LONDON: SSA issuers' shift to the euro market for funding is likely to continue in 2011 as the erosion of the arbitrage between the US dollar and euro markets continues.
As market access normalises for European banks, the distorted levels of the cross-currency swap market are diminishing, which should be good news for the euro primary sector.
Although the US dollar market has dominated SSA supply so far this month, on a year to-date basis it is the euro that has been in the ascendancy, despite the eurozone peripheral sovereign crisis.
According to a research note published by Barclays Capital at the end of April, euro-denominated SSA issuance has been increasing steadily since the beginning of the year. In January, it accounted for only 51 percent of total supply; this increased to 57 percent in February, 67 percent in March and 89 percent in April.
"This is partly due to less favourable basis swap conditions and partly to uncertainty regarding the stabilisation of some euro area countries, which made the placement of SSA debt from European issuers in the US more challenging," said Barclays strategist, Michaela Seimen.
The advantage of borrowing in US dollars and swapping into euros in the five-year sector has fallen to about 15bp, from nearly 30bp earlier in 2011. The threes/sixes basis swap, which is added to achieve comparability, has also been edging lower to around 12bp, some 5bp lower than at the start of the year.
The overall benefit that European issuers could have achieved through issuing in US dollars is now as much as 20bp smaller than at the beginning of 2011.
As a result of the normalisation in general money market conditions, particularly in Europe, many market participants expect this trend to continue, citing the fact that threes/sixes was closer to 6bp in early 2009, although the cross-currency swap was more elevated at that time as it peaked at 61.5bp in February of that year.
"This is a trend that is likely to continue if an increase in overall risk appetite from investors persists, although the tendency for the cross-currency swap to fall to historically much lower levels may be more pronounced than the ability of the threes/sixes basis swap, as the cross-currency basis is more directly influenced by European banks' access to short-term US dollar funding," said Lars Humble, SSA syndicate official at Goldman Sachs.
How long it takes will be a function of the time required for a more permanent resolution to the situation in Europe, and talk is currently of how the rescue package for Greece will be extended beyond 2013 as the prospects of the sovereign regaining direct market access are pushed into the future.
STRUCTURAL BIAS
While one driver of issuance is the improvement in costs, the euro market also has a structural bias in its favour, which will support its role for the SSA sector.
"Although the cross-market arbitrage between US dollars and euro has been in decline recently, the euro market retains one important advantage in being able to consistently cater to the longer-duration needs of most SSA issuers", said Jeremy Shaw, co-head of rates syndicate at Barclays Capital.
"While the US dollar market is periodically able to support 10-year supply, and even 30-year issues from time to time, longer-dated euro-denominated issues have been largely responsible for the increased importance of the market so far this year," he added.
There are a number of reasons for this, not least the recent rise in European yields as the ECB has shifted to a policy of increasing short-term rates after committing to combat fears of a rise in inflationary pressures.
In the government bond arena, the cross-market spread between Europe and the US has exemplified this trend. The 10-year Bund/US Treasury spread has recently traded through parity, compared with a year ago when Bunds were yielding 70bp less than US Treasuries.
This has favoured longer-dated supply in euros, with domestic investors chasing higher yields, while the persistence of easy monetary policy in the US has highlighted the relative attractions of the SSA issuers compared with US agency debt.
DOWN BUT NOT OUT
While some issuers may neglect the US dollar market and instead return to their home territory, for the more established and frequent issuers such as the EIB or KfW it will remain their second most important source of funding.
The EIB raised US$3bn last week at a spread of mid-swaps plus 2bp. Taking into account the cross-currency and basis swap, this produced an equivalent cost of funds of around Euribor less 25bp. If the issuer had opted - as was expected by some - for a five-year euro deal, it would probably have needed to have paid just above mid-swaps flat.
The likelihood is that the US dollar market will retain its competitive funding advantage for some time and that larger SSA issuers such as the EIB and KfW will, irrespective of the supply economics, remain active in both markets.
But for smaller, opportunistic issuers, as the economics deteriorate supply in the euro market will become more attractive, enhanced further by its ability to attract a much larger investor audience than is the case in US dollars.
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