Borrowing from financial institutions has long accounted for the lion’s share of MTN activity but, thanks to the European Central Bank’s targeted long term refinancing operation and the Bank of England’s term funding scheme, banks are awash with cheap funding.
With so much money available from central bank coffers, banks are quoting ever more aggressive levels for private placements.
And, in a market packed with competitors, dealers’ profit margins can be completely eroded by banks bidding to land deals. “In some biddings, only a holistic view on a client relationship can justify the aggressive prices some dealers are quoting,” says Friedrich Luithlen, head of MTNs at DZ Bank in Frankfurt. “Many private placements are not profitable in themselves for the dealers winning them at the start of the year.”
From an issuer’s perspective, this is, of course, an advantageous situation. Joakim Holmström, head of funding at Municipality Finance, says: “Our benchmark curve is a reference point, and we expect private placements to be cheaper. With many banks competing to offer the best yield at the level we pitch, there may not be much left for them from a fee perspective. When we evaluate our banks for benchmark trades, the amount of arbitrage funding they have provided us gives them a better chance of being selected for a fee paying benchmark.”
Municipality Finance sources between 50% and 60% of its circa €7.5bn funding programme through private placements.
While its role as a liquidity provider to the FIG sector is being eroded, the product’s key roles are unchanged. What the MTN market does best, and what makes dealers their money, is filling niches that are hard to access in the public market. That means tenors outside the standard benchmark range, currencies outside the core and structures too complex and specific to market broadly.
This flexibility has allowed the product to remain relevant through the most tumultuous events in financial markets, finding new solutions in times of political volatility and unprecedented monetary policy.
Back to vanilla
In the years before the 2008 financial crisis, the quest for yield pushed borrowers, particularly financial institutions and public sector borrowers, into ever more exotic structures with complex algorithmic coupons. Borrowers hedged their obligations out to dealer banks but, when the financial crisis took hold, some banks folded. David Morland, head of MTNs at MUFG in London, says: “Their swap counterparties disappeared and issuers were left with obligations that were extremely difficult to value, and were in a position where it was very difficult to find a new swap counterparty. To an extent, this pushed a reset button on the highly structured market with a move back towards the vanilla theme.”
The change has brought about a shift in the approach of an MTN desk. Smit Acharya, head of MTNs at Santander, says: “In 2008, MTN desks were largely structurers, but this has changed dramatically and we have primarily become originators.”
Morland says: “Nowadays, MTN desks often sit within DCM on the private side working as a complementary desk, part of an array of products on offer to issuers.”
In the years that have elapsed since the financial crisis, a few structures have crept back in. In any environment, there will always be investors keen to put a portion of their cash into products offering a little extra yield.
The exotic algorithms of the pre-crisis era are gone but light structures — notes with single call options and step-up coupons — are still in evidence. However, they have proved less popular than dealers had hoped. “Long end rates have moved higher and the market had expected this to lead to more callable supply, but market participants are still uncertain about long end rates, so the callable issuance has yet to ramp up,” says Toby Croasdell, head of MTNs at Barclays in London.
The increasing prevalence of Solvency II regulation is keeping the bulk of the MTN market firmly in vanilla territory. “More insurers are considering Solvency II impact of investments, which affects the type of names and pay-offs they can consider,” adds Croasdell.
The great migration
MTN bankers are still innovating, but now the innovation comes not in the form of new structures but with new ideas for moving down the credit curve, providing more attractive yields.
The last few years have seen a migration of investors into new, and more risky products — SSA investors moving into covered products, investors in covered products moving into senior FIG, senior FIG investors taking a keener interest in the gamut of loss-absorbing capital that banks around the world are required to issue.
It is this market that many believe holds much promise. They will have to be patient though. Volumes of holdco and other TLAC eligible private placements are still limited, partly because most borrowers are unwilling to issue less than €50m at a time so they need significant support to get a trade off the ground. Additionally, traders are less willing to warehouse paper which traditionally has a volatile spread.
Many banks have a great deal of loss absorbing capital to raise to hit the moving target of developing regulatory requirements. Investors are aware of this, says Luithlen, and it can make TLAC eligible MTNs a tough sell. “If they buy today, they might see a cheaper benchmark available next week.”
While the market is still developing, dealers are excited at the possibilities it stands to provide. “Banks continue to increase their TLAC stacks and MTNs will be an important tool for doing this,” says Croasdell. “As with conventional trades, MTNs are generally cost-effective and allow borrowers to diversify the markets and investor base from which they source their funding.”
While the market is a long way from maturity, both in terms of the regulatory backdrop and investors’ awareness of the product, it is already proving “a breath of fresh air” for the market, according to Croasdell. “The MTN market is always evolving, so we actively welcome new borrowers, new products and new ideas.”
The other driver of change in the MTN market is another central bank policy: quantitative easing. The ECB’s asset purchase programme has, since its inception in early 2015, distorted asset prices almost beyond recognition and the resultant compression of spreads has put the MTN market under pressure.
The colossal volumes purchased by the central bank have made benchmark execution easier than ever and eroded the value of MTNs for borrowers able to secure exceptional levels for their cost of funds.
Now, as speculation ignites about exactly how the ECB will wind down quantitative easing, MTN dealers are considering what the market will look like for their product in the aftermath. Some, like Santander’s Acharya, believe that the expected rise in rates will make little difference.
“Our task has always been to find the right solution,” he says. “The yield backdrop doesn’t make a big difference. We still have to find a way to offer relative value compared to the other products on offer. The real obstacle is the adverse political backdrop and the volatility.”
Others, like Barclays’ Croasdell, believe the end of QE will be a positive development for the MTN market. “As funding requirements revert to a normal range, the cost advantage of MTNs will be more obvious,” he says.
Either way, we can be sure the ever changing MTN product will find a way to thrive in the new conditions.
