What lies beneath Asia’s high-yield iceberg


Chris Leahy
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Asia’s high-yield market has taken off, driven by unprecedented demand from investors. Public deal structures are becoming increasingly aggressive and private deals are beginning to leak into the public markets, giving cause for concern. Chris Leahy reports.

FOR YEARS, ASIA’S high-yield debt market has been a nearly market, offering early promise only to fade later in the investment cycle. Last year all that changed. According to JPMorgan, Asian high-yield issues returned 11.45% in 2006, comfortably beating 10-year US treasury bills and investment-grade corporate and emerging market bonds. New issuance from Asia excluding Japan and Australia hit a record $7.7 billion (see chart), fuelled by foreign investment flows into the region and ample local liquidity. The market’s performance was all the more impressive since it withstood some stiff challenges, including a nuclear test by North Korea, a coup in Thailand and the bankruptcy of Chinese high-yield borrower Ocean Grand.

This year is already promising even more than 2006. Credit conditions remain benign and the perceived global credit default risk, which JPMorgan calculates at just 2%, remains low. Add to that the positive outlook for economic growth in Asia and increased allocation to Asian credits among international institutional investors, and it is not surprising that bankers are bullish.

Asia ex-Japan/Australia high-yield market

New issue volume since 2001

Source: JPMorgan

"There’s too much liquidity out here," says one head of leveraged finance, "all the big guys are out here now – Pimco, Citadel, Carlyle – this market’s not going to blow up."

As Asia’s credit markets tighten, so high-yield deals are becoming demonstrably more aggressive. The market is focused heavily on credits from China and Indonesia, which accounted for more than two-thirds of all Asian high-yield issuance in 2006. Early-stage Chinese property development companies have been a favourite sector for junk bonds, raising more than $1.5 billion alone. Indonesian shipping, utilities and plantation companies have also proved popular with investors.

When Indonesian shipping group PT Arpeni Pratama tapped the high-yield market in May 2006 through Citi, it raised $160 million from some 60 investors and paid a coupon of 8.75% for seven-year money, non-callable for three years. In April this year, PT Berlian Laju Tanker, another Indonesian shipping business, raised $400 million from 225 investors and paid 7.5% for seven-year finance non-callable for five years, a mere 291 basis points over US treasuries. Joint bookrunners Deutsche Bank and JPMorgan generated demand of $4.8 billion for the deal, enabling them to double the size of the transaction.

Demand for Asian high-yield credits is now so strong that so-called covenant-lite deals are starting to be negotiated. The $350 million dual-tranche high-yield bond issue by Road King Infrastructure, a Hong Kong/China property and infrastructure group, is one of the early Asian examples of such packages. Structured as a $200 million seven-year non-call four fixed-rate note and a $150 million five-year non-call one floating-rate note, the covenant package included a restricted payments test fixed at ebitda less 2.5 times interest and was the first non-call one deal ever sold in Asia. Demand for the bonds was so strong that the non-Asian leg of the roadshow was cancelled and replaced by conference calls.

"It’s the first high yield out of Asia I know didn’t even get to London," says Tim Donahue, head of Asia Pacific leveraged finance at JPMorgan, joint book runner for the deal. "We raised $1.2 billion of demand from just Hong Kong and Singapore."

Asia’s public high-yield debt market is growing rapidly but it is the private sector that is creating the most excitement. Increasingly, banks are clubbing together with a select group of large hedge funds to provide highly structured debt-funding solutions for borrowers that normally either cannot find the finance in the public markets or else do not want to. Although by its nature it is difficult to calculate its dimensions accurately, the private high-yield debt market in Asia is already larger than its public counterpart.

"We estimate there had been $10 billion of private issuance by the end of 2006," says Mark Leahy, head of Asian debt syndicate at Deutsche Bank, "and a further $10 billion on top of that this year, either closed or in the market now."

Growth phase demand

There are several complementary factors behind the growth in Asia’s market for privately financed debt. Demand for investment capital among Asian companies has grown significantly over the past few years as the region’s economies have moved from restructuring and the recycling of capital into a genuine growth phase, spawning large numbers of emerging companies seeking growth capital. Traditional sources of funding for such companies are no longer available.

"In the old days, they’d be financed by private equity and, perhaps, some friendly local bank finance," says Leahy. "Private equity is getting crowded out by more flexible, cost-effective financing and now that local bank managers have a higher standard of corporate governance and credit approvals are more centralized, pure relationship lending is becoming a thing of the past."

"On the private side, everything is negotiated, so you can have more aggressive structures, lighter, customized covenant packages and no disclosure"
Tim Donahue, JPMorgan
Tim Donahue, JPMorgan
He offers a specific example of the type of transaction that lends itself to private financing. "Let’s say a client has a mining concession due to commence production in 2009 as long as he can raise the money required to make the facility operational. He isn’t a banker and may have no sense of the right capital structure and has probably gone no further than determining immediate capex needs. That kind of deal is way too early to be put into the public markets, but post capex, with two years’ financials, it may be ready for a takeout."

Other companies are opting for the private markets for other reasons, as JP Morgan’s Donahue explains. "On the private side, everything is negotiated," he says, "so you can have more aggressive structures, lighter, customized covenant packages and no disclosure."

Investors in private high-yield debt also like the lack of public disclosure, say bankers familiar with private debt transactions, particularly since the instruments are unlisted.

"Because these deals aren’t public, they don’t trade," says the debt syndicate head of a UK bank, "so there’s no mark to market. Hedge funds like that."

Private debt financings are becoming so popular with institutional investors in Asia that the ranks of potential buyers have swollen in the past few months alone.

"Privates used to be bought by a handful of investors," says Leahy of Deutsche Bank, "now you have mainstream institutional money and banks involved."

Pushing the envelope

According to Tim Donahue of JPMorgan, Asia’s investors in the private debt market are following the European model rather than the US one.

"In Europe, the investor base is all hedge and prop books," he says. "It’s the same in Asia. They all use leverage and can get their returns that way, so they don’t need call protection so much. That makes things much more flexible: people are willing to price things far more creatively."

One example of such creative pricing is the increasing use of PIK (payment in kind) structures. These fall into two broad categories: PIK toggles, often employed in highly leveraged sponsor-driven buyouts that allow a company to withhold interest payments for a specified period in return for additional yield, and PIK-only structures, which provide a rolled-up bullet payment, often with a short non-call period, that are designed to be refinanced within a specified time period.

"PIK-only deals are nothing more than a bridge to an event," says a syndicate head.

Hedge and prop funds like PIK structures, say bankers, because they can arbitrage the credit risk, by investing in one layer of an issuer’s debt and selling the rest."These investors want carry, so they’ll often buy the PIK senior notes and short the subordinated and bank debt," says a leverage finance banker at a major global firm. "It’s fascinating and frightening at the same time."

Although Asia’s high-yield debt markets have not yet witnessed PIK structures, they are on their way, say bankers, with several deals employing PIK structures believed to be under discussion.

From private to public

As demand in Asia grows for structured high-yield product, the distinctions between the private and public high-yield markets are beginning to blur. One recent deal in particular highlights this trend. In April, JPMorgan and ING launched a $250 million high-yield bond for PT Indika Inti Energi, an Indonesian energy group, the key asset of which is a 46% interest in the Kideco coal mine. With a non-controlled asset as the main source of revenues to service the bond, investors were unable to enjoy a traditional cash waterfall structure, since Indika has no control over cashflow from the mine, instead relying on dividends streamed up from the holding company.

The deal required some intricate structuring, including a detailed security package that incorporated a pre-funded interest reserve and segregated interest accumulation and proceeds accounts as well as a minimum dividend payout threshold. The bonds, rated B2/B by Moody’s and Fitch, were issued with a five-year life, non-callable and priced at a coupon of 8.5%, or 391 basis points over US treasuries.

Mark Leahy, Deutsche Bank"Private equity is getting crowded out by more flexible, cost-effective financing and now that local bank managers have a higher standard of corporate governance and credit approvals are more centralized, pure relationship lending is becoming a thing of the past"
Mark Leahy, Deutsche Bank
Although the deal was complicated, the market’s reaction was little short of ecstatic. In just three days, the bonds generated demand of more than $3.8 billion.

Despite its success, some bankers question whether Indika should have been issued into the public markets and point to a worrying trend towards increasingly risky credits.

"Indika got sucked into the public markets right after BLT [Berlian Laju Tanker]," says the syndicate head at one of JPMorgan’s competitors. "Two years ago, that deal would have been private and priced at 600 to 700 basis points premium. It’s still really a private deal and should have been structured as such. Private deals are better understood, better priced and more relevant to clients."

Florian Schmidt, managing director and head of debt capital markets at ING, the joint book runner on Indika, disagrees. "Bondholders are very clear what the money from the issue is being used for and what the effect will be on the company’s ebitda," he says. "This isn’t subordinated, it’s very much senior debt. Investors obtain protection against structural subordination through the existing shareholder agreement, a strong covenant package for restricted subsidiaries and a second ratio test at Kideco level. Structuring was key to the success of this deal in the public space."

Schmidt points instead at some of the recent China high-yield plays as inherently more risky because of laxer structuring issues.

"Some of the China credits look strong based on disclosure but the structures are untested. These bonds are in fact deeply subordinated – there are no guarantees, no share pledges at the operating level. If it goes wrong, how do you enforce in China?"

The debt syndicate head at a UK bank warns of problems ahead regardless of jurisdiction.

"People aren’t being prudent at the moment," he says. "A lot of clients are getting their faces ripped off: there are some egregious deals out there. You’ll probably see four or five of these deals go down. The party will stop soon and that’s when the lawsuits will start. Hedge funds may be going in with their eyes open now, but when it goes wrong, they’ll go after the banks."

Perhaps, but while global credit markets remain so benign, it is Asia that appears to hold the most relative value, even if the risks are increasingly high.

"Asia is still cheap against other markets, but is it cheap for the risk you’re taking?" asks a head of leveraged finance at a US bulge-bracket bank. "I’m not sure."

Asia’s high-yield market is here for the long term but if aggressively structured private deals cross over into the public debt markets and banks start to peddle more lax high-yield bond structures, some high-profile casualties seem increasingly likely.