Euroweek debt capital markets, November 10 2011

Euroweek debt capital markets, November 10 2011

KOFC

The week’s most significant deal from Asia was a $750 million 10-year bond issue from new Korean policy bank Korea Finance Corporation (KoFC), which proved that windows for issuance do still exist provided they are exploited swiftly.

Unusually among the recent run of benchmark dollar issues in Asia, this bond was supported chiefly by the USA, which accounted for 51% of the deal, compared to 36% for Asia (which had been the anchor to most of the recent benchmark deals) and 13% to Europe. The deal priced in the middle of the New York trading day on Tuesday, by which time a strong book worth $2.4 billion had been put together. It priced at 265 basis points over 10-year Treasuries, the tight tend of 265-275bp guidance. They pay a 4.625% coupon and were re-offered at 99.699 to yield 4.663%.

There were a host of challenges for this deal, most obviously the volatile market conditions and changing mood around Europe. “Investor sentiment was boosted by the resignation of Berlusconi, but there was still a lot of uncertainty in the market,” Bong Sik Choi at KoFC told Euroweek. “We did not care too much about pricing. We listened to our lead managers and took their advice.”

The lead managers were telling them that the deal’s success would be all about timing. “The key is to identify market windows, because the market is extraordinarily unpredictable,” says someone close to the deal. “Two weeks ago, the market was buying into the big European plan, allowing some big deals. Well, that market rally lasted 36 hours. The market is in such an unpredictable state that when you do see signs of stability overnight, and do not expect as much volatility through your execution day, you have to proceed quickly.” The deal priced as vital budgetary negotiations were taking place in the Italian parliament, which could potentially have damaged the deal but did not. “With hindsight, it was the only day of the week KoFC could have done a dollar deal. The next day turned out to be appalling.”

Pricing also raised an interesting discussion, firstly because most Korean financial issuers populate the five-year space – an obvious comparable in 10-years was an outstanding bond from Kexim, which was trading at around 240bp over at the time of pricing – and partly because of an inversion in the treasury spread curve, making 10-year funding cost-effective. There was little rival backchat about pricing; the deal tightened modestly after launch before widening with the rest of the market. “We are very satisfied with how the bond is performing in the secondary market,” said Bong. US appetite was key to the final pricing, in contrast to KoFC’s previous deal, a five-year dollar raising earlier this year, which had attracted very little US demand.

Another issue was name recognition. KoFC is not exactly new – it was established in October 2009 to take over the policy banking role of the Korea Development Bank – and is not a first-time borrower, but for investors in the US in particular there was a need to remind investors just how it fits in among the host of Korean financial sector borrowers. KoFC had met investors on a roadshow earlier in the year, which helped. “We mandated the deal in May, but we had a large amount of liquidity so we let other state-owned banks go first,” said Bong. “Commercial banks find it more difficult to tap the market.” But a lead manager adds: “The market doesn’t know KoFC that well. Among the wider public, a lot of them didn’t know the initial deal. It wasn’t like a new name, but there was a need for a fairly intensive marketing exercise. Investors got the message.” KoFC is strongly supported by the Korean government and is the major shareholder in KDB Financial Group, whose holdings include KDB itself and Daewoo Securities.

Bong said the 10-year funding was an important step. “This is our second bond issue and it was important for us to create a yield curve,” he said. “We could sell even longer-dated deals in future, but the average tenor of our assets is between three and five years, so this is already a good maturity for us.”

Bank of America Merrill Lynch, Credit Suisse, HSBC, Royal Bank of Scotland and Daewoo Securities were joint bookrunners and lead managers on the A1/A/A+ rated deal (Moody’s, S&P, Fitch).

It remains to be seen if there is scope for more new issues in these increasingly volatile conditions. ICBC was on the road in Europe in the early part of this week, having visited Hong Kong and Singapore last week, ahead of a planned Regulation S dollar deal; at the time of writing there was no sign of it coming, and it appeared the Chinese bank was not attracted by the pricing guidance being quoted to it by its lead managers.

The mood changes from day to day. “I was doing the rounds with borrowers yesterday morning telling them markets are fantastic,” says one DCM banker. “I’ve changed my mind now.” On one hand Italy’s problems represent an extremely serious problem, potentially far worse than Greece. “It’s a very real threat that every borrower has to acknowledge and there’s not much we can do about it,” says one banker. But on the other hand, bankers say that many funds investing in Asia – particularly hedge funds – have very large cash positions, having set money aside in fear of redemptions that have not, so far, happened. “The appetite for those investors to commit to new issues is strong: stronger than it was pre-summer,” says one banker. “So there are opposing forces at work. Where does that leave you? In a state where you avoid the days when the markets are focused only on Europe. When that volatility diminishes, new issues from the right names, with the right groundwork, the right maturity and the right pricing, are going to be very successful. New issues are the only game in town.”

Another banker urged issuers to be realistic about funding costs, in an apparent reference to ICBC. “Borrowers don’t necessarily understand just how dark a cloud there is over the market,” he said. “In 2007 the market shut down for five or six months and it was very difficult to raise money. We’re in much better condition than then, but even so, I don’t think I would want to be a CFO who turned down a billion dollars of funding over five basis points.”

LAFARGE

A RMB1.5 billion dim sum bond from Sino-French joint venture Lafarge Shui On Cement on Wednesday evening proved there is still life in offshore RMB – if the issuer is prepared to pay up.

The three-year deal came with a coupon of 9%, a far cry from the exceptionally low yields that were commonplace a year ago. LSOC itself is unrated, but its guarantor, and the 55% majority holder in the joint venture, is France’s Lafarge, which is rated Ba1/BB+ (Shui On Construction & Materials, or SOCAM, holds 45%). Indeed, those close to the deal claimed that 9% was an impressively low number in this environment: the most obvious comparable, Shan Shui Cement, which is rated BB-, was trading at a bid of 10.42% at the time the Lafarge deal priced, having been priced at 6.5% back in June. “If Shan Shui wanted to come to markets today, it probably wouldn’t have access,” argued one banker. “Or if it did, it would be paying well into the double digits.”

At this price, investors were keen; books totalled more than RMB5 billion from more than 100 accounts. The French connection accounted for a relatively high European distribution of 12%, alongside 16% into Singapore, with the rest (72%) sold in Hong Kong. Private banks were the largest constituent, accounting for 56% of the deal, followed by funds at 35%.

“It’s been an unbelievable 12 months for this market, going from practically no bonds available in the market – with investors chasing every deal coming out regardless of its credit rating and structure – to a very different environment today,” reflected someone close to the deal. “CNH appreciation has hit a few speed bumps; the idea that it will always strengthen and so make up for any credit quality concerns, folks have realised that’s not a robust approach.” While recent issues for CNPC and ICBC (in subordinated debt) have shown that the right mainland names can still attract a loyal following, this deal was testing appetite for something different: a high yield issue from a joint venture with a guarantee from a western corporate parent. Indeed, it can be argued the deal established a new asset class in CNH.

Citigroup, HSBC, Mitsubishi UFJ Securities and Standard Chartered were joint bookrunners on the deal. The issuer is the largest cement producer in southwest China with 2010 production capacity of around 30.5 million tonnes of cement from 20 plants, and three million cubic metres of concrete from six mixing plants. It had HK$7.9 billion of revenues in 2010, with a 4.6 times net debt/EBITDA ratio.

Banks report full pipelines ready to come to market in CNH, but say that these pipelines have become so widely known in the market that they are affecting investor expectations. “The markets are aware there is a decent amount of supply coming,” says one banker. “A number of Chinese names have gotten approval to issue here and the markets know there is a fair amount coming through. That awareness of the pipeline is driving the market down: investors are aware they have a lot of choices.” This has been reflected in higher levels of secondary market activity than used to be the case, as some investors have sold bonds in order to make room for new deals. “It’s more of a buyer’s market,” says one banker.

RMB COVENANTS

As reported in Euroweek this week, investors in offshore RMB bonds are increasingly demanding tight covenant packages before buying new issues – in stark contrast to the situation a year ago.

Bankers almost universally see a change in investor expectation here. The initial supply-demand imbalance in the market meant that, then, the norm was “an inefficient market, with longer tenor, looser covenants, and rates below which one could borrow in onshore RMB,” says one banker. “In the last few months, the market inefficiencies have narrowed as there has been pushback from investors and the forward curve for RMB appreciation has come down. There is stronger price and covenant discipline among institutional buyers in particular.”

He adds: “Covenants always move in cycles related to the strength of the market.”

But what exactly do these covenant packages entail? Lawyers tell Euroweek that a high yield covenant package on an offshore RMB bond today typically include restricted payment, debt incurrence, negative pledge, asset sales, transactions with affiliates and change of control. As investor sentiment has become more picky towards these deals, investors are sometimes calling for still more in covenant packages, including restrictions on M&A, dividend payments, and issuance of capital stock by restricted subsidiaries.

As the market has evolved, so too the nature of specific covenants have changed. Asia Aluminum, for example, was a relatively early issuer, and had a covenant saying that it was only allowed to incur working capital debt onshore. Lawyers considered that impractical for most operating companies, so later deals, such as from Fosun International, focused on the ratio of offshore liquid assets to offshore debt, rather than the overall quantum of debt. Another feature of market evolution has been that some issuers require far more covenants than others. The strongest domestic issuers, such as CNPC, have been able to get issues away as recently as last month with relatively light covenant packages compared to more high yield names such as Lafarge Shui On Cement.

One thing covenant packages can’t do a whole lot about is an intrinsic challenge with offshore debt securities: upstream guarantees. “In some high yield issues from PRC issuers, investors want the issuer to provide security over assets in China,” notes one lawyer in Hong Kong. “Unfortunately, under Chinese foreign exchange regulation, that is not possible. To the extent that investors need security – and very often we see deals are not secured – they will have to settle for offshore security.” Offshore security just means security over the assets of the offshore holding companies, which rarely equates to hard assets.

This problem is not distinct to RMB issues: it applies equally to dollar issues from mainland issuers. “But with RMB bond issuance there is an extra layer of regulatory issues separate from the security issues, and the biggest of them is the repatriation of proceeds,” says a lawyer.

Even if covenant packages do attempt to address this, they may not have a lot of success in practice. “It’s all very well for cash to be generated onshore by an operating company, but if there is a big cash trap in China whereby you can’t get the cash out, that’s not going to help foreign creditors who are typically holding debts incurred by the offshore holding companies,” says a lawyer.