Swaps market still has currency with investors
Derivatives comment: Simon Boughey
11 Oct 2010
With banker bashing now a global sport, it is common to find the derivatives they have created equally disparaged and reviled. So it is pleasing to find an illustration of the way the swaps market
can work quietly, undemonstratively and efficiently for the benefit of all concerned. Regulators, please take note.
The story began at the end of last month, when Bank Nederlandse Gemeenten made its debut in the dollar-denominated 144a market with a $1.5bn five-year bond carrying a 1.75% coupon underwritten by
Bank of America Merrill Lynch, JP Morgan and UBS.
The borrower, referred to by its acronym BNG, raises capital for publicly owned bodies in the Netherlands and carries a pristine triple-A rating from all the credit agencies.
Although it has issued dollar-denominated funds many times, this was the first deal offered under 144a. Introduced in 1990, these made it easier for international borrowers to sell securities not
registered with the Securities and Exchange Commission into the US markets. Their use has become essential for borrowers wishing to place bonds with US buyers, rather than international dollar
investors. Integration of 144a rules into a borrowing programme is an expensive and time-consuming business. Issuers only undertake it if they want to make a serious commitment to the US
BNG wanted to make this commitment, but could only do so because the international cross-currency swap market permits it to take any dollar funds back into euros – the currency needed for
The Dutch bank wanted to reach a new investor base that had the most varied and deepest pockets in the world. After the deal had been executed, the borrower confessed that in the current low-yield
environment it had been worried that it would not enlist enough domestic US buyers to have made the 144a exercise worthwhile.
It need not have been concerned; more than 46% of the $1.5bn issue was sold to US investors. These were more often than not genuine US real money accounts as opposed to offshore units of Asian
banks. The order book was worth more than $2bn and the transaction was hailed by disinterested onlookers as BNG’s best dollar-denominated trade.
But it is when the swap back to euros is considered that the trade gets really interesting. The five bonds were priced to yield 56.7 basis points over the 1.25% Treasury due August 2015. Swap bids
were around 21.5bp over Treasuries at the time, indicating a re-offered yield of 35bp over mid-swaps or 35bp over dollar Libor after an interest rate swap to floating dollars.
The five-year euro/dollar basis swap is still very heavily offered and, due to long-term liquidity constraints in the global financial system, likely to remain so for the foreseeable future.
Consequently, the borrower would have received floating dollars to hedge the dollar leg of the trade at almost 30bp against euros flat. So the borrower picked up just under 30bp from this phase of
But it wasn’t finished yet. It wanted a final exposure in six-month floating euros rather than three-month euros and this final leg of the trade yielded another harvest. Due to another version of
the liquidity pressures that have produced such startling results in the cross-currency basis market, three-month and six-month euro basis has become decoupled. To pay six-month euros and receive
three-month euros for a five-year term yielded the borrower another 15bp or so.
All in all, the hedge back to euros provided cost savings of around 45bp, to produce a final cost in floating-rate euros of about Euribor less 10bp. As the borrower’s most recent five-year
euro-denominated bond was priced at 18bp over mid-swaps, this pioneering trip to the dollar bond market presented BNG with a cost of funds perhaps 28bp better than would have been the case in euros –
a market in which it has borrowed for years and is a very well-known and respected credit.
BNG has enlisted a thick booklet of new investors and all at a dazzlingly low cost of funds; three cheers for the much-maligned swap market.
In fact, the yield of 35bp over mid-swaps offered to investors was deemed by some rival syndicate managers to be a little generous. It was 3bp more than BNG’s most recent dollar issue and 10bp
wider than the five-year 144a trade from Kommunalbanken Norway in the same week.
Of course, basis swap arbitrage cuts both ways. While the negative values are a strong incentive to European borrowers to borrow in dollars, they are also a strong incentive for US borrowers to
avoid the euro market like the plague. They have no desire to pay 30bp or more for the privilege of wooing European investors.
But the situation is rather different. American borrowers chiefly want US dollar funds and for this purpose the US dollar bond market can always be relied upon. It is deep, robust and always
The euro bond market is often none of these things and European borrowers must sometimes look elsewhere. Without the swaps market, they would not be able to do so. It will be well to remember this as debates over derivatives regulation in the European parliament commence.