Betting on basis

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Large offshore capital raising efforts by Australia’s banks and a relative dearth of activity in the kangaroo bond market has led to a significant widening in the cross-currency basis swap. This imbalance has created a large profit opportunity for fund managers. But can the party last? Wietske Blees reports

It has been a rollercoaster couple of years for the Australian cross-currency basis swap (see box, opposite), which has ripsawed to unprecedented levels primarily as a result of large irregular capital dislocations during the global financial crisis. On October 10, 2008, a shortage of US dollars, coupled with major rehedging of Japanese power reverse dual currency (PRDC) notes, caused the five-year AUD/USD cross-currency basis swap to drop to –50 basis points – quite a move for a swap that has traditionally traded in a fairly predictable range of around six to 10bp. Its 10-year equivalent suffered an equally volatile fate, hitting –47bp on the same date.

By September 2009, this situation had completely reversed. Kangaroo bond issuance had all but ground to a halt, while Australian banks – buoyed by AA credit ratings and government guarantees – were able to comfortably tap offshore markets to shore up their balance sheets.

“Foreign investor appetite for Australian bank paper has proven to be strong during 2009, which has been a reflection of the banks’ AA ratings and widespread confidence in the Australian government’s guarantees,” says Daniel Park, director for group treasury at Westpac in Sydney. “As a result, the Australian banks have been able to obtain significant amounts of funding in the offshore markets. Kangaroo issuers, in comparison to the domestic banks in 2009, had much lower Australian dollar-denominated issuance than had been seen in prior years.”

Indeed, while 2006 saw A$32.4 billion ($29.7 billion) of kangaroo bonds issued in the market, by 2008 that number had dropped to just A$10.4 billion. The first quarter of 2009 saw no kangaroo bond issuance whatsoever, while the second and third quarters saw A$5.5 billion and A$5.3 billion respectively.

This has jammed the natural flow in the basis swap market. As a result, the five-year AUD/USD cross-currency basis swap spiked to 48bp on November 26, 2009, while the 10-year AUD/USD cross-currency basis swap hit a peak of 46.50bp on December 2.

“There is a bottleneck in the market,” says Anne Anderson, a managing director for fixed income at UBS in Sydney. “The swap market is a flow market – there have to be buyers and sellers – and if there is nobody to take the other side of the flow, the market has to push until it finds a price at which the swaps can clear.”

These extreme levels of volatility have attracted the attention of a number of hedge funds. “The hedge fund community has been active in the basis swap market for some time. By nature, it is a function of opportunity,” says Anthony Robson, head of rates for Australian and New Zealand dollars at Barclays Capital in Sydney.

Those opportunities, he says, have occurred regularly in the past two years. “In 2008 and early 2009, the yield curve was steeply negative, which reflected the sheer illiquidity at that time, severe global funding issues and bank hedging need to receive in the long-end around 30 years. For hedge funds looking for the basis swap to widen, that presented attractive opportunities to pay. For example, they could pay a five-year basis swap, starting in five years’ time and pick up 60bp, benefiting from the negative-shaped curve and the very rapid change in levels,” he says, adding: “At the moment, and especially late last year, the basis swap is quite steeply positive, so there are certainly receivers of the forward forward basis spread.”

Dealers say that since hitting its peak in late 2009, interest from hedge fund managers in the basis swap has noticeably picked up. Betting on the basis to trend back towards its historical average, they have put on a range of forward-starting basis swaps to extract value from the shape of the curve. “A fund manager could receive a five-year basis swap on a hold-to-maturity basis, yielding say, +31.5bp,” says Ian Martin, head of global rates for Australia and New Zealand at Deutsche Bank in Sydney, who says hedge funds have been particularly involved in two- to five-year maturities. “By hedging the first year’s cashflows at +5.5bp, the manager can create a forward starting four-year swap at 39bp. Assuming the swap tightens in line with its historical average, they would benefit from carry and capital appreciation as the trade rolls down the curve.”

Since the fourth quarter of 2009, following a surge in kangaroo issuance, the three- to seven-year basis swap tenors have come back in substantially from their late 2009 peaks, with the five-year AUD/USD cross-currency swap falling to +32bp on February 17. Ten-year and longer tenors, however, have not fallen as sharply. That caused the inversion of the long-end of the basis to remain pronounced and has led Deutsche Bank to recommend a butterfly spread to take advantage of the inversion of the curve. “While the basis swap spread slope has returned to fairly normal long-run levels, the five-year/10-year/15-year butterfly is currently near the wides reached in February last year. We think this butterfly (receiving 10-year basis against paying the five-year and 15-year) is one of the better trade opportunities in basis swap spreads at present, and we recommend entering the trade,” the bank wrote in a research note dated February 17.

 Hedge funds putting on these trades are effectively betting on a reversion to mean, a logical presumption, some say, given the swaps’ historical track record and the abnormal market conditions of the past years. “What caused the extreme market swings in 2008 was a lack of US dollar liquidity coupled with major rehedging in the PRDC notes as a result of yen appreciation in the second half of 2008,” says one hedge fund manager in Sydney.

The combination of weaker currency, the basis market starting to move and the negative gamma positions that the structured desks had in the basis as a result of PRDC positions, drove the need for dealers to receive the long-end basis. Hybrid books needed to receive AUD basis swaps to hedge their position after the sharp appreciation of the yen that resulted in PRDCs becoming 30-year zero-coupon bonds. So hybrid books then needed to hedge themselves at the 30-year end, as opposed to two to three years (see Asia Risk, February 2010, pp28-30).

By September 2009, market participants say it was an increase in offshore funding requirements for Australia’s four major banks, sparked by regulatory scrutiny related to their liquid asset requirements that triggered the moves. In particular, the release of the Prudential Standard APS 210 Liquidity discussion paper by the Australian Prudential Regulatory Authority (Apra) on September 11, 2009, is said to have contributed to the widening swap. Recognising that guidance on what constitutes a liquid asset for stress-testing purposes has so far been minimal, the prudential regulator proposes a definition of liquid assets as ‘high quality assets that can be readily sold or used as collateral in private markets, even when those markets may be under stress. As a backstop to the robustness of the liquid asset buffer, liquid assets should also be eligible central bank collateral for normal market operations.’

Sovereign bonds most clearly satisfy these criteria, says Apra, but it is willing to consider other Australian dollar-denominated assets that might be considered liquid. This has raised the question of whether banks will still be able to hold bonds from semi-­government or supranational, sovereign and agency (SSA) sectors in their liquidity books, or for that matter, each other’s paper.

While Apra has yet to finalise its standard, a draft of which is expected to be released for further consultation in early 2010 with a final standard to follow in the first half of 2010, market participants say the uncertainty surrounding the new rules has spurred banks to take more of their funding activities offshore. Meanwhile, there is also significant speculation as to whether banks would still be able to hold supranational paper, the outcome of which would have an impact on demand for kangaroo bonds going forward. “Market expectations are that semi-government paper and SSA paper will be included, but bank paper will not,” says one Sydney-based debt capital markets analyst. “That is likely to further limit the amount of funding the banks can obtain domestically, and will increase their reliance on offshore funding. Naturally, this has pushed the basis wider.”

Since the publication of the discussion paper, market participants say initial fears that kangaroo bonds might not be included in the liquid asset mix appear to have subsided. What is more, the flip side of a wide basis swap spread is that while it increases the offshore funding bill for Australia’s banks, it reduces the cost of financing for kangaroo issuers looking to borrow in Australia. That has attracted a flurry of foreign issuers to the Australian market.

“From a cost-of-funding perspective, Australia currently represents an extremely attractive opportunity to borrow and, as a result, we have seen a substantial increase in kangaroo issuance in recent months,” says Peter Christie, head of fixed income at the ­Commonwealth Bank of Australia in Sydney. Among the issuers that have taken advantage of attractive funding costs is the European Investment Bank (EIB), which raised A$6.3 billion in 2009, including an A$1.5 billion April 2015 kangaroo bond on November 11, 2009 – boosting issuance that year by a significant margin. Taken together, issuance in the fourth quarter grew to A$9 billion, picking up further in 2010 with A$13.6 billion issued in the year to March 16. That has gone some way towards reducing the five-year AUD/USD cross-currency swap basis swap spread to +29.75bp as of March 16.

But if the overall expectation is that as markets normalise, the swap will reverse to mean, some say patience could be required for those keen to benefit from forward starting basis swaps. “The basis swap is still quite elevated,” says Anderson. “Hedge funds that put these trades on in December will look for further tightening in order for those trades to really start paying off. They would not have made much money yet,” she says.

Meanwhile, there is a risk the scenario does not work out as planned and the swap, instead of tightening, actually widens. “There is no such thing as a free lunch,” says one Sydney-based hedge fund manager. “They might get a positive carry on the first year of the trade, but there is a clear mark-to-market risk on the forward forward, and what the capital markets will look like in one year’s time is the big question. What you’d hate to see if you had this trade on is a continued dislocation in capital markets around the world, combined with a long-term scenario where Australian banks and corporates are forced to clamour for further offshore funds because of ongoing capital shortfalls in Australia to fund their growth.”

That scenario is not entirely unrealistic. September’s sharp moves reflect some structural asymmetries in the Australian banking system that might not be so easy to resolve. As a result of consolidation in the banking and mortgage financing markets, the major banks’ market share of most products has increased substantially during the course of the crisis. For example, according to figures from the Australian Bureau of Statistics, the share of owner-occupier housing loan approvals of Australia’s five largest banks – the four majors plus St George, which was taken over by Westpac on December 1, 2008 – increased from around 60% before the onset of the financial market turbulence in mid-2007 to around 82% in 2009. As their commitments have increased, so has the need to tap offshore funding. Deutsche Bank, for example, reckons up to 50% of an estimated A$120 billion of issuance by Australia’s largest four banks in 2010 will take place offshore.

At the same time, refinancing concerns have forced banks to seek longer-term financing. “Historically, banks have looked for term funding in the three- to- four-year range. Today, tenors often range from five years out to 10 or 12 years,” says Patrick Winsbury, senior vice-president in the financial institutions group at Moody’s Investors Service in Sydney. “That reflects an effort to reduce their sensitivity to market conditions in two to four years’ time, when government guaranteed issuances mature, as well as a preparation for potentially more conservative regulation in respect to liquid assets and stable funding down the track.”

Market observers say the Australian market is simply too small to absorb these increased funding requirements, forcing banks to rely on offshore markets for capital. “The problem with the Australian banking system is that the domestic market is simply not big enough, at this time, for the banks to fund all their substantial requirements in the domestic market,” says Stephen Nash, head of strategy and market development at FIIG Securities in Sydney. “As a result, they are effectively dependent on issuing debt in foreign markets.” 

Although kangaroo issuers are back in the market, the question remains whether they will be able to match the funding conducted by Australia’s banks offshore. If not, the basis swap is likely to remain under pressure. “Looking forward, the four major banks still have large fundraising needs for 2010, with a good portion of it being sourced from offshore markets. So far this calendar year, the kangaroo market has had a good start, but even if issuance continues at its current pace, it would be unrealistic to expect the kangaroo supply to match the offshore issuance by Australian borrowers on a dollar for dollar basis. As a result, I’d expect the basis swap to remain comparatively wide,” says Enrico Massi, head of debt capital markets Asia-Pacific at RBC Capital Markets in Sydney.

For hedge funds, that could mean patience is required. “The unfortunate fact is that while the funding requirements of the banks continue to mount, there are only so many buyers for Australian dollar securities. You can wait for the carry to come back in, but at the end of the day, you need the real money investors to take the kangaroo side of the trade,” says the hedge fund manager. “That means the basis swap may stay under serious pressure for some time yet.”

Basis swaps

The floating/floating cross-currency basis swap allows Australian banks and corporates to convert offshore fund raisings into Australian dollars and, conversely, kangaroo bond issuers to return Australian dollar denominated borrowings into their home currencies. The swap trades on a basis point spread against Australian dollar bank bill interest payments – which enables both principal and interest to be swapped, or exchanged, between USD Libor obligations and Australian dollar obligations.

For example, a positive spread signifies a higher cost to Australian borrowers looking to exchange their US dollar principal and interest debt obligations into Australian dollars. An Australian borrower would typically look to enter the basis swap following a successful offshore bond issue, in the US dollar eurobond market. Conversely, a positive basis swap spread implies a reduced cost for kangaroo issuers looking to swap their Australian dollar debt obligation into US dollars.

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