Who Needs Eurocapital?

Europe is shaping up as a huge new source of capital, but demand, liquidity, and cost are still too big a mystery for most U.S. borrowers.

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The use of a single currency in Europe is widely expected to turn the continent into a huge new source of corporate capital. But you would never guess that from the reaction of U.S. borrowers.

Starting next January 1, when 11 European currencies will be folded into the euro, new bond issues will no longer be denominated in any of these currencies. And by 2002, all bonds already issued in those currencies will have been converted to euros. The change represents an ambitious and radical reordering of the world’s capital markets, with the size of the new euro-denominated bond market expected eventually to rival, and perhaps surpass, that of the United States.

European companies have embraced the euro by issuing bonds denominated in the new currency well in advance of actual monetary union. That’s because it’s long been possible to make interest payments in the form of European currency units, which are identical to the euro in all but name. But many U.S. issuers have not taken advantage of this opportunity. Between January 1 and the end of August, only seven U.S. companies–Associates Corp., Cellular Communications, Dow Chemical, General Electric Capital Corp., General Motors Acceptance Corp. (GMAC), Green Tree Financial Corp., and Mexico Capital Protected Investments–have issued euro-denominated securities of their own. Three U.S. investment banks–Merrill Lynch, Goldman Sachs, and Bear Stearns–have also waded in. But in total, just E3.6 billion, or about $4.1 billion, has been issued. The largest issue was Associates’s E750 million five-year floater of last June. In contrast, European issuers have raised E52.2 billion, or $59 billion, during the same period.

That is hardly a ringing endorsement of the new market by American borrowers, although many are far from strangers to Europe and have raised increasing amounts of capital in the traditional eurobond markets in recent years, primarily in the deutsche mark, the U.S. dollar, and the Japanese yen. The attractions are several. For one thing, European issuance allows issuers to broaden their investor base. Also, the fee structure is generally lower than in the United States. Underwriting fees on a 10-year, dollar-denominated bond would be about 4.5 basis points, compared with about 11 points for a U.S. equivalent. And thanks to arbitrage opportunities within the currency markets, total financing costs can remain much lower even after the expense of swapping the proceeds raised in a foreign currency to U.S. dollars.

An increasing percentage of Associates’s borrowings takes place in Europe for reasons of diversification, says Marvin Runyon, senior vice-president of corporate finance. Of the $7.4 billion Associates raised in 1997, $1.8 billion was accomplished in the euro market. And Associates, for one, says the market is so attractive that it felt compelled to establish a presence in the euro-denominated sector as well. Its E750 million, five-year floating- rate bond in June was increased by E250 million and could have found buyers for E1 billion. But Associates is an exception.

Are other U.S. companies merely exhibiting the parochialism they’ve been criticized for in the past? Not necessarily. Most U.S. borrowers don’t have as extensive and regular borrowing needs as does Associates. As a result, many will simply find no real demand in the euro for their bonds.

No Demand For Debutantes

As with any new market, it takes time for demand to be established. But this is particularly true for U.S. issuers in Europe, even those well known to investors there. Says Jerome Lienhard, corporate treasury manager of Toyota Motor Credit Corp. (TMCC), the U.S.- based financing subsidiary of the Japanese car manufacturer and one of the best-known U.S. names in the eurobond market: “Until about a month ago, it was unclear to me that there was yet a core constituency in euros for U.S. corporations.” Absent a clear and undiluted core demand, it would be foolish for most U.S. borrowers to risk a debut offering. Indeed, there seems little reason for the cost- conscious U.S. borrower that does not need to establish a European benchmark to even bother investigating issuance of euro-denominated debt.

Borrowers that do must leap other hurdles. Runyon says that when he was doing a road show for Associates’s five-year bond in Europe– which was the first by a AA-rated U.S. corporations–he was surprised to discover that German and French institutional investors, which together constitute the greatest source of potential demand, were not yet allowed to invest in the euro. Their nations’ statutes make foreign currencies off- limits to certain investors, and consider the euro foreign until January 1.

Blame the Swap Market

One analyst who says he is surprised by the euro’s poor liquidity points to the fact that many investors have instead flocked to issues denominated in the mark, the premier European currency and the backbone of the European monetary system. In fact, Associates contemplated issuing debt in marks instead of euros, but in the end saw no cost advantage in doing so.

Of course, the euro’s lack of liquidity is not entirely surprising, since ordinary payments are not yet made in the currency. If all goes well with next January’s 11-currency changeover, the capital market’s liquidity should gradually improve. Indeed, TMCC’s Lienhard says he believes the market already “has turned the corner” in this regard, as more investors have gained confidence in the euro’s prospects.

But the question of cost will remain more troublesome. Here the swap market is to blame. U.S. borrowers obviously have no need for euros, but converting them to dollars is expensive at the moment. When GMAC issued its E500 million, five-year floating-rate bond in May, the cost of swapping the euro back to U.S. dollars brought the total expense to one- to-two basis points above the amount GMAC would have paid on an equivalent U.S. borrowing. But the company was prepared to accept that premium because GMAC borrows $10 billion a year and wanted to plant a foot in the market. The company wanted to “establish a benchmark, as the euro will be a very important currency,” says David Walker, GMAC’s director of U.S. funding and securitization. Moreover, GMAC is a short- and medium-term borrower, where demand in the euro market is most concentrated.

Like the Associates deal, that floater found lots of buyers, and in GMAC’s case, that was enough to offset at least part of the higher costs. “The opportunity at a good cost doesn’t happen every day,” Walker concedes.

For its part, Associates was able to swap its E750 million note back to U.S. dollars at a cost comparable to that of its domestic financing. Its notes yield LIBOR plus 19.5 basis points, including underwriting fees, according to the joint lead manager Goldman, Sachs. And after the swap, the final cost came to five-year Treasury notes plus 62 basis points, in line with Associates’s comparable borrowing costs in the United States. Runyon says the company had “aggressive swap counterparties with good positions,” including HSBC Holdings and Goldman, enabling Associates to save money even though the swap was made at market rates.

But issuers not in GMAC’s or Associates’s position are likely to remain on the sidelines, at least for a while. “What do you gain by paying up, or even by taking an interest in it?” demands TMCC’s Lienhard. Yet he says that there is a “high likelihood” that TMCC, with debt requirements of $7 billion per year, will issue its first euro-bond before the end of the year. And Lienhard expects that because of the paucity of euro swap opportunities, TMCC will have to pay a premium of “single-digit basis points.”

The company would be willing to accept that, says Lienhard, if the demand for a large, liquid benchmark were strong enough to assure what he terms “a successful transaction and a platform for issuance going forward.” The company swaps all its foreign-denominated debt into U.S.-dollar-denominated instruments that pay a floating rate of interest. This reflects the fact that the market for floating-rate debt has consistently offered more-attractive opportunities than the fixed-rate market.

Familiarity Breeds Content

The liquidity of the euro swap market, as of that for euro-denominated securities themselves, will inevitably improve over time. As yet, no domestic financial instruments are denominated in euros. When the actual currency appears, holders of fixed-rate, euro- denominated mortgages will emerge, for example, injecting lifeblood into the swap market by seeking to hedge their positions.

Even then, U.S. borrowers will face other difficulties. Timing a first issue in an unfamiliar market is no easy matter, as U.S. treasurers looking at the market freely admit. Rushing in too early before a nest of investors has been cultivated is a risk, but so is joining a crowd.

And those treasurers who expect the new European capital market to be very like that of the United States are sure to be disappointed. For one thing, there is no European equivalent of the Securities and Exchange Commission. Although compliance with the minutiae of SEC regulations may be immensely bothersome, it does ensure a level playing field and access to a wealth of information that investors can use to evaluate credit.

“In the U.S., issuers have to run the gauntlet before issuance, and the SEC ensures everyone is speaking the same language,” Lienhard observes. Credit analysis is consequently much less developed in Europe, and to assume that Standard & Poor’s and Moody’s will be able to plug that gap is a “fallacy,” he adds. He foresees a market that will be much more fragmented, and although this may not be a problem in the short term, it will be when the first default occurs.

On the other hand, U.S. borrowers may have less reason than they believe to fear that the new euro market will be dominated by very large, liquid transactions. Although issues by sovereigns and supernationals, such as the World Bank, the European Investment Bank, and the European Bank for Reconstruction and Development, will take pride of place, there will be a niche for small, retail-oriented deals, says Walker. Lienhard agrees, predicting the development of a “barbell market,” with high-quality, triple-A names occupying one end and weak single-A credits the other.

And no one doubts that the euro will be the foundation of a very large, very important market–eventually. The travails suffered by Japan in recent months make the euro much more likely to become the second reserve currency after the U.S. dollar.

In addition, American companies have begun taking the new currency more seriously in other ways. As recently as April of this year, only about 30 percent of businesses in the United States had even looked at the myriad issues raised by the euro. However, according to the consulting arm of Ernst & Young, within the last four months, most U.S. companies have begun to examine such issues as when to convert earnings in, for instance, deutsche marks or French francs, to the euro during the three transitional years. And, they have begun to consider issues of suppliers and customers wishing to do business in the euro, as well as questions of regulatory compliance.

But the euro’s impact on U.S. corporate finance is an entirely different matter. Until the euro-based capital market develops better demand, pricing, and liquidity, U.S. borrowers will have little reason to pay attention to the new currency.

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