European issuers flock to Yankee market to benefit from dollar/euro basis swaps
        Author: Simon Boughey
        Source: Credit | 29 Sep 2010
        Categories: Cash Bonds
        Topics: Basis swap, United States dollar, Total, Volkswagen
                 The USD/EUR basis swap market affords generous savings for the European borrower of US dollars, as issuance figures attest, but how long will the window of opportunity last?

The bond markets in 2009 saw new records set for many asset classes, but in one respect 2010 has overshadowed its predecessor: Yankee issuance. Overseas borrowers have flooded to the dollar market throughout 2010, and if the evidence of early September is any guide, the trend shows no signs of abating.


There are many reasons for overseas borrowers to visit New York, but top of the list for many has been the deep cost savings that have been available courtesy of the basis swap market. Before the crisis, the amount of swappable dollar issuance priced over the past year would have been sufficient to eradicate this arbitrage. But these are not ordinary times: other long-term and deep-seated changes in capital markets are at work and the basis market’s allure is undiminished.


By the end of August, total Yankee issuance totalled $232 billion, 82.7% more than the $127 billion recorded in the whole of 2009. Corporate Yankee issuance was $101 billion, triple the $31 billion priced in 2009. Dollar issuance from financial institutions, meanwhile, was $131 billion compared with $95 billion in 2009. Indeed, according to syndicate managers in New York, Yankee issuance including banks and supranationals, sub-sovereigns and agencies has comprised almost 60% of overall volumes this year. Given the depth and robustness of the dollar market, and the almost limitless number of US firms that use it, this is remarkable.


Many corporate borrowers have offered debut deals under 144a rules during 2010. On August 5, for example, single-A rated German carmaker Volkswagen came to New York for the first time with $1 billion of three-year notes that priced at Treasuries plus 93 basis points, and $750 million of 10-year bonds that priced at Treasuries plus 120bp. The sale was led by Bank of America Merrill Lynch, Citi and JP Morgan.


This came only a couple of days after a $2.5 billion three-tranche deal from European steel conglomerate ArcelorMittal. Both deals were priced in a month when European treasurers are usually on holiday, but in summer 2010 the charms of the Yankee market were too good to ignore. The dollar market offers a series of advantages to overseas borrowers: investor diversification, the chance to offer in size and up to 30 years, plus, most importantly in a year when the euro market has frequently been in paralysis, it is always open.


But the principal reason for the surge of issuance, however, is the basis swap pick-up. “There has been a pricing advantage in dollars versus euros and sterling for a number of European issuers in the last 12-18 months. There has been a very significant pick-up and this has absolutely dictated the increase in Yankee business,” says Jeff Tannenbaum, head of European syndicate at Bank of America Merrill Lynch in London.


This is particularly true of corporate borrowers, who generally need to diversify sources of funding less than financial borrowers. Names like Volkswagen, but also Total, EDF, Veolia and Anglo American, came to the Yankee market this year solely because of the basis pick-up, say syndicate bankers.


“One reason there been so much Yankee issuance is because for much of this year there has been a 25–40bp basis swap pick-up in their favour,” says Jim Turner, head of debt capital markets, Americas, at BNP Paribas in New York. At the end of March, the two-year euro/dollar basis was –27bp, while the five-year basis was –21.5bp and around –15bp for 10 years. By the end of May these prices had been offered down even further to –46bp for two years, –35bp for five years and –23.5bp for 10 years. Even after the first week in September, which saw a mountain of swap-driven issuance, the five-year basis was –26bp and the 10-year basis was –18bp.


A borrower of fixed rate dollars swapping back to euros will need to receive floating rate dollars and pay floating rate euros in the basis swap. As the above levels show, this transaction has afforded consistently high savings over what would have been possible in the euro market.


“The dollar market has been an attractive option for European corporates for much of the year. There have been savings of up to 30bp depending on the credit and maturity. For some of the most frequent issuers, such as utilities and telcos, relative value between the currency markets has been a key driver,” says Mark Lewellen, Barclays Capital’s head of European corporate origination.


During the first week of September, France Télécom exemplified this. It issued a €500 million 12-year bond while at the same time selling a $750 million five-year bond. The basis swap pick-up diminishes as the maturity curve extends, so it was sensible for the borrower to issue at 12 years in euros while capitalising on the basis pick-up of more than 25bp by issuing in dollars at five years.


The euro notes were issued at mid-swaps plus 75bp, while the dollar notes were sold at Treasuries plus 82bp. But with the swap to floating dollars and then to floating euros, the dollar leg of the funding might have secured an after-swap cost of around Euribor less 35bp – much better than euros. It is not just European borrowers taking advantage: Australian banks, for example, have been big sellers of dollar debt this year.


Flip side


Conversely, the basis acts as a significant deterrent for US borrowers who might otherwise issue in euros. But they have the advantage of an unsaturated and mature debt market and for the most part have no need to issue in euros; unless, like GE Capital for example, they have sizeable European operations.


The basis swap trade has been in evidence since the back end of 2009, but it is reasonable to ask why it is still intact. Under normal circumstances, the constant pressure to pay euros and receive dollars would have driven prices back towards the historical mean. Until the crisis, the euro/dollar basis generally traded between flat and only a couple of basis points either way. Now, it is consistently camped in negative territory and has seemed largely impervious to the weight of swap-driven issuance. Indeed, at the end of the first week in September, in which $11.5 billion of new deals were priced from European borrowers, the five-year basis was a couple of basis points better offered than it had been just three days earlier, on the Tuesday after the long Labor Day weekend.


The answer to this conundrum lies in long-term structural shifts in bank funding markets. The impact of the crisis is demonstrated by the price seen for the one-year euro/dollar basis over the past couple of years. At the beginning of 2007, before the crisis, it was around 2bp and nestled into the tight range in which it then dealt. But by the end of 2007, it was offered down to –14bp. Over the next 12 months prices sank to a low of –106bp before climbing back to –57bp at the beginning of 2009. But levels are now only a little better bid at –40bp.


Post-crisis, US banks have drastically deleveraged and, as the high price of dollar Libor in the autumn of 2009 showed, banks were simply not lending to each other. The dollar money markets have shrunk by around 30%. But European banks still need to fund their US dollar assets and, in lieu of US bank funding, they have turned to the basis market. This has provided a seemingly permanent and irresistible offer in the euro/dollar basis market.


“European banks have dollar-based assets to fund, but insufficient natural sources of dollars so have used the basis to fund loans and bond purchases in dollars. The correlation between the Euribor/Eonia spread and the euro/dollar basis is very high,” says Edward de Waal, head of structuring at Barclays Capital in London.


Sovereign debt concerns further curtailed the willingness of US banks to lend dollars, with recent regulatory changes to money market funds in the US only exacerbating the problem. Under new rules introduced by the SEC at the end of May, money market funds need to improve both the liquidity and credit quality of the assets they hold. Some 40% of assets have to be in the form of cash, Treasuries or government securities with maturities of less than 60 days. There may be more changes of this nature as a result of Basel III or the recently passed US financial reform bill.


This makes it unlikely the basis will revert to the mean levels the market had come expect before the financial crisis. “The market has undergone structural and meaningful regulatory change. We shouldn’t expect things to go back to where they were,” says Jeff Rosenberg, head of global rates strategy at BAML in New York.


Market experts suggest the new mean level from short to mid-term euro/dollar basis prices might be in the region of –20bp to –40bp, but could even go as wide as –50bp. This means the dollar market will continue to offer considerable cost savings for European borrowers.


In fact, European companies that tap the dollar market regularly and become accepted by US investors may find their new issue spreads contract as well, further adding to the appeal of dollar funding. This could prove a permanent drain on euro bond market liquidity, further damaging its once proudly made claim to be the equal of the dollar market.


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