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High Yield Bonds In Asia

(Source: CFO Asia)

Local Bond Boost
Regulators in Korea and Malaysia are lending a hand to domestic bond markets.

Long written off for being inefficient and elitist, local bond markets in Korea and Malaysia are suddenly attracting fresh interest from CFOs of small- to medium-sized companies. The reason? A kinder, gentler attitude from regulators.

The Financial Supervisory Commission (FSC) of South Korea, for example, has come up with a way to get smaller companies into the local bond market. It has introduced collateralized bond obligations (CBOs) - investment grade won-denominated bonds backed by a pool of bonds issued by lower-ranked companies. It is even mobilizing insurance companies and other fund managers to buy them. Korean CFOs expect the move to break the chaebol-linked companies' stranglehold on the domestic market. In the first CBO issue in August, investment banks led by LG Investment sold 1.55 trillion won (US$1.4 billion) worth of CBOs, backed by new bond issues of 60 companies from different sectors.

Because pooling different assets reduces the risk of default, the CBOs were rated investment-grade and demanded a spread of just 30 basis points above comparable issues. The FSC says the debut issue was fully subscribed, and that more issues are in the pipeline. Analysts, however, are not fully convinced that the new bonds will take off. "At this point, the implication is positive, [that is] having a method to help these companies. But the more important thing is sentiment. It's still premature to say we (feel) that these companies are safe. So we have to wait and see," says Wonjong Koh, strategist at SG Securities in Seoul.

Meanwhile, the Securities Commission of Malaysia (SC) has also allowed companies that do not receive investment-grade ratings to issue bonds in ringgit. The SC was aiming to help large companies to refinance dollar-denominated debt. But Yeah Kim Leng, chief economist at Rating Agency Malaysia (RAM), the leading credit rating firm in the country, says the opportunity extends to smaller, less indebted companies as well. "We're gradually seeing more local investors moving down their credit risk profiles. The current low interest-rate environment is motivating their search for higher yield. And if they are comfortable with the start-ups or high-risk companies, then it can turn out to be a good investment," Yeah says. Since its establishment in November 1990, RAM has assigned investment-grade ratings to only about 100 private-sector firms.

To further attract investor attention, both the Korean and Malaysian governments are working on providing partial or full guarantees for the bonds.

High Time for High-Yield?

If a brick were laid for every word a banker said on the bright future of junk bonds in post-crisis Asia, there would probably be enough to complete the construction of all the abandoned buildings in Thailand. But truth is, this year, only two Asian companies have ventured into the US-dollar junk bond market - Singapore technology firm Flextronics and APP China, the Chinese subsidiary of Asia Pulp & Paper. In fact, new junk issues worldwide dropped to just US$6.1 billion in the second quarter of the year from US$17 billion in the first quarter, according to Thomson Financial Securities Data. Thomson also predicts the figure to fall to under US$5 billion in the third quarter, the lowest since 1995.

One reason, says InŽs NoŽ, head of debt origination at UBS Warburg in Hong Kong, is that many Asian companies are avoiding exposure to foreign currencies, unless they are fully or even partially hedged. The lack of liquidity in local currency swap markets - one of the most commonly used hedging tools - has made issuing US dollar high-yield instruments difficult. The local bond markets have, in some cases, bridged the gap, she says.

Yet investment bankers say the argument for junk bonds is now more valid than ever. With Asian economies recovering, they say, companies are in a good position to regain or expand market share, aided by funding activities. Telecom companies top this list, says NoŽ. Indeed, banks are so confident of their position that many are building up their high-yield teams.

But why junk bonds? Because aside from the difficulty for high-risk firms to get a good price for an equity issue at current market sentiment, raising equity has a far greater cost than issuing bonds. Jeff Brown, executive director of debt capital markets at Goldman Sachs in Hong Kong, argued in a recent paper that to attract investors, any company selling shares has to have a high cost of equity - the rate of return investors expect from a company. A standard way of computing cost of equity is by adding a risk-free rate, such as US Treasuries, to the product of equity risk premium and a company's beta - the extent to which its stock moves relative to the macro economy.

Debt Doubts

Given any sign that expected returns would not be met - say, a profit warning - investors punish the company by dumping its shares, therefore reducing its value. This could eventually make the company vulnerable to a takeover, or worse. A lot of CFOs working for dot.coms witnessed this after the Nasdaq shakeout last spring. Also, a higher equity component in a company's capital structure increases its cost of capital - a value that is inversely proportional to share price valuation. "Clearly, having very little debt, for a company that could reasonably service debt, is bad for the stock price," says Brown.

Funding through bank loans, meanwhile, could subject companies to maintenance covenants, which typically demand that the company reduce the ratio of its total debt to EBITDA (earnings before interest, taxes, depreciation and amortization), say from 4 to 1 to 2.5 to 1 in three years. "Unless the company can grow its EBITDA very successfully, initial compliance will turn into a covenant default with the passage of time. Even worse, the 'total debt' concept in the numerator [hinders] the use of subordinated debt to [repay] a portion of the bank debt," says Brown, adding that during the crisis, banks also showed a propensity of walking away from loan commitments already signed.

A promising company would therefore best meet its funding requirement through bonds because the cost of debt is cheaper than equity - and because interest payments, in most cases, are tax-deductible. And while more expensive than bank loans, high-yield bonds do not make the issuer beholden to any maintenance covenant that could hinder financial planning and make life difficult for the CFO. Importantly, the junk bond market will accommodate long-term funding, something to which commercial banks are still averse. Also, issuers have the flexibility to redeem the bonds through call options. "If local markets provided long-term debt in large size, Asian CFOs might never look further afield, but at this point, the global market for US-dollar-denominated high-yield debt is unique in its ability to place big-sized deals at long maturities," says Brown.