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Eurodollar Run Since 1994 Under Threat: Riskless Return

Fed Chairman Ben S. Bernanke
Eurobonds' performance turned negative after Fed Chairman Ben S. Bernanke signaled he may be poised to curb measures that pumped more than $2.5 trillion into the financial system since 2008. Photographer: Pete Marovich/Bloomberg

Eurodollar bonds produced better risk-adjusted returns than Treasuries in the past 25 years. Now they’re poised for their second-only losing year, showing how much the prospect of an end to the Federal Reserve’s asset purchases has rattled global markets.

The securities, as tracked by the Bank of America Merrill Lynch Eurodollar index, returned a risk-adjusted 125 percent in the period through July 2, beating Treasuries, U.S. corporate debt and stocks, the BLOOMBERG RISKLESS RETURN RANKING shows. This year, Eurobonds denominated in the U.S. currency and held by international investors are losing 0.9 percent after Fed Chairman Ben S. Bernanke outlined his stimulus exit strategy.

It would be the first annual decline for the bonds since Alan Greenspan roiled credit markets in 1994 by doubling benchmark lending rates. There’s a lot more at stake now, with $4.5 trillion of Eurodollar bonds outstanding compared with $163 billion 19 years ago, according to Bank of America Merrill Lynch data. The Eurodollar market, which began half a century ago with a $15 million deal for Italian highway manager Autostrade Spa, gets shelter from market swings because the notes are bought and held by long-term investors, according to Anders Svennesen at ATP, Denmark’s largest pension fund.

Long Term

“Most buyers of Eurodollar bonds have made a long-term decision about being in the asset class which makes the investor base stable,” said Svennesen, deputy chief investment officer at ATP, which oversees about $140 billion of assets. “There are faster and larger flows in U.S. treasuries as they are typically used for different purposes depending on the investor and allocations can go up or down significantly depending on the economy.”

While Eurodollars trailed U.S. corporate debt and stocks in the Standard & Poor’s 500 index by total return, the securities had the lowest volatility in the ranking over the past 25 years. They also produced the best risk-adjusted returns over the past 10, five and three years. In 2012, they produced a risk-adjusted return of 3.4 percent, beating the 2.9 percent for U.S. corporate debt, the stock market’s 1.2 percent return and the 0.6 percent gain for Treasuries.

Their performance turned negative after Bernanke signaled he may be poised to curb measures that pumped more than $2.5 trillion into the financial system since 2008.

“In 1994 the Fed was on the back foot when it raised rates to curb rising inflation,” said Chris Bowie, the London-based head of credit portfolio management at Ignis Asset Management Ltd., which oversees $104 billion. “Now arguably it’s ahead of the curve in warning the market the punch bowl of liquidity won’t be around forever. Both resulted in a selloff and in negative returns.”

Tax Exploited

Bankers underwriting Autostrade’s deal exploited 19th century tax rules allowing financial transactions originating in the U.K. between foreign counterparties to go untaxed. The new securities gave issuers and bankers access to a pile of cash called Eurodollars that were held outside of the U.S. for tax, regulatory or political reasons.

Now borrowers from Europe’s largest oil and gas producer Royal Dutch Shell Plc to Walt Disney Co., the world’s biggest entertainment company, are among issuers that have created a global market. And the notes have been a great source of profit since financiers led by Siegmund Warburg, founder of S.G. Warburg & Co., created the debentures in 1963.

Market Heyday

The Eurobond market had its heyday in the 1980s after interest rates in the U.S. peaked at 20 percent in March 1980. When they started falling, the scene for a bull market was set and issuance of Eurobonds surged with annual returns reaching an all-time high of 18.1 percent in 1985, according to Bank of America Merrill Lynch data.

Outstanding Eurobonds in dollars grew from 177 issues with a value of $49 billion at the end of 1982 to 465 issues with a face value of $107.7 billion just three years later, according to Bank of America Merrill Lynch index data, attracting U.S. firms to London.

“The high compensation for fixed income that existed in the 1980s with double-digit interest rates has normalized down to where we are now,” said Jens Vanbrabant, lead portfolio manager at London-based investment firm ECM Asset Management Ltd., with $9 billion in credit under management. “That’s been a huge driver for returns. Now we’re at the end of that cycle.”

Conspicuous Consumption

The fast-growing market and the returns generated in the 1980s allowed bond traders from London’s grittier suburbs to rub shoulders at the Savoy Hotel with luminaries such as then-Prime Minister Margaret Thatcher, and John King, who prepared British Airways Plc for sale to the public.

Young traders drove around in cars made by Porsche and Mercedes Benz, while banks hired yachts to take clients for trips at meetings of the industry association in Nice. The conspicuous consumption by the youthful bankers gave meaning to the word “Yuppie,” a new addition to the English lexicon.

Charles McVeigh, now a senior adviser to Citigroup Inc. in London, ran Salomon Brothers Inc.’s operation in the city at the time and he recalls transactions being underwritten at 1 a.m. in Annabel’s nightclub, a party place for British royalty as well as bond traders.

“People literally took a napkin out and outlined the underwriting commitment,” McVeigh said in an interview at his club near London’s Sloane Square. “We all knew each other incredibly well and trusted one another. The personalities, the friendships and the relationships that existed were incredibly important.”

Black Monday

The Eurobond market survived the Black Monday crash in October 1987, which wiped 23 percent off the Dow Jones Industrial Average index, and ended the year up 2.63 percent.

The investment-grade securities generated average annual returns, without adjustment for risk, of 7.5 percent over the past 25 years, according to Bank of America Merrill Lynch index data. That outstrips the 7.1 percent paid to holders of Treasuries and 6 percent price returns from gold, though falls behind the 8.2 percent offered by U.S. corporate debt.

Stocks in the MSCI All-Country World index handed investors 8.5 percent on average during the period although buyers of equities lost money in seven of the years, while gold produced negative returns in 11 of the years and has declined 25.5 percent in 2013, according to Bloomberg data. Holders of Treasuries lost money in three of the years and are down 2.4 percent this year, according to Bank of America Merrill Lynch index data.

Negative Returns

U.S. company debt is losing investors 3 percent this year, according to Bank of America Merrill Lynch’s U.S. Corporate index. The securities last produced negative returns in 2008 and before that in 1999 and 1994.

The market may now have reached another inflection point, with Fed officials saying that the economy may become strong enough for them to reduce measures that have buoyed bond prices. Economists surveyed by Bloomberg say the central bank could cut its monthly bond buying by $20 billion to $65 billion in September.

The average yield investors demand to hold the debt is 2.83 percent, after climbing to a 17-month high of 2.97 percent on June 25 from a record-low 2.11 percent on May 2, according to Bank of America Merrill Lynch index data.

The spread over benchmark U.S. treasuries rose seven basis points to 138 on June 24, the widest in more than nine months, and is now at 130 basis points, the data show.

“The tapering talk has been the death blow for the bull market,” said Vanbrabant. “Fixed income is likely to underperform equities going forward as rates adjust to more sustainable levels.”

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