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Sun, sea and basis swaps arbitrage

The global capital markets are about to enter the holiday season – a period traditionally celebrated with greater gusto in Europe than in the US. While corporate treasurers, bankers and investors in London, Paris and Frankfurt begin to slip off to Mediterranean beaches for long breaks of two weeks or more, their counterparts in New York must be content with a long weekend or two in Bridgehampton.

Yet, in 2010, European companies might well be advised to follow the American example. The best basis swap arbitrage between euros and dollars seen for years is beginning to diminish and those European names that can borrow in dollars should do so while they can. To miss this kind of chance would be unforgivable. There has been a considerable sea change in the credit markets over the past three weeks. The sovereign debt crisis, which has rumbled over the entire year, now seems a lot more contained. National borrowers, most particularly Spain, have completed bond offerings that secured much wider support than seemed likely earlier in the summer. The diminishment of global tension has had a couple of effects, both of which have influenced basis swap levels. Firstly, a number of European borrowers have been able to sell dollar denominated debt and swap the proceeds back to euros. Most notably, a couple of weeks ago, German development bank KfW sold a $5bn three-year bond in what was its biggest dollar trade of the year and its biggest three-year deal since January 2009. It also, and perhaps most tellingly, attracted an overall book of $8.1bn – a new record for the agency.

This trade seemed to indicate that dollar investors were once again ready to buy European supranational paper despite the heavy clouds of the sovereign debt crisis. Last week, development finance agency Agence Française de Développement brought a $1bn five-year Eurobond and the borrower conceded it had been encouraged to take this gambit by the success of the KfW deal. Although a Eurobond, rather than a dollar trade explicitly geared to the US investor, this offering once again showed that the waters were beginning to warm up for European supranationals. Both were swapped back to euros. The AFD deal was sold at 50bp over mid-swaps, but would have achieved, it was estimated, something in the region of Euribor plus 5bp once the currency basis swap pick-up and the arbitrage between six-month and three-month Euribor were taken into account. This is perhaps 5bp better than it could have achieved had it sold a new euro-denominated bond.

Meanwhile, KfW brought its blockbuster three year at mid-swaps plus 18bp, and after both basis swaps it probably hit a level in floating euros of Euribor less 30bp. Cost savings like this are hard to ignore, and if the US investor is now displaying a greater tolerance of European names than was the case until very recently, then it is time to sell bonds in dollars. But, with every large dollar deal that is swapped into euros, the bid side pressure on euro/dollar basis increases and prices firm. This reduces the possible arbitrage from dollars to euros, as capital markets are supposed to work in fact. There has been pressure upon euro basis from bond deals in other currencies as well. KfW, again, brought a large A$850m trade two weeks ago, which was swapped into euros while Dutch bank Rabobank sold a three-tranche samurai that was swapped into euros. The greater freedom that well-rated European names now enjoy in debt markets is being exploited. At the same time, the gradual but general diminishment of tensions in the world’s markets has loosened funding pressures and reduced the desire by banks to hold dollars rather than any other currency. This has a particularly pronounced impact at the short end of the euro/dollar basis curve, but prices across the whole curve enjoy a generally stronger bid. So, while euro/dollar basis is still very negative, it is a lot firmer than it was only a short time ago. Prices were bid up by at least 2.5bp last week alone and there has been a big change from those seen at the end of June. Four weeks ago, five-year euro/dollar basis was minus 35bp while 10-year basis was minus 24bp; at the beginning of last week, five-year basis was minus 29bp and 10 years was minus 21.5bp.

Three-month versus six-month euribor basis has also suffered a retrenchment. The extension of prices between three-month and six-month Euribor has been one of the stories of the year; nothing, seemingly, could stop it and brokers shifted an increasing proportion of resources to deal with the phenomenon. But the bubble has burst: two weeks ago 3s/6s basis suddenly collapsed under a wall of offered side interested. The two-year market, for example, plummeted from around 21bp to 16bp/17bp in a matter of days. These prices are still highly attractive for the European borrower of dollars, but they seem to be heading in one direction. Of course, if we see another surge of tension in global credit markets, keenness to own dollars would again boom, euro/dollar basis swap prices would be offered once again, 3s/6s basis would be bid wider and European credits would once again find it difficult to woo US buyers. At the moment, however, there is delicate equipoise: The basis market still offers considerable savings and some European credits can sell dollar debt. It might be advisable to take advantage of this before the basis market compresses even further. Treasurers might have to keep their minds off beaches in Sardinia or olive groves in Tuscany for a little longer.


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