasekera of Warburg Dillon Read. “The short end of Spain and the 2004–06 sector of France are rich to German Bunds, while the short end of Italy is quite cheap to Bunds,” he says. Moreover, the curve is concave rather than convex, which limits arbitrage opportunities. Everyone agrees that a better-defined yield curve must emerge before volume is to increase. One thing is certain: historical data will not serve as much of a guide. “You can’t simply add the curves up and assume that today’s yield curve should be solely governed by previous history,” says Ian Douglas, head of global fixed-income strategy at Warburg Dillon Read. “You’ve got to wait for the new euro curve to develop.” Most traders use only the last 60 or 90 days of the yield curve as a guide, and since convergence in euroland occurred around the Deutsche mark, rather than around some historical average, it’s clear that history has been thrown out the window. Like any yield curve, the euro curve will ultimately be based on liquidity in the short end and expectations about interest rates in the long end. The key to defining a euro yield curve may lie in the bond futures market. Paribas sees big changes in store for the exchange world as a result of European monetary union. “The introduction of a complete euro future, which allows for a multiple-issuer deliverable basket, is increasingly likely in the first half of 1999,” the bank writes. “The success of a euro 30-year future will be largely dependent on the liquidity of the contract and on the arbitrage opportunities within the deliverable basket.” The Matif has already launched such a product, which it calls the “Euro All Sovereign,” a 10-year future whose deliverability includes France, Germany, Italy, the Netherlands and Spain. It has also launched a multiple 30-year future that includes France, Germany and the Netherlands. Meanwhile, the London International Financial Futures and Options Exchange, stoking the fires of the benchmark battle, has issued five- and 10-year futures on euro swap rates called the Euribor-Financed Bond. Both exchanges are hoping their products can overtake the Eurex’s Bund product, which, by virtue of its sheer size, seems to have the inside track on euro interest rates. Like all battles in the exchange world, the fight for a euro benchmark will likely rage on. —R.H.

A new paradigm

While the united euroland fixed-income market is but a few months old, it’s clear that certain segments are poised for explosive growth. The corporate bond market has the biggest potential for stardom. Although Moody’s Investors Service has rated only 180 corporate credits in the euro zone thus far, some 70 percent of those are rated as investment grade—a soothing enticement to traditionally timid European investors. And because euro convergence has pushed government bonds to relatively low levels, more aggressive euroland fixed-income investors have grown hungrier for yield, and will have little choice but to move further and further down the credit curve to find it. As a result, many observers expect the high-yield segment of the corporate bond market to explode.

Investors need to walk before they can run, and in order to walk they need to build a robust credit curve for aaa issuance as well as bbb issuance. Andrew Readinger

“The high-yield market will develop from the successful base of last year,” predicts French investment bank Paribas. “New investors will be attracted by the greater depth, liquidity and variety of issuers.” Paribas also sees big growth in higher-rated credits. “Over the next few years, a market will develop that has issuers ranging from sovereigns and supranationals to high-investment-grade multinationals and conservatively financed mid-sized companies. Asset-backed and structured securities and high-yield debt from leveraged acquisitions will become the order of the day.” The bank predicts a corporate bond market of $10 trillion in the not-too-distant future.

Indeed, the future behemoth is already beginning to stir. “The corporate bond market in euros is going to explode,” says a broker at Tullett & Tokyo in London. “We’ve already seen an issue out of Repsol, which is Spain’s biggest petroleum company. A lot of the market-making has been driven to Germany on this issue, because that’s where the liquidity is, whereas in the past it would have remained pretty much in the Spanish market. Now we have customers in Germany who are obliged, because of their retail customers as much as anything else, to start looking at this stuff.”

Other brokers agree. “We’ve already seen a big appetite for the business,” says David Wolstenholme, director of international broking services at Eurobrokers. “While the Japanese banks have bought U.S. govvies, the U.S. people have bought high-yield bonds. That will probably be a mainstay of a new market for European issuers. We saw recently that some American banks were picking up a lot of secondary Japanese bank debt and repackaging it back into the States. As more issuers come into the market—and when the market comes out of recession—you’ll see that happening in Europe as well.”

Cracks in the EMU’s Armor?

Two years ago, Europe was full of euro-skeptics betting that the proposed union would never fly. Most were silenced by the triumphant launch of the new currency. But now, after three months of euro-scrutiny, the skeptics are starting to buzz anew. The main source of worry lies in the euro’s weakness relative to the dollar. The euro/dollar exchange rate has dwindled gradually, from $1.17 in January to $1.07 by late March, leading many to question the currency’s long-term viability. “I think the pre-euro assumptions in many cases have not come to fruition,” says Stephen Cherry, an international futures salesman at ADM Investor Services in London. “Rather than becoming a direct challenger to the dollar, the euro has proved to be fundamentally flawed—or at least that’s the fear the market has taken on. You can see that in the foreign exchange action from January 4 to today.” In addition, says Cherry, the way people trade the currencies involved in the euro has changed significantly. Even though each country still publishes economic figures such as growth and inflation rates, traders now treat euroland as a single, monolithic entity. What would have caused a distinct market movement pre-euro has become almost meaningless now. “For the market to step back and take on a broader view will be quite a big transition,” says Cherry. “That remains the key—trying to keep an eye on the bigger picture.” The pre-euro assumptions have indeed proved false. The expectation was that the euro would strengthen vs. the dollar, because the U.S. Federal Reserve was thought to be on the verge of easing interest rates late last year. But the United States has continued its torrid growth pace, leading to expectations that the Fed will tighten rather than ease. Meanwhile, Germany’s gross domestic product contracted in the last quarter of 1998, and, in mid-March, was expected to contract in the first quarter of 1999 as well—technically, a recession. The rest of the core countries of euroland are slowing as well. But the main issue, say many, is the credibility of the European Central Bank. Earlier this year, Germany’s then-finance minister, Oskar Lafontaine, began urging the ECB to cut interest rates, putting it in a political bind: If it cut rates, it would appear to be kowtowing to the Germans and would lose its credibility as an independent central bank; if it did not cut rates, Germany and perhaps other European countries might slip deeper into recession. Its solution? To let the euro weaken against the dollar, producing a de facto easing without lowering interest rates. Many people now wonder how far the ECB will let the euro drift, and some euro-watchers expect the ECB to cut interest rates this month. “People assumed that by the sheer size of the euro area, it would be a strong currency,” says Cherry. “If that doesn’t prove to be the case, a major shift in portfolio allocation may be warranted.” In addition to the ECB credibility issue, there appear to be more fundamental problems with EMU. The Stabilization Pact is the most obvious, acting as a fiscal straightjacket to euroland countries. When an EMU country slips into recession, it has limited tools at its disposal to reverse the process. The dream of labor market mobility has been just that—cultural and language barriers make a truly mobile labor force, as exists in the United States, an unrealistic goal. And unharmonious tax laws make business mobility difficult as well. Moreover, many wonder whether the European Union’s political structure is up to the challenge a single currency presents. The March 16 bombshell announcement that the entire 20-person executive body of the European Union was resigning amid charges of fraud, corruption and mismanagement may have delighted the members of the European Parliament who had long been trying to oust the executive committee, but market participants were left agape. The euro immediately flirted with an all-time low. Now, rumblings among euro-skeptics that the euro may be in trouble are growing louder. “I think the monetary union will unravel in one business cycle,” says a London banker. “It’s inflexible; there are no vents through which pressure built up in one country can be released. And the Maastricht Treaty doesn’t allow for fiscal transfers from one state to another. I think at some stage nationalism will become a force, and within one business cycle, when we go into deep recession, it could unravel.” The proposal by the French and Germans at the latest G-7 meeting to create currency target zones certainly doesn’t inspire confidence. In a target zone scenario, the dollar, euro and yen would be fixed to a trading band of, say, 10 percent, which central banks would vigorously defend via interest rate and open market operations. The potential dangers are clear—the possibility of volatile interest rates, as central banks defend their currencies, would lead to higher costs of capital as interest rate risk is priced into new issues. Liquid and affordable hedging tools could disappear entirely. Oskar Lafontaine’s resignation in March calmed some nerves, and the euro’s value against the dollar briefly spiked up. But the downward cycle returned quickly, and hard-core euro-skeptics, believing the euro has not yet seen its darkest days, are warming up their vocal chords for a rousing chorus of “We told you so.” —R.H.

Credit Bets in the New Euroland

How much will the euro affect U.S. fixed-income investors’ decision-making processes? The general consensus is, a lot. “I think the euro is wonderful for U.S. investors,” says Lisa Whiffen of Front Capital, a London-based software provider and consultant. “They have been tracking their way up the risk curve, trying to get greater and greater returns. They’ve exposed themselves to risks such as Russia, and they’ve got their fingers burned. Now, suddenly, there’s this whole opportunity opening up in credits.” By taking intra-European currency risk out of the investment calculus, the euro provides U.S. investors an opportunity they have never had before: to consider only credit when evaluating euroland. The main question on the minds of end-users these days is, Will longer-dated bonds show greater credit spreads or greater convergence? Predictably, the jury is still out. Bank of America foresees spreads widening during times of market distress, and stabilizing and becoming narrower during normal times. Warburg Dillon Read goes a bit further out on the limb. “The economic diversity of euroland is exaggerated by the symmetric shock of the global crisis,” the bank says. “It also means that the convergence of Europe’s bond markets, one of the features of the two years preceding monetary union, is likely to reverse—at least in part. Diverse economies will produce diverse bond yields in monetary union, because the fundamental factors that underpin sovereign creditworthiness will diverge.” Warburg has developed a system of weighted factors to determine sovereign creditworthiness in euroland. For a given country, growth will constitute 20 percent of its creditworthiness; debt, 15 percent; budget deficits, 20 percent; pensions, 10 percent; taxation levels, 15 percent; political factors, 10 percent; and other institutional factors, 10 percent. Barclays has gone even further—it has predicted the credit spreads for the 15 countries that are already part of euroland or are expected to join in the future. The AAA countries of Austria, France, Germany, the Netherlands, Norway and the Untied Kingdom will trade in the same band with no spread, while Belgium, Denmark, Finland, Ireland, Italy, Portugal, Spain and Sweden will trade at a spread of 15 basis points. Greece was not estimated. At the moment, those spreads seem optimistic. In the first week of January, Germany held a 10-year auction; two weeks later, France held a 10-year auction at a spread to Germany of 11 basis points. And Italy regularly trades between 20 basis points and 30 basis points. Convergence trades are still possible—and could be hugely profitable to those on the right side. There will also be opportunities for convergence trades between euroland and those countries presumed to be angling for inclusion in the next round of EMU. The United Kingdom, for one, is subject to long-term convergence plays. “If you look at gilts on a forward basis,” says Warburg’s Ian Douglas, “they’re already trading tight to euro assets. And there’s a long time to go—2002 at the earliest.” Traders are already making convergence plays with Denmark, Sweden and Greece as well. “Where there’s any semblance of a country that may be going into EMU,” says Jeremy Hawkins, chief economist for Europe at Bank of America, “the market is falling over itself to buy it.” The problem, he says, may be one of “premature convergence,” in which countries with large current-account deficits find yields falling too quickly. “In this environment, local currencies could become seriously overvalued vs. the euro and lack the interest rate differential needed to finance the external deficit. This raises the risk of a Thai baht-style scenario in which the currency suddenly collapses.” Like a good Bordeaux, second-round EMU convergence plays must be savored, not gulped. —R.H.

Not everyone is convinced that this will happen overnight, however. An early market shock or a structured deal gone awry could send investors running back up the credit curve. “My belief is that bank lenders are much more aggressive than potential junk bond investors are,” says Andrew Readinger, a vice president with JP Morgan in London. “Investors need to walk before they can run, and in order to walk they need to build a robust credit curve for AAA issuance as well as BBB issuance.” Until that happens, says Readinger, investors will take a wait-and-see approach—particularly in the United States. “U.S. investors are enjoying good credit spreads in the domestic market,” he says. “So looking across the Atlantic to the European market is not as critical as it was before the Russian default.”

Others agree that a high-yield market in euroland will take time. “There is some investor appetite for high yield in Europe,” says Warburg Dillon Read’s Gunasekera, “but it’s an ongoing process in terms of the internal restrictions that European fund managers have. It takes time for these restrictions to change.”

The first step for the euroland corporate bond market will be to take back some of its Yankee market business—wherein non-U.S. firms issue dollar-denominated bonds in the United States. This process has already begun. “The most startling phenomenon from our perspective,” says Readinger, “has been the acceptance of longer-dated and subordinate paper on a pan-European basis. Traditionally, the Yankee market has been stronger in longer maturities and weaker credits and in subordinate or structured paper. Some of that competitive advantage is now shifting to Europe, where there is a stronger investor base for European names in the long run.”

A host of new products will likely flourish on top of euroland’s burgeoning corporate bond market. Paribas predicts that corporates will tap into such fixed-income credit structures as forward rate notes, asset-backed securities and medium-term notes (usually seven-year debt that serves as the basis for a swap or as part of another hybrid security). The convertible bond and asset swaps markets are expected to grow as well.

Meanwhile, an entirely different sector of the fixed-income world is expected to develop rapidly—euroland’s regional and, to a lesser extent, municipal debt markets. Under the guidelines of the Maastricht Treaty, central government transfers of funds to regional and municipal governments are strictly curtailed, forcing these entities to look for alternative funding sources. Germany’s Pfandbrief market, which pools refinanced mortgage debt as well as regional public-sector debt, launched a big issue last year that traded 55 basis points over German Bunds. More issues are expected this year, and France is rumored to be following suit. Moreover, countries with big, relatively autonomous regions—Spain being the most immediate example—are natural candidates to issue regional-based, euro-denominated public debt.

The municipal markets, by contrast, aren’t expected to grow as rapidly. Many expect euroland’s smaller countries to follow a pooled approach, such as the one employed by Finland, where some 400 municipalities joined together to issue non-government-guaranteed debt that trades like sovereign debt.

Bigger investor base

Both the government and corporate bond markets should benefit from the imminent pension fund explosion in Europe, which is expected to send bond—as well as equity—volumes skyrocketing in coming years. With the advent of the euro, European pension fund managers are suddenly freed from restrictions that forced them to hold the vast majority of their assets in national currency-denominated instruments—80 percent, in the case of Germany. Now, fund managers in, say, Belgium are free to exploit the German, Italian or French markets to maximize performance.

And the pension fund market is expected to grow by leaps and bounds as well. The current state-funded system in most of the euroland countries, commonly called the pay-as-you-go system, faces bankruptcy as life expectancies continue to increase while birth rates decrease. Goldman Sachs estimates that by 2020 there will be one worker for every retiree across euroland. As a result, more and more money will be placed in the hands of private fund managers. Merrill Lynch predicts that private pension assets will grow from $630 billion in 1996 to $1.8 trillion by 2001. Morgan Stanley predicts an inflow of $12 trillion by 2010.

Such a huge infusion of funds will have a major effect on the euroland financial world. The most immediate: a surge in demand for 30-year sovereign paper. Some are also predicting a boom in total-rate-of-return swaps, which allow investors to capture an entire bond index in a single instrument. Moreover, European fund managers’ generally conservative approach to equities is expected to translate into growth for equity-linked structured products such as convertibles and other corporate debt/equity structures. And the euro landscape will alter straight equity plays as well, prompting managers to abandon country approaches in favor of sectors.

Across the pond

Amid all the Sturm und Drang of euro conversion, how are U.S. corporates responding? “A lot of U.S. end-users are still coming to grips with the euro,” says a banker in London. “We never thought it was going to go off with a bang—we always thought it would take six-to-eight months before things settled down.” Nonetheless, the currency benefits of European monetary union have clearly panned out. No longer do U.S. corporates have to engage in massive currency hedging programs to mitigate foreign exchange risk in euroland—it’s now a one-stop currency-hedging shop.

The euro may be a boon to the other side of the balance sheet as well. In the past, the U.S. bond market largely determined the direction of the European market, leading many U.S. investors to avoid the bother of playing Europe altogether. But now there are signs of a decoupling of the U.S. and European bond markets. After the Humphrey-Hawkins congressional testimony in Washington on February 23, for instance, the Bund/Treasury note spread shot up to 125 basis points—historically, a significant resistance point.

The benefits of a decoupled euro/U.S. bond market are substantial to U.S. corporates. “If there’s decoupling, it makes sense to have some debt that’s linked to European rates, because of the diversification element,” says Bank of America’s Godfrey. “Now, there’s diversification on the liabilities side of the balance sheet. Corporates will start to say, ‘Maybe we want some European debt, because what moves that yield curve isn’t the same thing that moves the U.S. yield curve.’ And right now, euro rates are lower than those in the United States.” Before long, the Baby Huey that is the euroland bond market could become the biggest kid on the block.

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