The Euro: a blessing in disguise for Eurobond markets.
 
Xavier Werner *
 

The introduction of the 'Euro’ is casting a shadow over Europe's bond markets. Fortunately, it looks like it will only be temporary. There is bright light shining on the horizon as the 'Euro' will create an exciting new landscape. It will lead to a more efficient capital market in Europe which is beneficial for us all. It will give rise to new opportunities, it will stimulate growth of the banking industry, and in the long run create more jobs. But in the short term, the introduction of the Euro is likely to have the same shock-effect on the Eurobond markets as the Big Bang had on the European banking system in the 80s. The number of players will drop dramatically; some will form alliances, others will be forced to withdraw from the market, few players will be able to do it alone.

European banks on the continent seem the most vulnerable as each of them will lose their niche. ‘Big Bang-Euro’ will remove at a stroke the thresholds separating their home markets from the rest of Europe. With the disappearance of each currency, a market will disappear and a ‘niche’ with it. What will replace it is a level-playing-field where only the fittest will survive. Despite strong competition in the eurobond markets, until now continental European banks have been remarkably good at defending their dominance in their home markets. Continental European banks remain the leading underwriters of eurobonds denominated in their home currency. French banks dominate the league-tables of French franc issues, Dutch banks are leading the guilder league-tables, Luxembourg and Belgian banks the Luxembourg league tables, Italians the Italian lire league-tables and even in the most competitive European market, Deutschemarks, the top underwriters of Eurobonds are German banks.

The key to their success in home markets has been the fact that they could heavily rely on the loyal group of ‘domestic’ investors. Despite freedom of capital flows between member countries being one of the cornerstones of the EMS, currency risk has been a major excuse for investors and their regulators for keeping the lion’s share of investments in-house, forcing institutional investors to buy domestic capital market products which were traditionally supplied by domestic banks. A good example is the ABP in the Netherlands, one of the largest investors in the world, which until recently was restricted from buying Deutschemarks denominated bonds (despite the fact that the Dutch guilder and the Deutschemark were more or less pegged together in the last 10 years). Another example is provided by the French insurance companies who are obliged by the French authorities to invest at least 80% of their portfolios in French francs. Not only institutional investors, but also European retail investors have shown a strong bias towards "home-currency-denominated" bonds.

However, the last remaining investment barriers will be removed by the introduction of the Euro. Currency risk will cease to be a factor between the EMU countries which will allow unbiased comparisons of credit spreads between issues which used to be separated by a different currency. Myopic preferences for 'domestic' products will fade away quickly .

Which banks will survive? Current wisdom is that international distribution power, a strong capital base and expertise are key factors. Add one other factor: strong commitment. Only those banks possessing these characteristics will be able to acquire the mandates from the top frequent borrowers.

Of course, domestic distribution power will remain important, but it will not be enough. Leading borrowers will want to deal with fewer banks for their issues in Euro's than they currently do in different 'Euro-currencies'. Only those banks who are able to distribute large issues quickly and to all corners of the EMU will be short listed. And if a well known borrower opts to launch an issue in Euro's via a foreign bank (and not a ‘domestic’ bank), the traditional loyal group of ‘domestic’ investors will prove to be far less ‘loyal’ than in the good old days.

Parallel to the EMU are developments in information technology such as Internet which will have a direct impact on the domestic distribution power of European banks as it will sooner or later lead to the opening up of the presently closed network of loyal domestic retail customers. The traditional distribution channels will slowly disappear.

However, the introduction of the EMU will also create new opportunities for existing market players. While the EMU will lead to the end of several home-markets, it will (and already has) directly and indirectly give(n) rise to new ‘markets’ or ‘niches’.

An already rapidly growing market is the market for Eurobonds denominated in the European currencies outside EMU such as Greek drachma and Danish kroner, and especially the market for 'emerging currencies' such as Czech crowns, Polish zloty , Russian rouble, South African rand, etc. Here the EMU will push both investors and borrowers to these new markets. Investors are looking for alternatives to diversify their portfolios as currency risk ceases to exist within the EMU. Borrowers have a need for alternative currencies as arbitrage opportunities between 'Euro-currency' markets will disappear with the start of the Euro. This in itself could lead to more expensive funding costs for borrowers specialising in arbitrage issues in 'Euro-currencies'. However, anticipating these developments, the answer from issuers like the World Bank and the European Investment Bank has been to help create new 'arbitrage' markets outside the Euro-currencies, by issuing bonds denominated or linked to 'emerging currencies'.

Against the background of the quest of European investors for alternative investments (to increase return on their portfolios now that traditional low risk currency diversification strategies will become harder), demand for bond-products offering a higher yield will increase. At last a European public market may emerge for low investment grade issues resembling the high yield market of the United States. This would open the Eurobond markets for the large number of corporates who haven't made it to a A-grade credit risk assessment of rating agencies such as Moody's and Standard & Poor's. But the need for return on investment will also increase the willingness of investors to put energy and time into looking at new and more complicated structures such as asset-backed issues. This would open the way to a variety of projects involving cash flow financing to tap the Eurobond market .

These are only a few examples of how EMU will be a catalyst for growth of the Eurobond markets. The face of the Eurobond markets as we know it today, however, will change dramatically over the coming years. And it may be at the cost of a few victims.

 

29-09-1997
 
* Vice President Head of Fixed Income Syndicate Amsterdam ABN AMRO Hoare Govett. PO Box 283 - 1000EA Amsterdam


 

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