Euroweek high yield report: story so far

Euroweek, July 2011

Third time lucky, they say; and investors are hoping the maxim holds true in Asia’s high yield markets. After two previous attempts when this nascent market has flourished then foundered, will the third time be based on more stable foundations?

“So far there have been three major attempts to implement high yield in Asia,” says Florian Schmidt, managing director, debt capital markets, Asia at ING. The first approach dates back to the 1997-8 financial crisis and was characterised by many corporate first-time issuers, typically in FRN format, with the investor base largely driven by Korean merchant banks. “The due diligence requirements at that time were rather non-standard, to say the least,” recalls Schmidt. “There were even documents saying investors were encouraged to do their own due diligence. It was no surprise that some issuers and investors went under.”

That attempt to build the market failed though a lack of corporate governance, appropriate structuring and covenant packages. On top of which, the Asian financial crisis itself clearly didn’t help, particularly for issues raised in dollars: Asia Pulp & Paper, which remains by far the largest default of its kind in the market, fell apart not so much because of structuring issues but the huge and swift devaluation of the rupiah, making it impossible to meet dollar obligations.

“The second attempt was much better,” recalls Schmidt. “We implemented a US standard with respect to due diligence and structuring, so the deals that came out from 2003 to 2007 followed that US template. Credit was looked at from a different angle, sponsorship management quality was much better analysed, and this was really the advent of high yield in Asia.” This market was derailed by the global financial crisis of 2008, “largely due to the fact that the investor base was not solid enough yet. Lots were sold by lead managers to their own proprietary desks as anchor orders, and then on leverage to hedge funds and private banks. Leverage of 80% was not unheard of,” Schmidt says. “But when the crisis hit, and margin calls were made and anything tradable needed to be sold to generate cash, Asian high yield suffered a lot.” Whereas US high yield issuers continued to print through the crisis, backed by a more solid and liquid real-money investor base, “that power from the buy-side wasn’t there in Asia.”

Post-crisis, a third attempt is in full swing: already more than $13 billion had been raised by Asian high yield issuers in 2011 by May 30, without counting big issues from technically high yield names such as Indonesian quasi-sovereign Pertmina, or the thriving offshore RMB high yield market. “If this keeps up, we might hit a new record,” says Lang Liew, on ING’s flow trading desk in Singapore. And where the first attempt failed for governance and the second for an inappropriate investor base, this third version will stand or fall on how well those failings have been addressed.

Part of the reason for the swift revival is that there were relatively few defaults in Asian high yield during the crisis. Some issues did arise – see the structuring chapter for concerns around structural subordination in China, for example – but generally the storm was weathered rather well.

This has encouraged investors to stick with the sector, characterized by a growing presence of real money asset managers and of US capital – increasingly from offices that US managers have set up in Asia.

“The whole idea of a Regulation S-only market developing in Asia, which a lot of people used to subscribe to, has proved to be wrong,” says Schmidt. “We are still seeing 40% of Asia deals sold into the US. You may not need the 144a tranche to get the order book filled, but you need it in order to optimize your order book and get the finest pricing for the client.” He says the typical allocation is 40% Asia, 40% US and 20% Europe, “sometimes even more at the expense of Europe.”

Nevertheless, Asia-based bankers continue to see the local bid as essential. “The Asian investor component of these transactions tends to be the bedrock, accounting for 40 to 60%,” says Henrik Raber, global head of debt capital markets at Standard Chartered. “You do need the local investors on board in order to have placement power.” Paul Au, in debt syndicate at UBS, adds: “You are still looking at Asian investors providing leadership in Asian high yield. European investors are becoming less active in the Asian credit space. Sometimes it depends on the sector: a coal mining company will get more US interest, and a Chinese real estate issuer will get less.”

And to a degree, the US and Asian bids are merging as US expertise sets up within Asia. “Asian high yield transactions used to be much more driven by the US,” says Rod Sykes at HSBC. “That investor base is still very important, and there are a lot of high quality buy and hold accounts there, but what has also happened is that a number of US accounts have set up a physical presence in Asia.”

Ricardo Zemella, managing director and global head of emerging market/high yield debt syndicate at ING, adds: “A few years ago you used to go to Hong Kong for an emerging market roadshow and routinely target a mere handful of dedicated HY accounts. That dedicated universe of HY investors has grown. Most Chinese high yield deals will consistently see in excess of 20 accounts in HK alone. Some are Hong Kong shops of bigger firms, some are partners that have split off from them, and some are local; but they are growing.”

By investor base, a typical split today is 75% asset managers – 50% being real money and 25% hedge funds – plus around 15% banks, and 10% private banks. Some bankers report an increasing role for private banks, some for hedge funds, and most for fund managers generally. “I don’t expect massive changes from here,” Schmidt says. “Asia’s bond market as a whole has traditionally been a bank market, all the way into the early years of the millennium, but that has changed quite dramatically and we expect the bank bid to continue to become even more marginalized.” He also expects more engagement from sovereign wealth funds – already in evidence with the launch of the asset management vehicles Fullerton and Seatown for Temasek.

Generally, the story of high yield is a story of issuers realising there are other funding options beyond easy bank credit. “The financial crisis forced a lot of companies to take a hard look at their capital structure and debt maturity profile,” says Sykes. “It has encouraged people to make sure they have a better mix of bank and bond financing, and to pay attention to matching more closely their assets and liabilities.”

This is nowhere more true than in China, where a reduction of domestic liquidity has forced borrowers to look further afield. “Chinese issuers are seeking to diversify their funding sources rather than just relying on the bank funding market,” says Terence Chia, in debt syndicate at Citi. “They’re realized that with the expansion and growth of their businesses, they do need to seek alternative sources of funding, so come to the capital markets for that.”Consequently, of the $13.095 billion in true high yield dollar issuance from Asia in the first five months of 2011 (ie, excluding sub-investment grade sovereigns and quasi-sovereigns, and also dollar-settled RMB bonds), $10.275 billion of it was from China. “I think it [the pace of Chinese issuance] will continue, given that China is such a huge market,” Chia says. “Every day there is another Chinese company that has done an IPO, and once they are listed, the next step is to think about accessing the bond markets.”

How does pricing stack up between Asian and US high yield? “You’re not talking apples and apples: it’s not easy to draw straight comparisons,” says Raber. “To begin with, there is a natural investor base in each market pre-disposed towards its own region. That tends to have a strong influence on the pricing dynamic,” since the US high yield market is obviously much deeper. “You can get BB credits raising funds at very different prices from one another.”But he says pricing in Asia has continued to drop, pointing to the recent Indika Energy deal – a seven-year non-call four single B credit pricing at 7% – as an example of progress. “Historically, single B credits were looking at double digit coupons.”

Still, the yield remains high on many Chinese deals in particular, which has contributed to a broadening of the investor base. “Investors will consider the more hairy credits, as long as the yield compensates them for the risk they’ve put in, which is why you’ve see such a range of high yield names that have come to the market,” says Chia. “If an investor has a portfolio of 50 names with 2% in each, and one collapses, in the context of high single or double digit yields they’re going to be compensated.”

One of the obvious failings of high yield in Asia is that it is so focused on a few small markets: Indonesian resources, Chinese real estate, and recently Chinese industrial borrowers. And within that, Indonesian issuance has faded lately while China’s has boomed. It’s a shift that has created some challenges for banks. “I’m sure a lot of our competitors need to think how to convert an Indonesia-savvy team to be more Greater China-savvy,” says Augusto King, co-head of Asian debt capital markets at RBS. “It’s not that easy. Putting language aside, the cultural issues are very different as well.”

Those who look closely at the trading side are beginning to see headwinds for the market, given the huge level of issuance from China. “We’ve seen deals that have done very well in terms of being organized in their order book, but have not performed,” says Lang. “China Resources Land priced at 290 for a five-year deal, with a good pedigree and ownership and a $3 billion order book. But by Monday it had widened to 308. In a sense, you can say market issuance may have run ahead of itself.”

His colleague Zemella adds: “In the last month the primary market [for dollar high yield from China] felt strong, as evidenced by the level of issuance, however in a couple of instances you did get a sense of saturation and new issue fatigue. Investors were going to five roadshows a day. Asian CDS levels and secondary market levels largely traded sidewise; possibly as a result of having to digest all this new issuance.”

But even if issuance slows, the hope is that the market is now robust enough to withstand the lows and remain a vital part of Asia’s debt markets. . “Now we’re seeing even more sophisticated credit work, largely bottom-up as it should be with high yield, more screening of management and sponsors, and a much more solid investor base,” says Schmidt. It’s a solid foundation.