The man in the middle

The high yield market is an exciting — and profitable — part of any serious debt capital markets business, and any serious Asian investors’ portfolio. But the market still has a long way to go before it can match the liquidity and scale of the US market, or even its European counterpart. Florian Schmidt, head of debt capital markets Asia at ING and a veteran in the high yield market, guides us through the major issues.

  • 13 Jul 2011
Email a colleague
Request a PDF

Asia’s high yield market is growing every year, but some people still argue that it is much less mature than Europe and the US. Are there big differences between the Asian, European and US high yield markets?

Schmidt: Asia is obviously different in terms of size — it is still the smallest of the three — but there are other important differences. The composition of both the investor base and the issuer base is at an early stage compared to the rest of the world.

The concentration of issuers is the most remarkable difference. High yield bond supply in Asia largely comes from two sectors: Chinese real estate and Indonesian natural resources. In the US and Europe you have 10 or more industry sectors with established credits, yield curves, and relative value patterns.

Asia’s growth was stunted for years by the Asian financial crisis, which ultimately struck a huge blow to people’s confidence in the region. That held the market’s development back, and it is still trying to catch up.

Asian companies have, instead, traditionally relied on either loan or equity financing. That’s probably the reason why in absolute and relative terms, the bond product has much less importance than it does in Europe and even more so in the United States.

How do the loan and bond markets compare for Asian high yield borrowers, both in terms of the price and the covenant packages?

Schmidt: The pricing of Asian loans has been a mystery to me, and arguably to other observers. There has been this decade-long debate as to who is getting it right. Is it the loan bankers or is it the bond and CDS markets? Who is pricing risk right? Who is allocating risk correctly?

The way markets react to crises is important within this context. Loan markets really shut down after the 2008 crisis, which demonstrated that banks can be a lot more fickle than high yield investors. The high yield market in Asia had its off moments during and after the crisis, but it kept going in the US, where the crisis originated, because it is such a mature product over there. A mature product that relies on different types of investors, versus a product like loans that essentially still relies on banks. So who is getting it right, the lenders or the thousands of institutional investors globally? I would lean towards the thousands of institutional investors.

But from the company’s point of view, pricing arguably is all that really matters — and an Asian company can still fund more cheaply in the loan market.

That’s true in many cases, but you need to look at why companies can get cheaper funding in the loan market. For one thing, you normally don’t get the duration you can get in the bond market, because many loans start to amortise early. But the major difference is the covenant package. You have incurrence tests in the bond market and maintenance tests in the loan market — and there are additional bank covenants that the bond market does not use.

Then of course you are looking at secured versus unsecured and which part of the capital structure you are in. It is very obvious and very clear that the senior secured product needs to be priced more tightly.

So the ultimate question is which structure is going to give you most flexibility.

There are a lot of reasons to go with one over the other, but on top of the three factors mentioned, it’s important for companies to look at technical factors too. How many bankable credits do you have in Asia? How much money is chasing those borrowers? Banks need to deploy their capital, and sometimes pricing is a function of that rather than a genuine reflection of credit risk.

Let’s focus for a moment on those two key sources of supply you mentioned: China and Indonesia. A lot of investors consider buying high yield bonds from China to be equivalent to buying equity because of the structural subordination. There are some questions over whether that risk is really compensated. Do you agree with the argument that yields do not reflect that structural subordination?

Schmidt: Whether you are buying subordinated equity — the more cynical interpretation of that market — or whether you are buying senior debt, which the offering memorandums have you believe, really depends on the sponsor and their willingness and ability to meet their obligations. There have been cases where offshore investors were clearly not fairly treated, and that makes people think very carefully about where they are in the capital structure.

Let’s consider where you stand if you invest in the typical Chinese high yield deal. You have no access to the operating companies, no access to the cashflow, no access to the shares and, in reality, no access to any type of security. That means that you are in the same room as the equity stakeholder. But your interest with the sponsor may not be aligned: you want your money, but he may not want to give you your money. That is the worst case scenario, and unfortunately it has happened a few times here.

The first truly consensual, successful restructuring by a Chinese company was Titan Petrochemicals. You had a sponsor and a management who recognised mistakes made and sat down with investors to ask how the company could survive, and they made all the cash they could available to bondholders.

They sold ships, they sold equity in order to create cash for investors, and they gave bondholders more equity through the convertible feature. This is an example of an entity getting into trouble, and at least trying to make investors whole as much as possible.

You also have a lot of companies in China that are very well managed, totally in line with best corporate governance standards. A good example is China Oriental Group, which has heavy involvement from ArcelorMittal. Investors would not even ask questions about the integrity of the sponsor, and China Oriental was naturally able to generate huge order books for their bonds.

The conclusion: legally, you are deeply subordinated, almost to the point of being equity-like. But whether you hold de facto equity or debt depends on the sponsor. This is important everywhere, but especially in China, to find out where you sit in the capital structure.

But how can you really know?

Schmidt: It’s all about due diligence. You need to check the track record. Who is the main shareholder? Who are the other shareholders? Is the main owner transparent? Is the owner accessible? There are a lot of little things you can put together to figure out where you stand, although of course with a lot of first-time issuers you can never be 100% sure.

That’s perhaps why a lot of first-time issuers struggle to push deals past the finish line, and end up selling much of their deals to so-called ‘friends and family’, those investors who have a close link to the company. Is there an argument that getting friends and family to place orders for the bond will help you bring smaller accounts into the deal?

I have had that situation before, where people have said they want the sponsor to come in and commit to the issue by buying the bonds. It does give investors a feeling of security that they are in the same boat as the sponsor and their interests appear to be aligned. But then again how quickly could the sponsor possibly sell his bonds? Unless it is a really chunky stake and a small deal, that anchor investor could get out quickly.

Or look at the flip side of the coin: what if the sponsor does not sell his stake? How many investors really read the indenture to find out what percentage of the total amount of bonds issued you need to accelerate payments? Some investors may look at a sponsor holding 40% of an issue and feel safe; but other accounts would realise that he may only need 11% more and he can prevent any credit action being taken against the company in a stress or even default scenario.

Some Indonesian owners did buy their bonds in the secondary market, became their own creditors, embarked on ‘cram downs’ and restructurings, knowing that they would be virtually invincible in an Indonesian court. This is why I don’t like the idea of friends and family buying bonds. It can ruin the structural integrity of any deal.

What are the rules about selling bonds to friends and family?

Schmidt: There are no rules at all. It is a potential negative that has not really been addressed since the Asian crisis — and it has been abused. Most of the credits that rely on friends and family during the bookbuilding are not really good credits. That’s why they go to friends and family: that’s the backstop bid, and without them you might not be able to make a deal work. The really good credits have hundreds of investors, and thus don’t need friends and family support.

It is totally counter-productive. The bookrunners know they’re relying on friends and family, so they know the reputation of the sponsor or the issuer is not solid enough to get a wide placement. There may be reputational issues for the bookrunning banks when they try to sell such deals to investors outside of the inner circle, and actually expect such third-party investors to buy this as senior debt.

We have talked about the risks of buying Chinese high yield bonds. But let’s move on to that other source of supply. How big are the risks of buying international bonds from Indonesian companies?

Schmidt: Well, investors are at least buying into the cashflow generating opco. They are at truly senior level and even in some cases senior secured — so theoretically the lack of integrity of the sponsor can be overruled by the rule of law. But that is exactly the most questionable issue in Indonesia. We can say for sure that the legal system on the archipelago has not delivered in this regards.

It is unfortunately the same story as in China: foreign noteholders lose out to domestic investors. It is incredibly difficult to see your rights held up in Indonesia and that has not changed since the 1990s.

This means that investors are again forced to rely on due diligence exposing the true quality of the sponsor. But having said that, some fantastic companies have arisen in Indonesia since the financial crisis, in terms of corporate governance, transparency, investor relations work — the whole package.

Names like Indosat, Adaro and Indika Energy are world class when it comes to these disciplines, and it is the strength of such quality companies — not the legal system — that has brought foreign investors back into Indonesia.

China and Indonesia go, in a sense, in tandem. You are forced to make the integrity of sponsors your most important discipline when doing your due diligence.

Where is the next source of supply?

Schmidt: We think there will be increased issuance from the countries that are already big parts of the market. For now, that means more supply from Indonesia and China.

We have already seen more non-real estate issuers coming out of China, like soft commodities companies, coal miners, steel mills, textile companies and construction companies, to name just a few sectors. That is good news and the recent rout among Chinese high yield bonds [following allegations against Sino-Forest Corp that caused that company’s bonds to lose almost half of their value] will not last forever. Chinese industrials will be an important source of supply in the future, although their pricing may converge with that of real estate developers.

We have started to see more issuance from the Philippines as well. Is this a key source of future supply?

Schmidt: I don’t see many of these Philippine transactions as genuine high yield. High yield is, among other criteria, a product that is distributed globally, according to a true book-build price mechanism. In the Philippines, we don’t see that happening. These bonds rely on a strong onshore bid. It is not a genuine addition to the Asian high yield market, not in terms of distribution and not even in terms of structuring.

The conglomerates in the Philippines typically issue covenant-lite. We pitched one recent Philippine issuer, and they told us: ‘If you want to put a covenant package on us, don’t even bother to bid.’ That suggests it is not a true high yield transaction.

Supply from other big economies like Thailand and Malaysia is disappointing. Why have more companies from those countries not tapped the high yield market?

Schmidt: It’s the same theme everywhere. Asian governments realise the importance of small and medium enterprises (SMEs), so they encourage banks to lend to these SMEs money at very attractive rates.

This is something that it is hard to see the end of, and without India, Malaysia, Thailand and other Asian countries coming in I don’t see the high yield market growing exponentially.

It will grow for sure, because the product is needed and it is wanted. But pan-Asian growth will only kick in once this becomes a product that’s been promoted in all of these countries.
  • 13 Jul 2011

All International Bonds

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • Today
1 Citi 29,333.03 101 7.94%
2 JPMorgan 27,208.83 91 7.37%
3 Barclays 23,714.00 55 6.42%
4 Bank of America Merrill Lynch 20,332.10 65 5.50%
5 Goldman Sachs 20,005.21 49 5.42%

Bookrunners of All Syndicated Loans EMEA

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • Today
1 Mizuho 299.85 1 21.73%
1 ING 299.85 1 21.73%
1 Commerzbank Group 299.85 1 21.73%
1 BNP Paribas 299.85 1 21.73%
5 UBS 60.22 1 4.36%

Bookrunners of all EMEA ECM Issuance

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • Today
1 Goldman Sachs 1,607.28 5 23.03%
2 Credit Suisse 1,301.65 4 18.65%
3 UBS 970.80 3 13.91%
4 BNP Paribas 522.35 4 7.49%
5 SG Corporate & Investment Banking 444.17 3 6.37%