Redenomination and renominalisation of debt securities

 

Charles Clark
 
There has been a lot of discussion in recent months about the redenomination of debt securities in the context of the start of the third stage of economic and monetary union. Much of the discussion has also related to the renominalisation of securities.
  1. This article discusses some of the implications and consequences of redenomination and renominalisation. First, however, we must define our terms.
  2. Redenomination is the simple translation of the denomination of an obligation from an existing national currency into Euro at the regulatory conversion rate. Thus a FF10,000 bond would become a Euro-denominated bond in whatever amount of Euros that FF10,000 becomes when converted at the fixed legal conversion rate. Clearly it is most unlikely that this would be a round number and will almost certainly result in the figure being rounded to two places of decimals in accordance with the applicable Regulation. Apart from such rounding, there will be no change in the external value of the bond.

    Renominalisation, however, involves the changing of the external value of the bond. For example, having redenominated a bond into Euros it may be desirable to have a round number as the nominal amount in Euros of that bond and so to change the nominal value from (for example) Euro 1,849.73 to (for example) Euro 1,000. This raises the question of what to do about the Euro 849.73.
     

  3. Before that, however, one should stop to consider what happens if nothing is done and also why issuers would want to redenominate or renominalise their bonds.
  4. If nothing is done, the national currency bond will continue to be expressed in that national currency during the transitional period (though technically that national currency will have become a subdivision of the Euro) and payments will continue to be made in that currency. At the end of the transitional period, on 1 January 2002, if it is still outstanding, the bond will ineluctably become denominated in Euros at the official regulatory conversion rate. It will have been redenominated by operation of law regardless of the preferences of the issuer or the investor. The external value of the bond will not have changed. One may trust in the law for the law will provide.

    This therefore begs the question why redenominate and why renominalise.

    Simple redenomination without renominalisation merely brings forward the date on which payments would by operation of law otherwise be payable in Euros. It may have limited advantages in terms of treasury management but, given the extent to which many issuers hedge their currency exposures on bonds through swaps, there is little point in changing the bond terms without changing the swap terms.

    Renominalisation however can bring two advantages.

    Firstly it can facilitate secondary market trading. Traders deal in round principal amounts of bonds, not in numbers of bonds. A trader will prefer to deal with Euro 5,000,000 rather than some odd number of Euros derived from a round number of national currency units. It may therefore be attractive to renominalise. But this will depend on how much trading there is. Certainly for sovereign and supranational issuers it is of interest given the highly developed and liquid markets for their bonds. But for the average corporate issuer, secondary market trading usually tails off within at most a few months of the issue date. It may therefore not be worthwhile to renominalise.

    Secondly, renominalisation allows for two or more issues in different national currencies but with identical terms (other than the currency and denomination) to be treated by the market and the clearing systems as fungible once the currency for the different issues has become Euros and the denomination has been made the same. This should lead to greater liquidity and ultimately lower borrowing costs and may help to establish a particular issue as a benchmark issue for the pricing of other issues. A number of issues have been made (called variously "parallel", "Euro-fungible", "Euro-tributary" and even "catamaran" bonds) by the European Investment Bank, a number of EU member states and some banks and corporate issuers. For the corporate issuers, for the reasons given above, it is doubtful whether it will bring them much, if any, advantage and the prestigious status of benchmark issue is the preserve of the sovereign and supranational issuer.
     

  5. There are a number of ways in which redenomination and renominalisation can legally be done. Changing the currency of payment or the amount of the payment involves changing the terms of the bond and cannot normally be done unilaterally by the issuer. Firstly, it may be done by statute. The law by which the bonds are governed may permit (or indeed require) renominalisation to be effected by the issuer without the agreement of the holders. It is important to note however that it must be the law governing the bond (the law of the contract). It is irrelevant under international principles of conflicts of law that the law of the place of incorporation of the issuer or the law of the country of issue of the relevant national currency may contain such provisions: the contract (for that is what the bond is) will be interpreted according to the chosen law which governs it.
  6. Secondly, an existing issue may be amended (as indeed any contract may) by agreement between the parties or otherwise in accordance with its terms. In the Euromarkets it is very common for English law governed bonds to have provision for the issuer to convene meetings of bondholders at which changes to the terms may be agreed provided that a specified proportion of bondholders votes in favour. The dissenting minority and those who fail to vote are bound by the decision of the meeting. Similar concepts (for example the "masse des obligataires" under French law) exist in some other legal systems. In the absence, however, of contractual or legal mechanisms for holding such meetings of the holders, as with any contract, to amend the terms would require the unanimity of all the holders (as well as, as always, that of the issuer). This is in practice extremely difficult to achieve if the issue is widely held.
     

  7. From this one may conclude that existing issues (so-called "legacy instruments") are best left to continue their lives as they are, with mandatory redenomination (but not renominalisation) occurring in 2002. The only alternative for such issues is for the issuer to make an offer to the existing holders to exchange their existing national currency bonds for new Euro-denominated bonds, though there is no certainty in doing so that the holders will accept the issuer’s offer.
  8. For new issues, however, provisions may be included at the time of issue to permit redenomination and renominalisation without having to get the consent of the holders at the relevant time. It will be a term of the contract to which as holders they will be subject. The "Euro-tributary" and similarly named issues referred to above are examples of this approach.
     

  9. Where however approaches may differ is in the methodology used. Should each bond be treated separately (the "bottom-up method")? Should the aggregate issue amount be redenominated without regard to the individual bonds ("top-down method")? Or should it be done by reference to holdings of investors? Each method has its protagonists but no method is perfect. In each case it is assumed that the bonds are held within a clearing system (such as Cedel Bank or Euroclear) and are either represented by a global note in respect of the entire issue or in fully dematerialised form. In other words there are no definitive certificates in respect of individual bonds. The expense of reprinting definitive bond certificates to reflect a different external value and the paying agency costs relating to the exchange of certificates would be prohibitive.
  10. The bottom-up method where each bond is redenominated and renominalised is probably the most popular in the market. There are two alternative ways of doing it. The European Investment Bank has issued bonds where the principal amount of each bond is converted from national currency to Euros at the official rate and rounded to a whole number of cents in accordance with the applicable EU regulation. The issuer then repays a small amount of principal in order to reduce the new denomination to an integral number of the smallest amount of Euros on which it would still be possible to make an annual interest payment at the contractual rate in a whole number of cents. An example may make this clear: If the interest rate were 5% per annum it would be possible to have a bond of 1 Euro (coupon = 1 Euro x 5% = 0.05 Euros). If the rate were 5.25%, the minimum denomination would be 4 Euros (coupon = 4 Euros x 5.25% = 0.21 Euros) since if the denomination were 1 Euro, the coupon would be an unpayable amount of 0.0525 Euros. If the interest rate were 5.125% the minimum denomination would be 8 Euros. Having arrived at an integral number of (say) 4 Euros, the issue can be redivided into a new round denomination of 4 Euros, 1,000 Euros and, if desired, higher denominations without changing the external value (apart from the initial rounding payment) of any holder’s bonds. This method preserves the notion of each bond and coupon as a separate obligation and avoids problems of splitting individual bonds. Clearly the rounding payment is lower if the denomination of the bond in the national currency is as high as possible. It will also only work if there is one such denomination. Its detractors dislike the payment of the rounding element as handling it (even when it coincides with an interest payment) may be inconvenient and its tax treatment uncertain.

    Other issuers have provided for each bond to be redenominated in the same way but then renominalised to an integral multiple of 0.01 Euros. This is the method proposed by the International Primary Market Association (IPMA). There is thus no rounding payment and, legally, no change in the external value of each bond. There will however be a change in the aggregate size of the issue compared with the result obtained from the top-down method but it will be smaller than the EIB’s method. Having renominalised to an integral multiple of 0.01 Euros, bonds could be traded in round lots such as 1,000,000 Euros, any balance of odd amounts becoming effectively an untradable sludge in the holders’ accounts.
     

  11. Either of the bottom-up methods may result in a slight mismatch for related swaps where the amount payable would be calculated by reference to the original total amount of the issue. With the IPMA method, it is not possible to pay interest by reference to individual coupons and interest has to be calculated and paid by reference to the aggregate amount of the issue and it will be for the clearing system to allocate payments to accountholders and for accountholders to account as best they can to the customers for whom they are nominees or custodians. IPMA is (at the time of writing) expected shortly to approve and recommend some wording for use in bond terms and conditions.
  12. The top-down method rides rough-shod over individual holders’ entitlements as the application of the official conversion rate will be made to the total amount of the issue. It is therefore likely that the new amount in Euros will not be capable of division by the number of bonds outstanding without there being further rounding. It would be for the clearing systems to sort out who gets what. It does however have the slight merit of not giving a mismatch with the issuer’s related swap (though it should not be difficult to draft the swap to allow for bottom-up renominalisation).

    The third method is to start in the middle, to renominalise by reference to holdings of accountholders in the clearing systems. This method is superficially attractive as it would appear to be a compromise between the two other methods but it too has its disadvantages. If the issue is not traded, we have seen that the exercise of renominalising may not be worth doing. If it is traded, the sizes of individual holdings will vary from day to day so there can be no certainty until the exercise has been done as to what the new total payment obligation will be. It is therefore guaranteed to result in a mismatch for swaps and the paying agents and clearing systems will have to make separate individual calculations for each accountholder.

    Sovereign issuers (if issuing under their own law) have the supreme advantage of being able to change the law or bring in laws to achieve their objectives. Corporate issuers, if they want to renominalise, are probably best advised to follow either the EIB or the IPMA methods.
     

  13. One postscript to the debate. Hitherto the Euromarkets have traditionally used a day-count fraction for calculating interest of actual/360. Other markets have used a variety of other conventions. For the new market in Euro-denominated bonds, the convention being generally adopted (by both national governments and IPMA) is actual/actual. In addition, once payments are in Euros it will no longer be necessary for payments to be made on days which are business days in the principal financial centre of the relevant national currency. It will be sufficient that the TARGET system be operating. It is therefore recommended (both by IPMA and other influential market bodies and participants) that any provision included in bond terms for redenomination and renominalisation should also provide for the day-count and payment provisions to change in respect of periods after the date on which the redenomination takes place. The IPMA recommended wording is expected to include wording to this effect. It will also recommend that the triple action of redenominating, renominalising and reconventioning should only be done on an interest payment date. To do otherwise could cause confusion and difficulty in respect of the accrual of interest and the acceptability of payments to banks’ computer systems.
Given the different methods, each with its own attendant advantages and disadvantages, one can only hope that issuers will prefer to issue as from now in Euros and not continue to issue in national currencies for the remainder of this year or indeed during the transitional period.
27-05-1998
 
 
* Partner, Linklaters & Paines London. cholmqui@linklaters.com


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