Turbulence ahead

Asian bond markets have been on an uninterrupted growth path since the financial crisis, but the economic slowdown across the region threatens demand for financing just as increased global market volatility begins to bite.

Asia’s offshore debt markets have shrugged off two major financial crises to grow relentlessly over the past two decades. Nevertheless, many caution that the region’s primary markets are vulnerable in the face of a normalisation of US interest rate and the eurozone crisis.

Total G3 bond issuance from Asia (ex-Australia and Japan) broke records yet again in the first half of 2015, with a US$115.6bn print for a 4.8% increase over the same period last year. Since the global financial crisis, this has become a feature and consistent annual growth in volume has been registered over the past seven years – notwithstanding global market volatility.

The backdrop has been auspicious. The late 1990s Asian financial crisis starkly demonstrated to the region’s borrowers the dangers of the “double mismatch” of short tenors and foreign currencies, which was seen as the cause of the problem.

Short-tenor borrowing in dollars was replaced as the modus operandi when collapsed Asian currencies produced a round of defaults in offshore debt originated in the region. A reliance on local markets and at the longest achievable tenors became the discipline, and the following decade marked a period when balance sheets were repaired and cash positions built up.

Asia’s domestic bond markets became an ever more significant source of funding and, despite fears of destabilising hot money inflows and outflows putting pressure on onshore rates (something India experienced a few years ago), local Asian bond markets flourished. Their main contribution in the long run is likely to be in the field of infrastructure finance, with Malaysia’s having one of the world’s most developed project bond markets and India’s attempting to follow suit.

Perhaps ironically, local market dynamism and healthier balance sheets placed Asia in prime position relative to other global emerging debt markets and Asian issuers gradually returned to the G3 markets after the rout of the late 1990s. Tight covenants and structures became the norm and the global investor base for Asian credit grew deeper as US and European investors became ever more willing to put in the necessary credit work on unfamiliar names.

“The reality is that there has simply been much less demand for financing, something clearly illustrated by the decline in loan volumes. With a backdrop of volatility, the risk-on mindset is not there.”

Real money US and European investors began an onslaught of opening Asian offices. Meanwhile, the local bid for offshore credit grew via increased liquidity at life insurers and pension funds, as well as a frenetic pace of growth in assets under management at private banks. At the same time, ultra low interest rates in the G3 currencies has produced a quest for yield that has enabled Asian issuers to front-load financing and retire outstanding debt early in possibly the rosiest conditions ever seen for hard currency debt financing.

The impact has been manifold. High-yield Asian paper, which was an exotic and erratic asset class as recently as 10 years ago, became established as the signal product of Asian primary issuance.

China has become the most fertile source of Asian high-yield debt since the global financial crisis, although a question mark hangs over the raft of property issuance that has emerged from Chinese firms over the past seven years. A domestic property bubble, slowing China GDP growth and a default earlier this year from Kaisa Properties have all contributed to a sharp decline in sentiment towards China property issuance.

Herman Van Den Wall Bake, head of Asia Pacific DCM at Deutsche Bank in Singapore, believes international investors have become more defensive towards Asian credit – even though they are buying record amounts of G3 bonds.

Emerging investors

“Total volume for the first half of 2015 was up marginally on the same period last year, but there were some notable declines, including a 16% fall in high-yield issuance from Asia, a near 50% drop in Korean issuance, a similar drop in quasi-sovereign issuance and around 10% less in sovereign issuance,” said Van Den Wall Bake. “FIG stepped in to fill the gap, but the basic take would be that a more defensive mindset took hold in the context of weakening economic activity, particularly in China, India and Indonesia.”

Issuance in G3 currency from the PRC has surged this year as Chinese issuers rush to catch prevailing low interest rates prior to what is expected to be rate normalisation from the Fed as early as September. Dollar issuance from Chinese entities surged 36% year on year in the first half, while euro issuance jumped a staggering 600%, albeit from a low base.

“The euro has been something of an oasis as far as Asia DCM is concerned this year, although, with Greece looking likely to exit the currency and the consequent strains this seems likely to inflict on the euro, it looks like the run of issuance is likely to peter out,” said a Singapore-based asset manager.

Despite eurozone tensions, the euro has proved a popular alternative to dollars among Asian issuers, given post-swap savings the currency offers, enabling price savings of as much as 10bp for quality issuers at tenors of five and seven years.

Also heartening for Asia-based DCM bankers looking to retain wallet in these increasingly challenging times has been the emergence of the Formosa bond market in Taiwan.

Issuance in offshore currencies booked in the Taiwan domestic bond market has surged since a ruling last year by the Taiwan financial authorities allowing local bonds from offshore issuers to be held in domestic quotas. The huge pile of liquidity sitting onshore with Taiwan’s life insurers has found its way to Formosa bonds since the ruling was made. The liquidity has, traditionally, been invested in offshore products, but, over the past few years, it has hit the 45% ceiling allowed for offshore investments.

Key issuers have included European banks and corporations, such as Deutsche Bank. Arbitrage savings have driven issuance, as well as a hunger from Taiwanese life insurance companies looking to beat their 4% yield hurdle rate. However, bankers talk of an impasse whereby the targets of issuers are increasingly meeting resistance from the Taiwanese investor base.

Still, with the Formosa bond market’s ability to deliver long tenors and investors’ willingness to book size and callable paper, the market is reckoned to have staying power as an alternative to the traditional 144A or Reg S arena in offshore Asian debt.

Bankers guessing the fate of fee income from Asia’s offshore primary bond markets may, perhaps, take a cue from the region’s syndicated loan markets where volume in the first half was down 15% year on year to US$214bn. Slowing regional economies have been blamed for the shortfall although, ironically, the march of disintermediation is also seen as a major factor that has stymied loan growth.

“The reality is that there has simply been much less demand for financing, something clearly illustrated by the decline in loan volumes. With a backdrop of volatility, the risk-on mindset is not there. Looking forward, you have European volatility and mixed US data, which suggest Fed normalisation is not necessarily a given. A stronger dollar is partially doing the job of tightening anyway. Should it become clear that the Fed is on hold, sentiment could return and demand for risk reappear,” said Van Den Wall Bake.

Bank capital

However, should balance sheets deteriorate in Asia on the back of further economic sluggishness or debt service become a challenge in the face of weakening local currencies, then the high-yield product will continue to become something of an ask. Also, chief among the casualties will be the China low-grade printing press, and issuance from Indonesia and Malaysia, where the rupiah and ringgit have come under major pressure. China’s equity markets have experienced a brutal 30% correction from their mid-June peak on fears of slowing growth.

Still, there are some bright spots. As the Basel III compliance process continues in Asia, bank capital issuance will keep DCM staffers busy. The region’s hefty infrastructure needs will also prompt bond issuance and it may be that the call will finally be heeded for project bonds to step forward as an alternative to conventional project financing.

Loss-absorbing bank capital has arguably been the biggest innovation in the big ticket Asian offshore debt markets over the past few years and, after some initial wobbles on the structure that appeals most to investors, the market looks set to become a staple source of paper.

The bank capital need across Asia is vast, with China alone estimated to require US$17bn to comply with Basel III. A fascinating development was the recent issuance in the Malaysian ringgit of Basel III-compliant paper that had a loss-absorption feature staggered between Tier 1 and Tier 2 debt holders.

Once again, as it did around three years ago, the ringgit market has proved tempting for foreign issuers, where the basis allows considerable cost savings versus funding in US dollars. In Krung Thai’s case, it shaved 50bp off its implied US dollar Tier 2 curve.

“Asian debt markets have proved attractive where an arbitrage opportunity exists. We have seen it in the Formosa market and again in ringgit. The only caveat is that often the market is too illiquid to absorb large swap volume and a big ticket can cause price spikes,” said a Hong Kong syndicate head.

Another juicy prospect is the establishment of a viable project bond market in India. Earlier this month, the Asia Development Bank’s local joint venture stepped in to provide a partial credit enhancement to a rupee-denominated deal from ReNew Power Ventures. Although small at just US$61m-equivalent and just 35% guaranteed, the deal may offer a blueprint for project bond issuance from India.

The Indian Government has called for US$1trn of infrastructure spending over the next five years, with the Indian Planning Commission estimating the country needs 180 new airports in the next decade. In this context, a project bond bonanza looks likely barring accidents.

Interestingly in all this, it is easy to forget the private-placement market as a valuable source of fee income for the region’s banks. Prior to the global financial crisis, the private market was thriving, but was effectively killed off by investors’ fears of structures and the shadow of sub-prime. Structures are now simpler, but bankers report some recent activity in placing paper directly to private-equity investors in the form of warrants with mandatory conversion. Fees can be as high as 3% for arranging these deals.