roundtable discussion

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DIVERSITY KEY AS NEW ZEALAND FUNDS FLOWS CONTINUE

PartICIPantSn Andrew Blackler NZ Fixed Interest Manager BT ASSET MANAGEMENT n Mark Butcher Treasurer AUCKLAND COUNCIL n Deidre Copley Head of Fixed Income CRAIGS INVESTMENT PARTNERS n Iain Cox Senior Fixed Interest Analyst ANZ WEALTH n Patrick Hoerler Treasurer MIGHTY RIVER POWER n Vicky Hyde-Smith Portfolio Manager, Fixed Interest AMP CAPITAL n Andrew Lance Manager, Fixed Income TOWER ASSET MANAGEMENT n Tim Main Treasurer BANK OF NEW ZEALAND n Fergus McDonald Head of Bonds & Currency TYNDALL INVESTMENT MANAGEMENT n Patrick Mitchell Head of Long-Term Funding, Asia Pacific RABOBANK n Phil Neutze Manager, Business Intelligence AUCKLAND AIRPORT n Ross Pennington Partner CHAPMAN TRIPP

bnZ PartICIPantSn Florence Besson Director, Debt Capital Markets n Mike Faville Head of Debt Capital Markets n Alec MacKay Head of Securitisation NZn John Marsh Head of Investor Sales n Sarah Raudkivi Asociate Director, Debt Capital Markets

Moderatorn Laurence Davison Editor KANGANEWS

nstitutional investors in New Zealand say their challenge is securing

the allocation of healthy funds flows to domestic, rather than global,

fixed income in an environment where supply diversity is scarce.

Local corporates are well-funded by a banking sector which continues to chase

deposits hard, while the local government sector is in a transition period.

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FUNDS DYNAMICS

davison what dynamics are driving flows of funds into the fixed income market at present?n Cox Our flows are reasonably good, with KiwiSaver being a strong contributor. Our wholesale business is relatively stable, or perhaps slightly reducing, but the private bank side of the business is also experiencing good inflows. Overall, we are seeing quite a bit of money coming into fixed income – the challenge is placing it. The majority of our fixed interest flow goes offshore nowadays, because of lack of domestic diversity.n MCdonald We are not as well-placed in the KiwiSaver as a bank-owned fund manager, but even so KiwiSaver is still the main game in town in terms of inflows. Tyndall Investment Management is the fund manager for about six or seven KiwiSaver providers, mainly smaller ones. Since KiwiSaver started – about five years ago – there has been a gradual closing up of corporate superannuation schemes and a transition to KiwiSaver.

Flows into our funds overall have been quite constant, but for every dollar that goes into domestic bonds and cash probably two dollars goes into global bonds.

n blaCkler The picture is similar for us. Most of the KiwiSaver flows we see are quite conservative, meaning allocations to cash and fundamentally conservative products. That means a lot in fixed interest, but as Fergus McDonald says probably twice as much goes to global product as to domestic.

One significant factor is that the advisers who previously bought direct bonds and weren’t interested in funds have started to capitulate. They are at least listening to the story on the value of funds because there is nothing in the retail space for them to buy.n Hyde-SMItH Our funds have grown by roughly NZ$2 billion (US$1.6 billion) since December 2011. Most of that growth is related to the transitioning of AXA funds. Outside that we continue to see KiwiSaver flows. This has probably contributed NZ$400 million of the flow into fixed and cash in the last year.n lanCe We are also seeing funds coming in to balanced and conservative portfolios. What has changed over the past three or four months is the amount of times we are asked when the global bond cycle will turn around. We have traditionally had a fairly substantial global allocation, but now we are asked that question in virtually every meeting – including by asset

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consultants. This means we have a tendency nowadays to look more at domestic than global.n Cox The fact that the default KiwiSaver allocation is directed into conservative funds means a lot more money is going to fixed interest than we believe is necessarily the right outcome. We feel a more balanced approach may be appropriate.

davison what is the funds inflow and allocation story in the retail sector?n CoPley We are a smaller player in KiwiSaver but we have benefited from the same kind of inflows, mainly into balanced funds. One of the differences in our model is that we are not significantly invested in global bonds. With respect to our asset allocation recommendations for both direct investment and managed funds, we have increased our bias to local over global markets and to equities rather than bonds.

davison andrew Lance mentions a desire to repatriate some allocations that have traditionally gone to global fixed income. are other investors experiencing that, and if so what is driving it?

n MCdonald I think it is a question of return. When global bonds are performing better than domestic bonds there is a perception that global is a superior asset class, and vice versa. But it is something of a rear-view mirror phenomenon, and it is also influenced by the perception that the traditionally beneficial effect of hedging back offshore product to Kiwi dollars is an added extra to existing bond allocations.

However, it is also true that both retail investors and superannuation scheme trustees in New Zealand feel far more comfortable with names they know any understand. The fact is that problems seem to be driven by global, rather than domestic, factors.n Hyde-SMItH There are other reasons to want to repatriate bond funds. The duration of global indices has grown and investors may be wary of extending duration in a low yield and negative real yield environment. In addition, the hedge benefit of investing in foreign currencies is not as great as it has been in the past. n MaIn Does that suggest there could be more capacity in the domestic market for issuers like the banks or major corporates?n MCdonald I think most of the banks have pushed domestic issuance quite hard, and diversity is still important in domestic

“The banks in New Zealand have raised significant amounts of cash and are facing the fact that local corporates are not in growth mode. In that context, the cost of funding the banks are willing to provide is very competitive.”Pat r I C k H o e r l e r m i g h t y r i v e r p o w e r

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n butCHer Auckland Council monitors its investor base every six months. We have around 15,000 investors at present, of whom around 14,000 hold parcels of less than NZ$100,000 – even though we haven’t done a retail issue for more than two years. We have also seen a 5-6 per cent increase in the number of investors in that less-than-NZ$100,000 category in the last 18 months – despite lack of issuance and low yields. We will sign retail documentation in mid-August, but in advance of that we were surprised to see increased retail participation.

davison do you get any sense of why that might have happened, given most of the factors – such as attractive term deposit rates and the low yield environment – seem to be headwinds to retail buying high-rated, low-yielding paper?n butCHer We haven’t drilled right down but our recent experience of increased retail holders is certainly surprising.n CoPley I can explain part of it. In addition to KiwiSaver, there is new money coming into the retail market that for a variety of reasons – such as the sale of an asset or an inheritance – may be substantially in cash form. This means a portfolio recommendation starts from scratch. We structure the fixed income portion to include a diversified and laddered section of bonds on issue where supply can be obtained.

We don’t tend to buy government securities – though we would like to see a liquid inflation-indexed product – but we continue to buy well-rated local authority and bank paper. Auckland Council is one of the handful of non-financial names whose stock we can acquire.n Cox We do something very similar through our private bank business, thought we hold government bonds for added liquidity and diversification.n FavIlle In terms of the ability of the type of investor we are talking about – the model portfolio investors – to support a deal, that sector would be able to support transactions of about NZ$100-200 million. To achieve more than that in a retail deal requires a broader-based bid, much of which is still somewhat married to historical yields.n MarSH We find that all the private banks are being run more like institutional investment houses nowadays. For example, a lot of them have cut out triple-B securities from their portfolios

portfolios. Gradually, differentiation between different classes of debt issued by banks – covered, senior and subordinated bonds – may create a reason for greater allocation to some asset classes. But that would need to come from asset managers pushing for it rather than an innate desire of trustees.n Hyde-SMItH There is a lack of diversification in New Zealand. You inevitably end up holding a higher weight to local authorities and bank issuers in addition to government bonds, which are more investable now than before the crisis. Domestic capacity has improved because of KiwiSaver flows but also because of the growth experienced in bank liquid asset portfolios. While we consider investing offshore, we are aware of the costs involved in doing so and are mindful of wanting to retain a home-market bias in our portfolios.

YIELD DIVISIONS

davison how challenging is the yield issue for borrowers in terms of achieving an acceptable cost of debt in the domestic market, especially with regard to attracting retail investment?n Hoerler There is strong competition between the various sources of funding. The banks in New Zealand have raised significant amounts of cash, via deposits in New Zealand and issues offshore, to refinance their balance sheets. They are facing the fact that local corporates are not in growth mode. In that context, the cost of funding the banks are willing to provide is very competitive compared with the debt capital market.n neutZe The relative attractiveness of different sources of funds depends on what tenor we are looking at. We see three to five years as very competitively priced by the banks at the moment, seven years is the sweet spot of the domestic capital market and anything longer than that would probably mean Australian dollar bonds or the US private placement (USPP) market.

We have a very well-balanced debt book at the moment. Our board is focused on diversification of funding but we have already achieved that. Our next debt issues are likely to be in the five- or seven-year bracket rather than longer. While any debt capital market issues will be retailable, we expect institutional investors to dominate.

Sarah RaudkiviMike Faville Alec MacKay John Marsh Florence Besson

bnZ PartICIPantS

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more subordinated a security is, or if it is lower-rated or not listed, the more restrictive the investment guidelines applied.

DEPOSIT MARKET

davison term deposit rates continue to be an attractive option for retail money, but how

completely, with the exception of state-owned enterprises (SOEs). They are raising their credit quality and moving out of discretionary investments in double-B equivalent capital notes.n CoPley We have certainly seen a move towards higher-quality bond portfolios over the past few years. Our internal guidelines are for at least 70 per cent of a portfolio to be in vanilla bonds, usually with investment-grade or higher credit ratings. The

DAVISoN In the context of the RBNZ’s oBR plans, how cognisant are retail investors of the purpose of diversifying deposits among financial institutions?

CoPley Our guidelines recommend diversification across banks when investing in bonds. But I suspect many people have personal banking arrangements with a single institution, and therefore would be over-invested. Generally, I do not think retail investors are aware of the implications of OBR.

PennIngton Any concerns about OBR rest on an assumption that it is anything other than the myth that it actually is. The RBNZ thinks OBR is coming, but the policy doesn’t have any basis in reality.

We are talking about a country where the government put its balance sheet out to support some of the worst finance companies the world has ever seen. The idea that it wouldn’t make it available to support the banks that are a part of the fabric of the New Zealand economy is not credible politically.

The only way OBR can have any credibility at all is if it is contracted for by the recipient investors. In other words, it will either have to become

Closed door for open bank proposaLsThe Reserve Bank of New Zealand (RBNZ) has proposed an unusual version of bail-in for future troubled local financial institutions. Open bank resolution (OBR) would apply a haircut across an insolvent institution’s capital structure – including depositors’ funds – to provide the liquidity to maintain operations. Market participants are unconvinced by the proposals.

part and parcel of Basel III-type mechanisms or it won’t happen at all. The notion of advancing a policy that requires a fundamental cultural and political change, other than through consent, is pure fancy.

MarSH But bail-in has been talked about all around the world.

PennIngton It has been talked about by a small group of people who understand what bail-in involves. It hasn’t taken off beyond limited test cases. The issue is that you have to get US$1 trillion just to replace existing regulatory capital. While we’ve seen issuance from stronger names, it is hard to see this filtering out to the periphery, such as the Spanish banking system. Spain, like most countries, probably has depositor insurance – the opposite of bail in.

The point about the Spanish banking system is that you have to get investors to agree to take a punt on it knowing that there is a haircut, or worthless equity, if it doesn’t work out.

Like Greece, Spain is also suffering an exodus of deposits.

DAVISoN Is it problematic for oBR that the majority of the New Zealand banking system is Australian-owned? oBR includes the expectation that depositors can be haircut, where the Australian banking regulator holds protection of depositors as its number one goal.

PennIngton One of the most interesting things about OBR is its potential to drive a wedge into [Standard & Poor’s] banking industry country risk assessment (BICRA) dynamics, to the extent that there is credit divergence in the trans-Tasman banking industry. Every time something is set up that creates up a delta between the Australian and New Zealand banking industries there is a consequent possibility of influencing BICRA. So far the ratings agencies have ignored OBR in the same way as I’m suggesting any rational person would ignore it. But the further we go towards

trying to make a concrete reality of OBR the more it has to be paid attention to.

blaCkler The lack of awareness about OBR is a fair point: I think it would come as a shock to bank customers to learn that the system is set up only to support their deposits with a haircut. Nobody is likely to comprehend that until they fill in a term deposit form that asks them to acknowledge the system.

MaIn I am not getting any feedback from international investors that OBR is a problem. Certainly it isn’t making us pay a higher premium on our international debt.

PennIngton They are not pricing it because it is a fantasy.

MARSH Is Bank of New Zealand working on the principle that oBR is happening?

MaIn Yes – we have made all the necessary system changes and expect it to be a condition of registration.

“ANy coNcerNs AbouT obr resT oN AN AssumpTIoN ThAT IT Is ANyThINg oTher ThAN The myTh ThAT IT AcTuAlly Is. The rbNZ ThINks obr Is comINg, buT The polIcy doesN’T hAve ANy bAsIs IN reAlITy.”r o S S P e n n I n g to n c h a p m a n t r i p p

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attractive an option are they for banks relative to other sources of funds?n MaIn Regulation is a key driver, encouraging banks to compete to grow deposit balances. But it is also true that the financial crisis taught banks the importance of domestic deposits as a stable source of funding. All banks have been very keen to acquire deposits as a substitute for short-term wholesale funding. Going forward, it is difficult to see banks doing anything but remaining very competitive in deposits.

In terms of cost of funds, deposits sit somewhere between onshore wholesale and offshore wholesale as a spread over swap. I don’t expect that to change much, given banks’ need to keep market share growing and to protect their deposit bases. We see it as a cost worth paying given deposits grow our stable funding sources and reduce the reliance on offshore markets.n MItCHell The rates we and other banks pay for New Zealand term deposits are generally higher than we would pay for a bond. But I think investors take the view that bonds

DAVISoN There is some investor concern about the additional volatility they believe fixed tender volumes could bring to the New Zealand government bond (NZGB) market. How conscious is the NZDMo of this issue, and what are your observations on tender volatility so far in the trial?

doyle NZDMO is aware that there will be a period of transition as the market adapts to a consistent volume approach. However, we are confident that it is the best way forward for the market and the Crown in the long term.

Consistent volume provides clarity which helps develop the secondary market and, over time, should reduce volatility, improve liquidity, bring more investors to New Zealand and reduce funding costs for the New Zealand government.

We are comfortable with the results of tenders so far this fiscal year. There has been variable demand over this period and some price volatility, which is consistent with a period of transition and with the uncertain times we are experiencing globally. On the other hand, issuance is on target to complete this year’s funding programme.

Additionally, recent bond tender results should be taken in the context of what has been a very quiet time, with the Olympics and the northern summer holiday period affecting demand.

DAVISoN There was also a suggestion that fixed tender volumes could be a disincentive to some larger investors in NZGBs, as they could make it harder for substantial exposures to be added or moved in a short period of time. Is this issue on the NZDMo’s radar?

doyle Ultimately, we would like to see the secondary market facilitate spikes in investor demand or supply. As noted, consistency of supply should build confidence and increase intermediary involvement in the secondary market. This includes warehousing bonds in order to facilitate investor demand. Increased secondary market activity should assist sellers of bonds in the same manner.

While the previous flexible issuance approach was helpful for investors looking to buy bonds, and allowed the NZDMO to increase bond outstandings to NZ$56 billion (US$45.6 billion) from NZ$20 billion, the approach

did not assist investors who might want to sell bonds from time to time. Investors have periodically told us that the market’s ability to manage a large sell flow of bonds continues to be a challenge and a point of concern for them.

It is also important to remember that government bond issuance is forecast to fall in New Zealand over the coming years, in line with the government’s planned return to fiscal surplus by 2014/15. Only NZ$11.5 billion of net new bond issuance is planned between now and June 30 2016. Sourcing bonds from high credit quality sovereigns like New Zealand has become – and will continue to be – an increasing issue for the global investor community, regardless of issuance approach.

DAVISoN What are the NZDMo’s observations on the robustness and scale of domestic demand for NZGBs?

doyle The fact that financial intermediaries facilitate investors via the primary and secondary markets, and the use of security custodians, makes it difficult for us to know who owns our bonds. However, offshore holdings as a percentage of bond

the NZdMo perspectiveThe New Zealand Debt Management Office (NZDMO) was unable to be present at the KangaNews/BNZ roundtable. However, the agency’s Wellington-based treasurer, Brendon Doyle, responded separately to the segment of the discussion relating to its issuance strategy (see p53).

outstandings have fallen recently, implying a relative pickup in domestic demand. This has partly been due to regulatory changes but could also be attributed to increases in KiwiSaver funds under management. Overall, we are happy with domestic participation in the government bond market and we expect it to continue to increase along with national savings.

DAVISoN What feedback has the NZDMo received on the relative appeal of New Zealand versus Australia to international investors?

doyle Global investor diversification is a consistent and ongoing trend. Anecdotal evidence suggests that Australia continues to experience high demand for fixed income product across the board. New Zealand has benefited from that demand as it is the next logical diversification location for investors who have made the move into AUD product. While New Zealand is smaller, both countries have similar characteristics with good credit stories, transparency and commitment to fiscal discipline.

Expectations of monetary policy are relatively more important than today’s cash rate in determining investment decisions. Other factors are also important, and as such we are still seeing new investors come to the New Zealand market.

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are tradeable instruments and apply a value to that, so we still see retail buyers participating in our bond deals – especially in seven-year tenor where there is also additional yield available.

All banks have put a lot of work into analysing the relative value of retail versus wholesale funding, and clearly there is a regulatory benefit from having a retail deposit relative to wholesale funding of the same duration. Calculating that value is not straightforward, though I feel the likelihood of, for instance, a six-month term deposit rolling into another six months at maturity makes it worth paying a margin that might be more akin to fair value on a longer initial-term instrument. Making direct comparisons between retail deposits and same-maturity bonds is not necessarily accurate.

Copley how much switching do the banks see in the deposit market? do investors chase yields between banks or switch deposit duration to capture special rates?n MaIn As a rule we try to be either top or equal top among the majors in deposit rates. If we get more than about 10 basis points adrift of the top levels of key deposit terms we tend to lose market share. Term deposits are very homogenous products and people will switch between them.

However, I get the sense that all the banks have been reasonably successful at raising what they want from deposits and the sector has not had to push rates really hard. That is pleasing in one way, though it also reflects the fact that asset growth has not been strong.Cox Fluidity of deposits is somewhat ironic, given the Reserve Bank of New Zealand (RBNZ) states that retail deposits are stickier than wholesale. Retail depositors are happy to shop around whereas I am restricted by my mandates to bank limits – in fact, my investments are more likely to stay put as I have to remain diversified, rather than shopping for rates.n beSSon Regarding deposits, there is also a valid risk to be considered in the form of a run on a bank. Even in commercial paper (CP) markets funding might be in place for three months, where many deposits can be taken within a day.n MarSH The point about deposits is that they are sticky to the system, even if not to an individual bank. I think that’s where the RBNZ derives comfort.n Hyde-SMItH A low asset growth environment should lead to lower deposit price pressure, but in reality not all deposits are equal in the eyes of the RBNZ. It appears that rather than grow the pool aggressively, bank pricing is merely changing the mix of those deposits toward the regulator’s definition of stickier funding.

Faville the intense competition for deposits over recent months has

enabled all the new Zealand banks to reach the regulatory minimum 75 per cent stable funding requirement, with a buffer. since there is no higher level to migrate to, might the competitive pressure now ease a little?n MaIn For us it is now a question of refinancing existing debt only, which means there will be a large reduction in our term funding requirement – we have had to raise a lot to meet regulatory standards but we are now comfortably above them.n blaCkler While the RBNZ rightly wanted to shore up the banking system as quickly as possible, the time frame they put in place clearly created distortions by the way it forced banks to be so competitive on deposit rates. Normally at this point in the cycle investors would be considering reallocation out of cash, but I suspect the extent to which that is happening is reduced by a willingness to stay in term deposits given the yields.n MaIn I get the sense that there has been a shift in household asset allocation, with more willingness to look at term deposits as a reasonable return provider compared with property and equities. Savings rates have also improved. I think those two things were both happening naturally as a result of global events, though the regulatory aspect may have accentuated the process.n Hyde-SMItH I think the competitiveness of the deposit market is something we will all have to get used to – but I think fund managers will react. Our fixed funds now capture a running yield due to higher term funding costs, generally. Our cash portfolios are not as competitive on yield as a term deposit, but they offer more diversity and more liquidity. Banks will look to capture fund manager KiwiSaver flows via other products which are more fairly priced, such as repo-eligible floating rate notes and extendable products.n MarSH We have heard frequently from retail money managers that their plans for maturing bonds are to put the proceeds into term deposits then switch back into bonds as and when rates go up. There is still yield-seeking going on, but it has limits.

SOVEREIGN DEBT

davison the new Zealand debt management office (nZdmo) has recently moved from a system of flexible tender volumes to trialling fixed tender volumes. what impact will that

“retail needs to go further in terms of accepting lower yields – there is no way well-rated corporates will issue at 7 per cent coupons when they can do so much better from their banks.”a n d r e w b l a C k l e r b t a s s e t m a n a g e m e n t

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change have on the new Zealand government bond (nZgb) market?n lanCe The change has been really interesting. There is definitely a sense that demand, especially from offshore, is very variable and dependent on circumstances. For a small market like ours, to try to issue a fixed amount each week seems a little risky – and leaves the NZDMO prey to problematic tenders as has happened already in August. On the other hand, it would be interesting to hear whether market makers think the fixed tenders help from a trading perspective.n MarSH We see the move as good for the market but also risky for the NZDMO. The market benefits because there was in the past no reward for being long securities – as soon as there was demand it could be taken to the NZDMO and filled. There is more symmetry to the risks traders have under the new system – there can be short squeezes as well as long ones – which will encourage traders to take a view and transact based on the flows they see.

Seasonality should also be considered, especially the fact that this trial has so far only been undertaken during the Northern hemisphere summer. The big Asian central bank and sovereign wealth fund investors, who have been strong NZGB supporters, may also be in holiday mode. So we will need to see how this plays out through September and October.

n Hyde-SMItH It’s certainly true that there are other dynamics in the market that are making it hard to assess the impact of the change in isolation. Banks may be holding more NZGBs than they had been, in part because we haven’t had the same offshore flows of late. I don’t think we will know the answer until offshore investors return to the market.

It is positive to have additional transparency in tenders. But along with that will come additional volatility, which brings opportunity for bank trading books and fund managers alike.

davison is there a concern that capped tender volumes could engender a degree of frustration in those accounts, in the sense that they may be less able to gain or change exposures as quickly as they could via reverse enquiry?n MarSH For sure. Fixed volume will add volatility and it will add tails to tenders at times. The fact that both buy and sell flows in the NZGB market tend to be lumpy certainly puts a question mark over the value of the project.n Cox As an end holder of government debt risk we would prefer to see less volatility rather than more. I worry that the kind of volatility we are talking about could drive investors away from the market. Liquidity for the sizes we deal in is already good enough.

FAVILLe Issues around credit valuation adjustment (CVA) and its impact on swap costs are huge. How much visibility are corporates getting on those issues from banks, and how important are they?

Hoerler Some banks are talking to us about the

cost associated with new regulations, including those relating to central clearing and CVA. I think we have an understanding of what is happening, but we are yet to see the application and pricing of new regulations in practice as recently we haven’t been active in the capital market domestically or offshore.

neutZe The basis swap for US private placement issuance has been a significant added cost for a couple of years now. We normally look at pricing on an all-in cost swapped back to floating New Zealand dollars.

On the CVA issue, it is clearly front-of-mind for some banks and being priced as such,

Cross-border concerns brewing in Credit seCtorIf New Zealand’s corporate borrowers are less obviously engaged with the potential impact of more expensive cross-currency swaps than some of their Australian peers, it is only because many Kiwi companies do not expect to be active near-term international issuers. New Zealand will not be immune to what is a key challenge for global capital markets.

whereas for others it is not. The banks that aren’t incorporating CVA costs in NZD interest rate swaps are winning our business at the moment.

beSSon When considering the all-in cost, particularly in relation to basis swaps that tend to have a longer duration and generate higher counterparty credit risk, we are seeing an increased tendency for borrowers to incorporate the credit standing of their bank counterparty into their decision making.

butCHer We have also seen inconsistent pricing of CVAs between banks. That, combined with the approved issuer levy (AIL), is a real headwind to our offshore issuance – as a double-A rated borrower with an eye to margin contraction, adding 10 basis points for swap costs and the same for AIL can blow the whole offshore issuance value proposition out of the water very quickly. We are also trying to lengthen the tenor of our debt, in an environment where very few banks are

“cvA Is cleArly froNT-of-mINd for some bANks ANd beINg prIced As such, whereAs for oThers IT Is NoT. The bANks ThAT AreN’T INcorporATINg cvA cosTs IN NZd INTeresT rATe swAps Are wINNINg our busINess AT The momeNT.”P H I l n e u t Z e a u c k L a n d a i r p o r t

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seeking to be benchmarked against the government, the LGFA would also prefer less volatility in NZGB tenders.n MarSH There is a paradox, in effect. Issuers and investors don’t want volatility. But at the same time banks are finding it harder in the new environment to provide capital to the market to support trading, and as a result to act as market makers. Under the new regime market markers are encouraged to hold more longs, but we haven’t necessarily yet found the right balance between volatility and liquidity.

LGFA EMERGENCE

davison could the Lgfa pick up some of the slack by being more flexible in its own tenders

n MCdonald Most fund managers would call themselves investors rather than traders, and having a volatile market isn’t really necessary for investors.n blaCkler It certainly seems likely that the market will end up experiencing some periods where there are chronic long positions, and others where a big offshore buyer lifts a whole tender and we need three or four weeks to restore order. I’m not sure it’s necessarily the right way to go, but no doubt time will tell.n butCHer As a board member of the Local Government Funding Agency [LGFA] I would like to mention an issue that relates to the LGFA. The agency's issuance strategy is to tender against government stock maturities, and to do so every four or five weeks just outside NZDMO tenders. As a new issuer

“As A double-A rATed borrower wITh AN eye To mArgIN coNTrAcTIoN, AddINg 10 bAsIs poINTs for swAp cosTs ANd The sAme for The Approved Issuer levy cAN blow The whole offshore IssuANce vAlue proposITIoN ouT of The wATer.”M a r k b u tC H e r a u c k L a n d c o u n c i L

prepared to go beyond 10 years in cross-currency swaps.

DAVISoN Would more costly swaps make borrowers more inclined to consider allowing rights to break?

neutZe Rights to break are raised with us by various banks. Our board is very focused on certainty and diversification, so when we are looking at long-term hedges we want to be sure we are getting what we think we are getting. That means we regard rights to break as a negative at the moment.

Hoerler It’s the same for us. We are unlikely to enter into transactions that will result in a sub-optimal hedge position. However, this issue provides an opportunity for banks to differentiate – the ones that can only offer swaps for a restricted tenor will be less favoured than the ones that can offer full hedges.

butCHer We are yet to be offered any real information

about swaps earlier in the deal process than was formerly the case?

FavIlle From what we can tell, the situation is still evolving within all the banks. But we are keen to get it into the conversation with our borrower clients, because we are not serving them properly if we do not discuss the fact that it will at some stage entail a charge. We're also interested to see how it might alter short- and long-term borrowing plans.

DAVISoN Would borrowers consider changing their debt funding plans as a result of swap issues – for instance advancing borrowing plans in order to complete

transactions before new costs fully kick in?

Hoerler Not in our case, no. There are currently enough funding alternatives available, which will create pricing tension among different funding markets.

neutZe Offshore issuance already looks too expensive as we look at our funding plans over the next 18 months – it is just not competitive with the levels we can achieve either from our banks or domestic bonds. That is also probably why the foreign currency swap situation has not yet been front of mind – offshore is not currently a realistic option anyway.

from the banks about the specific benefits of either rights to break or cash collateralisation. We’re being told that we will be charged, but not what would happen if we started to post collateral – one of the key challenges for us this year is to work on this with our banks.

beSSon Collateral agreements are useful in the sense that the lower the threshold and minimum transfer amount, the lower the CVA charges. That reduces credit risk exposure and therefore potentially enables counterparties to do more OTC derivatives business.

DAVISoN Is it important to start the conversation

“There is an ongoing trend globally to allocate to Australasia, at the same time as there are some big issuers on a downward borrowing trend. The timing is good for the lgfA to build its curve and improve its pricing with the help of international demand.”P H I l I P C o M b e S L o c a L g o v e r n m e n t f u n d i n g a g e n c y

roundtable discussion

5 6 | k a n g a n e w s s e p t e m b e r 2 0 1 2

– effectively providing volume when the market has more demand for nZgbs than fixed tenders are providing?n CoMbeS That would be difficult. In some ways the LGFA is a competitor issuer with the NZDMO but mostly we are part of the same New Zealand curve. I’m not sure we would benefit as much in the short term by flexing our issuance as we stand to

gain in the medium term from having the NZDMO issuing in the most efficient way possible.n butCHer The LGFA is a conduit for a sector. And it is very hard for the sector to take advantage of a short-term borrowing opportunity because each individual council’s borrowing requirements are based on annual capital expenditure plans.

DAVISoN How much demand would there be for subordinated paper from strong bank names?

CoPley These instruments should be attractive to retail investors on a yield basis. But, having said that, investors are becoming more cautious as to structure. A one-year reset, deeply subordinated perpetual note, for instance, would likely not be popular. A subordinated 10-year non-call five bond should see reasonable demand depending on the final terms.

MCdonald From a pure institutional perspective there has been a swing away from subordinated debt, or at least deeply subordinated debt. The more a debt instrument resembles equity, the less the desire to have it in a conventional bond portfolio.

blaCkler I agree. The more evidence there is in the documentation covering

these instruments referring to loss absorbency, the less appropriate they will be for bond funds.

Hyde-SMItH I don’t think the new, loss-absorbing, capital instruments will be appropriate for wholesale investors in New Zealand. They are clearly equity rather than fixed income, otherwise there would be no reason for banks to issue them. So they will be retail products. However, the likes of the recent AUD 10-year non-call five instruments, eligible as transitional tier two capital, would have interest here if the reserve bank could confirm eligibility.

MItCHell Most of the hybrid deals Rabobank has issued in New Zealand went to retail so that would not of itself be a concern to us. Regulators are encouraging us to issue instruments that are as close to equity as possible, but it is not a new development that there

is a struggle to work out which portfolios hybrids best fit into.

Once the market is established and the risks are understood – and priced in – I don’t think the global institutional investor base will walk away. The new hybrids will include equity-style risks that have not been there in the past, but it will be a question of risk versus return rather than a pure yes or no judgement.

MARSH Could this be an academic question in New Zealand, in the sense that we still don’t know what form regulatory-compliant capital instruments will have to take?

MaIn There is still a lot of uncertainty about what will qualify as Basel III compliant, and I am reluctant to even look at the market until there have been further developments. The clear preference from regulators is for common

iNstruMeNt diversity for banks and corporatesNew Zealand’s banks have been waiting for regulatory clarity on capital instruments and, as a result, have not issued subordinated or hybrid securities for some time. In the meantime, the investor market appears to have bifurcated – with retail now the most likely buyer of subordinated paper and wholesale investors continuing to favourhigher-rated instruments.

equity capital rather than hybrid. So for the time being I don’t anticipate any appetite to issue capital instruments.

Hyde-SMItH My feeling is that the New Zealand market will tend towards the use of core capital only, as opposed to significant volume of capital instrument issuance. In the absence of domestic bank listed equity that means retention of earnings, predominantly.

PennIngton The reality is that the New Zealand market has particular features that the regulator will have to consider if it is thinking properly about this issue – the most notable of which is the fact that we don’t have any listed bank equity. In that context, sub debt arguably gives the regulator a pricing signal on domestic banks that it currently does not have.

FAVILLe Is the regulatory environment heading in the right direction in New Zealand?

PennIngton There is a toxic brew of market and regulatory factors that are making things hard. This market needs to optimise its situation as a capital market because we are not in the fortunate position of having a global reserve currency or other ‘natural advantages’, and it seems that our regulatory direction is quite the opposite.

“from A pure INsTITuTIoNAl perspecTIve There hAs beeN A swINg AwAy from subordINATed debT, or AT leAsT deeply subordINATed debT. The more A debT INsTrumeNT resembles equITy, The less The desIre To hAve IT IN A coNveNTIoNAl boNd porTfolIo.”F e r g u S M C d o n a l d t y n d a L L i n v e s t m e n t m a n a g e m e n t

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davison speaking of the Lgfa curve, what are investors’ experiences with the new borrower?n Hyde-SMItH We are a holder of LGFA bonds but we have not yet been a seller. The flows we are experiencing mean there will be a natural need to hold those assets at a margin over government. It also makes sense for bank liquidity books to hold LGFA bonds and broadens their investable universe, given

they are less likely to hold unrated local authority CP. What’s interesting to me is that the LGFA has been able to trade significantly inside some of the supranational names. I think that is a product of swap costs, and of the fact that so far the LGFA has only issued once a month – there is an accumulation taking place. The fact that the LGFA does not have an offshore risk component is also to its advantage.

“my feelINg Is ThAT The New ZeAlANd mArkeT wIll TeNd TowArds The use of core cApITAl oNly, As opposed To sIgNIfIcANT volume of cApITAl INsTrumeNT IssuANce. IN The AbseNce of domesTIc bANk lIsTed equITy ThAT meANs reTeNTIoN of eArNINgs, predomINANTly.”v I C k y H y d e- S M I t H a m p c a p i ta L

The regulatory environment is operating as if there were still finance companies, and by acting in that pro-cyclical way all it is doing is kicking a market that is already down.

DAVISoN Do corporates have any interest in issuing hybrid instruments?

neutZe We took a close look at it about a year ago, but pricing didn’t stack up compared with our other options. A subordinated issue could give us a little more financial flexibility in the face of events, but there are far more cost-effective options available for us to manage financial risk.

DAVISoN A couple of the recent Australian corporate hybrids are being offered in New Zealand – APA Group (APA) and Crown. Is there likely to be significant interest in those?

CoPley Neither of these issuers are making a lot of effort to market to New Zealand investors, and in reality to generate significant interest I would have thought they would need to offer New Zealand dollar tranches.

I note that our clients are significant investors in APA equity and we are comfortable with the company risk, so if APA had brought a New Zealand

being willing to explore it as they seek diversification.

lanCe I think we have been reasonably clear in our belief that residential mortgage-backed securities (RMBS) issuance would be a positive step. The product suits KiwiSaver and is easy to understand, provided the structure is relatively simple. The fact is there is a dearth of product in New Zealand and anything that adds to that would be welcomed.

The CP programmes have not been very visible in the market and investors have not needed to address them. My understanding is that they are tightening as investors are starting to show more interest. Even so, I suspect a new, vanilla prime RMBS issue would price quite competitively.

MARSH Would there be demand for lower-rated RMBS tranches?

lanCe I suspect there probably would be, within reason – for the mezzanine tiers, if not the equity ones.

MACKAy How much of a premium would there have to be for different asset classes?

lanCe It’s not an issue we have actively explored. There is so little choice at the moment that it’s difficult to work out a genuine triple-A premium.

blaCkler There could be what we might call a new-sector premium. If the market was looking at a credit card-backed deal, for instance, there might be some investors who wouldn’t want to or be able to look at it. And until the wider market gets some comfort about how an asset like that performs it would likely trade wider than an RMBS on a familiarity basis.

MCdonald I think RMBS would have to be issued by an entity that has a balance sheet, to deal with concern about extension risk. A security would also have to be repo eligible as a result of liquidity issues. If those two elements were met we could be interested.

Our clients like things they know and understand, and while the mortgage market has performed OK in Australia and New Zealand, the asset class is still tarnished to some extent.

Securitisation of other assets is not well-known in New Zealand, and that means it carries a question mark. That, combined with lack of liquidity, means an inevitable pricing premium.

Cox From a ratings perspective prime RMBS has performed very well. But from a liquidity and a price perspective it has not. There are also still old deals outstanding that are taking a very long time to clear up.

dollar issue to the New Zealand market we probably would have seen some demand.

PennIngton Issuers in these dual offerings are sometimes motivated by the desire to include existing stockholders who would otherwise be shut out, and it costs very little to make an offer available on both sides of the Tasman. So if an issuer simply wants to service its existing investors it can do so even without really marketing the offer here.

SECURITISATION DEMAND

MACKAy Does investors’ desire for diversification extend to securitisation?

blaCkler I think it does. The frustration for us is that the diversification we seek is sitting on banks’ balance sheets. The banks are funding corporates, and there is very little ability for us to access that.

MaCkay There are two high-rated asset-backed commercial paper (CP) programmes in the market, which have significantly higher yields than other CP programmes.

blaCkler Spreads have come in on the RFS programme though, and I think that is the product of investors changing their view from seeing it as too complex to

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5 8 | k a n g a n e w s s e p t e m b e r 2 0 1 2

n Cox We don’t actually own any LGFA paper in our wholesale funds. For the LGFA to be considered a semi-government curve requires two things: certainty about both credit quality and liquidity. Liquidity will come with size and with dealer participation. I want to see very transparent reporting to mitigate what I see as a credit conflict caused by the fact that the LGFA’s shareholders are also its borrowers.n MCdonald We are holders of LGFA bonds, and we have undertaken some switching out of NZGBs into the LGFA as a result of the low sovereign yield environment. A number of our insurance clients are also moving towards risk-weighted assets on their balance sheets, and the LGFA falls nicely into that bucket. So I think there will be an increasing array of investors in the LGFA – though I think it will remain largely institutional for some time.n lanCe We don’t hold the bonds but we are experiencing the same regulatory factors in the insurance sector that Fergus McDonald mentions. One of the frustrations there is that the LGFA sits in the same issuer category as local banks, though it has been successful at achieving significantly tighter spreads than the banks. It would be good to have a separate category within the insurance regulations – there is a big gap between the top and second tier.n Cox The other thing to note from a relative value perspective is that the LGFA curve is in its infancy, while there is a very well-established Auckland Council curve outstanding which is at least as liquid and offers a 40 basis point pickup over the LGFA.n Hyde-SMItH The LGFA has performed very well, and while there are reasons for that performance it is also true that the other double-A rated councils have lagged. There is an argument in favour of switching out of the LGFA and in to Auckland Council or other double-A councils, should you have available limit.n blaCkler I have purchased LGFA paper and I have sold it – on a switch basis, into Auckland Council.

davison if international investor interest in the Lgfa develops, could it take the curve out of the realm of relative value for local buyers?n CoMbeS I think a similar argument applied to the NZDMO three years ago when it started marketing offshore in earnest: I don’t think that takes our curve out of the realm of domestic investors, though clearly admitting a new investor base to the market will improve pricing. From an issuer’s point of view it

is vital to create a diversified investor base, and in part that is because of the price tension it creates.

Our interest is in growing the investor base in our New Zealand dollar curve, because issuing a lot of smaller foreign currency transactions only produces a limited amount of price tension. Our goal is to get the same New Zealand dollar bonds into the hands of international investors – but it will only happen over time, perhaps in the range of one or two years.

davison would a reduced cash rate differential between new Zealand and australia attract more offshore interest to new Zealand dollar investments, including the Lgfa?n CoMbeS We are already being helped by the ongoing European sovereign debt crisis, because at the international level there is clearly switching away from Europe and into this part of the world. The fact that the Australian Commonwealth is also substantially reducing its issuance should also be beneficial – as will a reduction in NZGB issuance over the coming years.

There is an ongoing trend globally to allocate to Australasia, at the same time as there are some big issuers on a downward borrowing trend. The timing is good for the LGFA to build its curve and improve its pricing with the help of international demand.

davison how are auckland council’s offshore funding plans progressing?n butCHer Investors are keen to understand both our credit and the LGFA whenever we go offshore – which demonstrates the level of interest in the sector. Investors like our name and our credit rating and diversification appeal, so everything comes down to price. We have visited investors in Europe, Asia and Canada in the past year, and the limit of our international issuance has been some 10-year Australian dollar private placements. We were close to doing a Maple issue earlier this year, but the pricing didn’t quite work.

davison before its establishment the Lgfa was a source of some controversy in the investor market, as fund managers were concerned about the loss of diversity if individual councils did the bulk of their funding via the agency. how is the presence of the Lgfa viewed now?

“retail depositors are happy to shop around whereas I am restricted by my mandates to bank limits – in fact, my investments are more likely to stay put as I have to remain diversified, rather than shopping for rates.”I a I n C ox a n Z w e a Lt h

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n Cox We still invest mainly in individual councils directly. We have always prided ourselves on our ability to rate councils internally, so the LGFA has to some extent eaten our lunch. We have needed mandate changes to view the LGFA as a sector rather than a single issuer, and it has taken away from our diversity.n MCdonald I agree. The smaller the number of issuers the worse it is for our diversity. Corporates are not borrowing much, so it would be better if there was more diversity in the local authority sector. Having said that, the LGFA has done a good job in reducing cost for ratepayers around the country and from that perspective it has probably been good for New Zealand in general.n Hyde-SMItH We have always been strong supporters of the LGFA, even in its infancy. It has surprised me how quickly the LGFA has performed. We are at the point now where other councils – even those not in the LGFA – are benefiting from its pricing.n blaCkler It is still early days in the process of defining the LGFA as a sectoral borrower, and it is not easy to define it as an established semi-government curve. At the moment we are between a rock and a hard place to some extent – we can see where we are going but it is hard to have a conversation about where the asset sits at the moment.n lanCe We had the conversations about mandates and got ourselves comfortable with the LGFA. Then when it started issuing its spread was tighter than we had anticipated. The next stage for us is about getting comfortable with the underlying credits.n butCHer I suspect that, going forward, individual council issuance will become a dinosaur. There is no price advantage for individual councils issuing in their own names. The LGFA already represents about 65 per cent of the sector and I expect the rest, perhaps barring one or two names, to fall in behind over the next 18 months. The only reasons councils wouldn’t have signed up already is a possible unwillingness to be part of the LGFA guarantee, a different maturity profile from what the LGFA has issued so far, and the fact that there is approximately a three-month consultation process to get approval from ratepayers to participate.n Hyde-SMItH We have moved to a sectoral limit for the LGFA. But it can’t offer everything to every borrower yet, so we believe there will continue to be opportunities to lend to individual councils for the foreseeable future. There are still private placement issues emerging, even from councils that are part of the LGFA.

Cox is there potential for asset financing to be done by the Lgfa and project financing to be done through the institutional market?

n CoMbeS In the start-up phase we have focused on a very limited set of maturities. Councils can already borrow fixed or floating from the LGFA, and over time I definitely believe there will be more flexibility in the lending the agency offers. Over time, we will offer more flexibility to councils as we increase in size and manage risk more actively.

CORPORATE CREDIT

davison is the lack of corporate issuance in new Zealand solely a product of conservative corporate balance sheets?n CoPley That, and the very competitive levels at which banks will lend to corporates.n blaCkler The banks are cashed up and need to put those funds into play. Retail also needs to go further in terms of accepting lower yields – there is no way well-rated corporates will issue at 7 per cent coupons when they can do so much better from their banks.

Marsh is the competitiveness of the loan market a function of static bank balance sheets?n MaIn There is certainly reduced demand for credit.n Hoerler I think the loan market is competitive in particular for bank funding with tenors up to five years – it is currently tighter than debt capital markets pricing in New Zealand. If we wanted to issue longer-dated maturities we would look at other options, including offshore issues.n Cox It’s understandable why this dynamic exists for retail: term deposit rates at up to 5 per cent exceed the yield offered for the first five years of the curve for high-quality corporates. Corporates are trying to borrow longer because it’s the only place they will get retail demand and therefore lender diversity.n CoPley We had really good demand for the seven-year bank issues that came to market at the end of 2011 and in March 2012, when they sat at 6 per cent. They offered a reasonable premium over five-year term deposits and benefited from sectoral redemptions. It gets harder when yield falls closer to 5 per cent – a much shorter term deposit is not far off that level.

Despite this, we still see retail demand for high-quality bonds with maturities over five years. Retail investors benefit from the higher yields offered in part by the positive yield curve, and the willingness to extend duration is one of the few points of differentiation from the banks. •

“There will be a large reduction in our term funding requirement – we have had to raise a lot to meet regulatory standards but we are now comfortably above them.”t I M M a I n b a n k o f n e w Z e a L a n d