High interest rates, a strong currency, and rapid increases in volatility amid turmoil in European and US debt markets have resulted in another challenging year for the derivatives dealers and brokers in Australia. During a period that saw foreign banks reassert themselves in the country, Deutsche Bank emerged as the winner of Risk Australia’s annual derivatives rankings. Harry Thompson reports
Events outside of Australia appear to have shaped many of the developments in the corporate and financial markets during the past year as much as affairs occurring within its borders. This is with the exception of some significant regulatory rulings and limited privatisations, mergers and acquisitions activity onshore. The most striking event was the ongoing sovereign debt crisis in Europe, which caused large reductions in risk across a broad range of asset classes followed by more risk taking at different points throughout the year as sentiment regarding the ability of eurozone peripheral economies to pay back their debt waxed and waned. As Risk Australia went to press, new problems with Greek debt, combined with concerns about whether or not the US Congress would approve a temporary increase in the country’s debt ceiling – needed to avoid a possible default by the world’s largest economy – were causing widespread market jitters.
Turmoil offshore also resulted in more foreign participation in the Australian markets, particularly as the country is viewed as a safe haven economy – as long as Chinese growth remains robust – with highly attractive interest rate versus developed-world peers. The Australian government continued to issue treasuries, reversing its move to retire debt witnessed prior to the financial crisis of 2008. This resulted in a significant resurgence in the Australian dollar carry trade where market participants fund in low interest rate currencies, such as US dollars or yen, and buy higher-yielding assets in Australia. The interest rate differential was also favourable for Australian corporates and financial institutions that tapped overseas markets for funding and swapped the proceeds back into Australian dollars – although activity by the banks was less than some parties might have expected.
By helping market participants manage these risks, Deutsche Bank emerged as the winner of the Risk Australia Rankings 2011, with National Australia Bank (NAB) coming second, Citi third and UBS fourth – all for the second year in a row. Changes in the rankings placings this time around occurred with JP Morgan claiming the number-five spot and Commonwealth Bank of Australia coming in sixth, both leapfrogging over ANZ and Westpac – the latter being the year’s biggest faller, dropping from fifth to ninth.
NAB took the interest rate products crown, narrowly edging out Deutsche Bank, with Citi performing strongest in equity and JP Morgan heading up credit. Deutsche Bank, which also did well in credit, topped the table for risk advisory for the second year. UBS climbed the rankings in this area to take second place, up from sixth last year, perhaps due to the reorganisation of teams to ensure different asset classes were more closely connected.
One major market trend was that Australian corporates were highly active in debt issuance overseas, according to Michael Ormaechea, head of global markets for Australasia and New Zealand at Deutsche Bank in Sydney. In part, this is because corporates can issue paper at longer-dated maturities – five years and more – than is generally possible in Australia’s domestic fixed interest markets. “The post-2008 lesson is to expand duration, and that has come through offshore markets rather than onshore,” says Ormaechea. “Corporates have found a tenor of maturity of issuance, especially for hybrid products such as those done by Santos and Origin Energy, at a more competitive price offshore than they have generally found onshore.”
Australian oil and gas exploration and production company, Santos, issued €650 million ($935 million) in hybrid subordinated notes in September 2010, while Origin Energy allocated a €500 million hybrid issue in June this year.
Andrew Brown, head of debt solutions for Australia at UBS in Sydney, also notes the rise in corporates in Australia seeking funding offshore. “There is a top-end, tenor-wise period of ten years for funding in the Australian market, so you’ve seen Telstra and a couple of others who offered at that tenor last year in Australian dollars, but you can’t really get longer tenor in Australia – whereas, for example, Telstra can certainly get longer tenors overseas,” says Brown, adding that, since Australia is viewed as a strong economy in the current global economic climate, overseas investors are keen to buy its offshore debt. “If you were trying to do a long-dated deal in Australia, your volume just wouldn’t be there… for lower-rated counterparties, they’ve been accessing tenor through the US private placement note market and this is proving extremely attractive for Australian borrowers.”
Brown says the corporate trades are cost effective despite the fees involved in converting borrowings back to Australian dollars at a time when the basis swap remains elevated. Kangaroo bonds are issued by companies, financial institutions, supranational and multilateral agencies in Australia, and tend to get swapped back into US dollars or other major currencies. This opposite flow of transactions keeps the floating-to-floating cross-currency basis swap market closer to equilibrium (Risk Australia Winter 2010). At the start of 2011, there were high hopes that supranational bonds and some covered bonds would be included in Australian Prudential Regulation Authority (Apra) liquidity requirement. “During the year, we saw statements from Apra saying they would not be included in level 1 or level 2 liquid assets and so we saw some of the domestic treasuries back away from buying those primary issues,” says Ian Martin, head of global rates for Australia and New Zealand at Deutsche Bank in Sydney. These instruments are still permissible under the Reserve Bank of Australia’s repo facility.
The reason the decline in kangaroo issuance has had only limited impact on market dynamics is due to less-than-expected offshore funding activities by Australian banks. Until the start of this year, long-term offshore funding by banks was hugely popular as they sought to bolster their capital to meet net stable funding ratio requirements under Basel III capital rules. But this has tailed off since the turn of the year. “The Aussie banks have raised sufficient amounts of deposits onshore and their balance sheet growth has been slower than they expected,” says Matthew Yencken, head of debt and derivatives sales at Deutsche Bank. “The net result is that they have actually been less of an offshore issuer than people had originally expected at the start of the year.”
Debt woes in Europe have also caused problems for Australian bank debt issuance. “The point is that, if Europe is wobbly, then access to the markets – that window of opportunity to get your funding in – is just shrinking and shrinking,” says Brown. He adds that Westpac New Zealand’s June issue of a €1 billion covered bond had an issuance window of just 48 hours, after a significant period of monitoring to ensure the time to issue was ripe.
“Corporate activity has increased since last year, but that’s probably a smaller percentage of that market than the banks, and the banks have gone down significantly, while Kangaroos are down only a little bit, and net the market is pretty balanced,” says Brown. It’s a view echoed by Martin at Deutsche Bank. “The cross-currency basis swap was much more active at the start of the year. But, as some of the bank borrowing has reduced, some of that activity has dropped off,” he says.
John Feeney, head of rates and credit at NAB in Sydney, says interest rate markets this year have become range bound as the Australian rate hikes, with base rates hitting a peak of 4.75%, have tailed off. The three-year bond futures contract has been kept to a range for a long time. “We’re not seeing a lot of direction in the market and it has been difficult for us to identify good trades and good trends,” he says. Feeney notes that 12 months ago the expectation and the call from the Australian government was that rates would continue to rise. Meanwhile, he calls the strength of the Australian dollar the surprise development of the year, as it rose above par with the US dollar and stayed there. It reached levels not seen since the early 1970s, due to the underlying strength of the economy.
Meanwhile, concern about the global economy put pressure on financials as well as raised concerns about whether or not Australian house prices were overinflated. This resulted in some international hedge funds and real managers taking views on interest rates and specific credits. Some funds used Australian instruments to hedge against a downturn in the Chinese economy. “We saw hedge funds buying protection on the Australian sovereign because they see Australia as a high beta play on China,” says Yencken at Deutsche Bank. “If the China growth story were to falter, Australia would suffer proportionately and we have a more liquid market in both rates and credit derivatives.” Another popular trade was for cross-asset class investors to buy low-strike receiver swaptions.
Russell Taylor, managing director for institutional sales at JP Morgan in Sydney, says activity was particularly high among international hedge funds. JP Morgan’s credit team, which topped the rankings again this year for credit derivatives, saw sizeable volumes from hedge funds buying protection against an Australian sovereign default. These trades are viewed as a cheap way to gain protection against a downturn in the Chinese economy – which would hurt commodities demand and dampen the Australian economy. “The hedge funds know the story and they like buying what they view as a cheap short, given the low premium,” says Taylor.
JP Morgan started offering customers electronic trading for credit indexes this year, quoting Australia, Asia and European indexes on the same platform. Taylor says trading in Australian financials has been particular brisk during mid-July as investors became more wary of financial institutions in the event of further contagion out of Europe and the US.
The equities markets, meanwhile, were also dominated by macro trends, with derivatives activity picking up at some dealers, such as Citi, winner of the equity category. “It was all about macro – whether the EU, the US ceiling or inflation – the macro events moved around the market and you did see a lot of the equity players step to the side. You would see volatility get bid and then fall off again depending on what the actual macro event was,” says Sydney-based Luke Randell, co-head of global markets for Citi in Australia.
Randell says it was a difficult year from a stock selection perspective and a strong currency made Australia an expensive place for some foreign investors. “So it was basically the domestic players trying to find the marginal value in the market,” he says. Some equity investors turned to specific sectors, such as the resources sector, but often did some derivatives overwriting to bolster performance. Overall, derivatives tended to have more appeal, especially as three-month 90/110 skew steepened from 7.1% to 8.5%. “When you get into a situation where it is difficult to get alpha on your portfolio, you tend to go for another dimension. We saw a lot of people using derivatives,” Randell adds. “Tie that into your macro or fundamental stock strategy and you can come up with a pretty good combination. And that is what we have attempted to do this year.”
Another area of growth was exchange-traded funds (ETFs). “We have seen the growth of ETF instruments – whether in the global sector, emerging markets, rates, commodities or equities – these things have taken off like wildfire,” says Randell. “They are a very efficient tool for people to invest across the world.”
A relative change in term deposit rates also gave the structured products market a boost at the end of the tax year on June 30, 2011, according to Stephen Conrad, a managing director in global markets at Citi in Sydney. “The term deposit rates may have reached their high,” says Conrad. “We expect to see the return of structured products as deposit rates come down.”
While structured products activity may be on the rise, dealers say mergers and acquisitions activity has had a few ‘false dawns’. Meanwhile funding was relatively cheap, company owners tended to place a higher value on their companies than potential buyers. Deutsche Bank’s Ormaechea predicts a reasonable amount of downgrades of earnings per share will take place in the coming weeks. “The guidance has been for 10% earnings per share growth,” he says. “But, in reality, it has been low single digit or flat.” Ormaechea adds that the Australian equity market is feeling some impact from the major structural changes that are going on in the super fund industry. He believes the incremental increase in savings is resulting in a lack of new funds moving into equity, because more retail money is moving into fixed income and cash, particularly due to attractive deposit rates in the country.
There were also some pressing new issues for domestic banks. “Probably the biggest issue that we’ve seen is around the regulatory environment, which is changing pretty rapidly,” says NAB’s Feeney, specifically highlighting the impact of the introduction of the Dodd-Frank Act in the US and other new regulations requiring over-the-counter transactions to use central counterparties.
“What we’re noticing the most with the market is the move to cleared OTC derivative trades,” says Feeney. “We have relied pretty heavily on bilateral credit support annexes and we’re seeing a lot more of the liquidity going through cleared platforms like LCH.Clearnet.” He says regulatory issues such as these are particularly important in dealing with foreign bank partners, and adds that he doubts the issues will be resolved for a while yet.
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