Euroweek high yield report: Indonesia

Euroweek high yield report, July 2011

For many years, Indonesian energy and resource companies were the dominant part of Asia’s high yield sector. They remain a powerful group. But lately, issuance has tailed off and been comfortably trumped by Chinese real estate.

It’s true that there have been big deals from Indonesian high-yield credits, but the biggest have been from the sovereign (which raised $2.5 billion in 10-year funding at the end of April) and a quasi-sovereign (state energy group Pertamina, which brought 10- and 30-year deals of $1 billion and $500 million in the same week in May), both rated a single notch below investment grade and likely to be upgraded, rather than the pure corporate high yield issuers the market has long been associated with. If those sovereign-linked deals are removed, the total high yield issuance from Indonesia this year is just $425 million: $125 million from real estate group Lippo Karawaci in February, and $300 million from Indika Energy, the natural resources group, in April.

“The entire sector is under $3 billion,” says Simon Moore, credit analyst for non-Japan Asia at Credit Suisse, referring to outstanding Indonesian coal high yield bonds. “A large real money account outside the region could theoretically buy up the whole market if it wanted to.” There is about five times more outstanding in Chinese real estate dollar bonds alone.

This scarcity value is one reason that Indonesian bonds are trading exceptionally well. “Everyone loves Indonesian coal, and the bonds trade like it,” Moore says. “The market has priced in an enormous amount of good news. It’s fundamentally a great story, but at some point you have to ask yourself: are these bonds looking a bit rich? Bumi [Resources] is now trading at 6.5% but was in double digits not long ago.”

Herman van den Wall Bake, head of global risk syndicate for Asia at Deutsche Bank, agrees. “Indonesia has been the flavour of the last year and a half,” he says. “If you look at where the sovereign funded itself two years ago, it was at 10.75%; its last exercise was at 5.1%. It has literally halved its cost of funds, it is on the cusp of investment grade and there is tremendous liquidity onshore.”

Indeed, this onshore liquidity is a large part of the reason that issuance has slowed: bank capital is so readily available, and so cheap, that there is little obvious need to go offshore anyway. The situation of Buma Resources, explained in an issuer profile and in the issuer roundtable elsewhere in this guide, is a case in point. “Buma did a deal a year and a half ago in double digits, and just refinanced with a loan at a spread over 375 basis points over libor for seven years,” says van den Wall Bake. “These are tremendous savings relative to where funding was two years ago. So in the near term, borrowers will find that financing themselves in the loan market is more attractive.”

But there are other, structural reasons too, and one is a change to withholding tax laws. Indonesian issuers have typically set up an offshore SPV, often in the Cayman Islands, Singapore or the Netherlands, and generally in a place with a taxation treaty with Indonesia. That treaty, until 2010, usually required a 10% gross-up. The bond would be issued from the SPV and then lent inter-company into the operating company in Indonesia. Then, in 2010, Indonesia announced that for corporate issuers launching bonds in this way, they were required to get a certificate of domicile of all bond holders – clearly impossible – or gross up to 20%.

In the case of the Buma acquisition, for example, this triggered a tax call on its bonds. The situation ended well enough for investors: while Buma could theoretically have gone back and tax-called everyone at 100, it instead did so at 106 and won 97% participation in its offer.

But it complicates things enormously for issuers. “As is usual with these things, as the law comes out, banks find ways to structure around it,” says one issuer. “But the Indonesian government will see through that.” This is another reason that some borrowers prefer bank lending: straightforward and transparent from a tax perspective.

And in the meantime it creates an impediment to issuance. “It is a continuing challenge for the bond market in Indonesia: how to structure around the withholding tax gross-up,” this observer says.

Another issue is a rule by Indonesian regulator Bapepam about what it calls “material transactions”. These require issuers to get shareholder approval before they launch a deal, including pricing and a fairness opinion. “That has put a number of deals on hold,” says Matthew Sheridan, partner at Sidley & Austin.

Set against this, though, is the fact that Indonesian companies do clearly need capital. “Indonesian issuance has been predominantly related to natural resources,” says Eric Greenberg, managing director, financing group and head of leveraged finance in ex-Japan Asia at Goldman Sachs. “That trend is going to continue so long as energy and commodity prices remain high, prompting companies to expand production and to extract resources at higher prices which makes sense with the higher sales price. The need for capital expenditure and acquisitions or expansion is going to drive demand for financing.”

And the clamour from investors to get exposure to Indonesia is only going to increase as the macroeconomic situation around it continues to become more robust. A large part of this is the likely upgrade to investment grade for the sovereign at some point in the future. When Standard & Poor’s upgraded Indonesia to BB+ with a positive outlook in April, it meant that all three agencies were exactly one notch below investment grade. “Our view is that at least one [rating] agency will raise Indonesia to investment grade by the end of the year,” says Moore.

That is a big theme that will have a major impact on the way that foreign institutional capital – already extremely active in Indonesia, accounting for more than 30% of the local rupiah government bond market – behaves towards the country. But the weight of capital still might not be enough to coax new issuers if they can get what they need at home. “One thing that is critical is that Indonesia is a credit upgrade story, which has a positive impact on pricing for Indonesian corporates who want to tap high yield,” notes Paul Au, head of Asian debt syndicate at UBS. “But with the withholding tax situation, it’s a cost consideration: if there is cheaper funding onshore, why go offshore?”

While Pertmina is not everybody’s idea of high yield, the fact that it is rated BB+ and still managed to secure a book of more than $5 billion for a 30-year deal at just 6.625% demonstrates how investors feel about credit in the country. And it’s notable that this appetite remains despite the fact that there are major issues, discussed in more detail in the structuring and restructuring chapters, about what happens if an Indonesian deal runs into trouble, including issues about court impartiality and sponsor behaviour during restructurings.

In short, if Indonesian issuers want to launch more high yield deals, they’ll get the funds they need. It’s just that right now, they may have better options at home.