Interest grows for Asia bonds
Twenty years on, Asian debt markets remain resilient amid growth challenges
It might be disingenuous to say that Asia invented the “financial crisis” but the events of almost 20 years ago which roiled the region were in many senses the precursor to what happened in global markets a decade later.
In Asia’s case it was artificially pegged regional currencies that supposedly caused regional equity and bond markets to precipitously crumble in 1997 in a classic example of the financial chain reaction, while the global financial crisis was purportedly caused by over-zealous lending in the US sub-prime mortgage sector.
But that is to look only at one element of the causality. In Asia’s case, although the collapse of the Thai baht was the apparent trigger over two terrifying days in May 1997, the underlying reason was the region’s long running addiction to short-term offshore debt, principally denominated in US dollars. Academics and pundits now agree that the mismatch of tenor and currency was the underlying cause of the Asian financial crisis.
Asia has come a long way since the days of that “double mismatch” and a crucial dynamic to have emerged from the tumult of the regional financial crisis has been the steady development of Asian domestic bond markets as regional financial authorities and central banks sought to nullify the inherent risks of that mismatch.
“Prior to 1998, the Asian bond market was predominantly a disguised syndicated loan market, dominated more by FRN (floating rate notes) issues than fixed rate bonds. This was because, at that time, debt funding needs in Asia were more than adequately met by cash-flushed Asian banks. When the Asian crisis hit, the handful of Asian banks who collectively funded Asia’s growth were badly hit and the rush to pull back lines exacerbated the Asian debt crisis,” says Clifford Lee, head of debt capital markets at DBS in Singapore.
“After the 1998 Asian financial crisis, Asian bank funding almost totally withdrew and the advent of a new debt funding source in Asia surfaced – hedge funds. The private financing by these hedge funds in very many ways replaced bank financing, and the relevance of the more authentic dollar fixed rate bond market began to gradually grow. Then the 2008/2009 global financial crisis came about to blow the hedge funds out of the water and accentuated the need for borrowers to diversify their debt funding source away from banks, all the more as committed bank financing avenues start to renege,” adds Lee.
At the same time, Asia’s domestic bond markets grew exponentially in size and depth. The emergence of a ratings culture, the burgeoning depth of the institutional bid for local credit thanks to booming local life insurance and pension funds and a consequent lengthening of the maturity profile, the growth of local currency derivatives markets in terms of liquidity and sophistication and a quest for yield among global investors in the face of scant rates in the developed markets have all played a part in Asia’s domestic bond market boom.
That dynamic represented the most significant change in Asia’s credit market to have taken place over the past two decades as a response to the financial crisis. But without doubt, the offshore G3 credit markets have been a necessary and crucial element in Asia’s economic emergence. Crisis or no crisis they never went away. Indeed, if anything they have grown ever more significant to the region’s credit landscape in terms of functional solution and prestige.
“We have seen impressive growth in Asia’s debt capital markets over the past 20 years, with total annual G3 issuance rising tenfold from around US$20 billion to over US$200 billion last year. In the same period, rated G3 high yield issuance has also expanded dramatically, from less than US$2 billion of issuance from a handful of deals, to more than US$20 billion across 68 deals last year,” says Haitham Ghattas, head of debt origination, Asia, at Deutsche Bank in Hong Kong.
“China’s economic emergence and its capital hungry corporates have been one of the most significant factors in the development of Asia’s debt capital markets. In the financial institutions space, FIG issuance has increased significantly over the past five years, in line with China’s growing banking sector.”
In an ideal world, Asian domestic credit markets would do all the heavy lifting involved in funding to avoid the perils of double mismatch; but the simple truth is that they lack the depth of the G3 markets. And although the ability of Asia’s local markets to print size and tenor has grown steadily since the late 1990s crisis, they currently represent no viable match to what can be achieved in the G3 markets.
But still those markets have often exacted a heavy price: at the height of the Asian crisis it was not uncommon for regional governments desperate to plug the liquidity gap paying in the high triple digits over Libor to bulge-bracket international banks for the privilege of accessing the offshore loan market. That painful experience led to the growth of a multilateral swap culture whereby developed rich countries such as Japan put swap lines with developing countries in place to guard against a repeat of the crisis.
China fills the gap
The spike in loan market borrowing rates precipitated by the Asian crisis might have been painful but it didn’t last long; a mass restructuring of Asian balance sheets allowed the region’s borrowers to bounce back such that five years later it was almost as if no crisis had happened.
To take the sine qua non example: the Asian crisis prompted the US$14 billion default by Indonesia’s Asia Pulp and Paper, the biggest in the region’s history. Yet just over six years later the company was back in the offshore markets with a bond issue as if nothing had happened.
Meanwhile, despite the astronomical spike in offshore lending rates at the height of the Asian crisis, it’s a perennial joke among Asian loan bankers that syndicated loan pricing in the region is tight (and getting tighter).
There might have been a slight pause in this dynamic when embattled European banks, constrained in liquidity terms by regulation and soured loan portfolios, exited the Asian loan market in the face of the Eurozone debt crisis five years ago.
But the entry of China’s banks into the market filled that gap and the willingness of these banks to lend at highly competitive rates and with looser covenants restored the dynamic of ever tighter Asian loan pricing which has been in place for the best part of 15 years.
The competition for infrastructure funding which will be a stable feature of Asian financial markets in the foreseeable future – given the urgent need to plug the region’s infrastructure gap – might see loan pricing spreads ratchet up.
But a developing theme is the ability of the bond markets to compete in the project financing space. And that underlines the theme, which has been developing in the region since the Asian crisis: disintermediation.
Asia has weaned itself off an addiction to bank loans since the crisis via the bond markets, both onshore and offshore. And it is disintermediation in flourishing action which has allowed Asia’s high-yield bond market to develop and thrive over the past 15 years.
The emergence of Asian high-yield has had distinct nuances. Alongside the public market for high-yield, where each successive deal was in and of itself something of a watershed in developmental terms for that market, so the private high-yield market has thrived in the region.
Often there has been an equity element to the equation and these “sweeteners” saw private deals print at internal rates of return as high as 20% back in the days around a decade ago when dollar credit spreads over Treasuries and swaps were far more generous than they are now.
Indeed back in those days when there were some meat on Asian credit spreads, the pricing discipline for new issuance was a different species from what it is now. Pricing at a negative basis was a frequent feature of G3 new issuance around a decade ago; it was possible to book primary paper and hedge it against credit default swaps from the issuer for a positive fully hedged carry.
The global hunt for yield which has driven the secular compression of Asian credit spreads (there have of course been bumps in the roadmap of that compression, not least of which was the global financial crisis) has seen off that arbitrage opportunity. But it has also been a boon for issuers in the Asian G3 markets and allowed various segments to develop at warp speed.
“The science, the process of execution has dramatically and continually improved. The transaction numbers and volumes we see these days dwarf those of even 10 years ago and, by and large, most of which is processed relatively smoothly much to the chagrin of the region’s financial journalists,” says Mark Leahy, principal at Singapore-based private equity fund Presidio Capital, and a capital markets veteran, having previously headed up the debt syndicate teams at UBS and Deutsche Bank in the city state.
High-yield has come of age across a variety of credit categories, most notably in the China real estate sector, where issuance over the past seven years has been rampant. Indonesia has also been consistently represented in that space.
The salient feature of Asian high-yield has been its dovetailing with the equity markets; high-yield debt issuance has frequently been a precursor for the issuer’s foray into the initial public offering market.
Meanwhile the Asian sovereign space at the lower reaches of the credit curve has been opened thanks to the yield hunger globally, allowing frontier credits such as Mongolia, Sri Lanka and Laos to print in size and tenor.
Growing investor base
Versus the situation of a decade ago, the buyside has basically transformed the Asian credit arena. Large asset managers in the US and Europe are ever more willing to put the credit work in on Asian primary debt offerings, which has led to a more nuanced Asian credit curve, both in the secondary and implied primary curves. Inevitably this has led to a lower cost of funding for a swathe of Asian issuers over the past decade.
But increasingly, the primary bid from the US and Europe is playing second fiddle to the Asian investor base, where liquidity and sophistication has steadily deepened over the past 20 years.
“We have started to see Asian investors taking the lead in new issue order books. This lead will extend well beyond its current measure such that the New York or London desk driven late night conference calls that plagued Asia’s capital market’s professionals are a thing of the past. It won’t be long before US and European investors wake up to find benchmark deals launched, priced and allocated while they slept,” adds Leahy.
The primary benchmark landscape has also transformed substantially over the past 20 years. From the sovereign perspective, the Philippines dominated with a mind-numbing deal flow over that time.
FIG issuance has been driven by the strictures of the Basel banking reforms, and although most banks in Asia are well capitalized, there is room for a flood of Tier 1 issuance as full Basel III compliance is scheduled to be enacted across the region by 2019.
What has changed in the past few decades in the banking issuance sector in Asia has been the ability of markets to take on risky assets, such as loss-absorption paper; this is a measure of the steadily growing credit sophistication in the global investor base and the ability to discriminate among Asian credits.
Invariably the question which springs to mind in recalling the Asian financial crisis is whether such an event or series of events could happen again. One reason why this is unlikely immediately springs to mind: the systemic risk which was presented by the effective pegging of Asian currencies and the double mismatch has been obviated.
Of course, Asian currencies have not been immune to competitive devaluation in the face of Japan’s efforts under “Abenomics” to push down the value of the yen; but the lock-step round of devaluation which characterised the Asian crisis is unlikely to happen again.
“Any system that persists without reform must collapse. Everything can and will get hacked, its weaknesses exploited, its poor DNA replicated through inbreeding. Without evolution the regions’ balance sheets, and those of the countries and companies within it, will get over-borrowed at some point. That said, in the current race to the fiscal bottom among most of the so-called developed nations, Asia (ex-Japan at least) will be the prettiest girl at the dance for some time,” says Leahy.
Rather than an endogenous home-grown crisis a la 1997, Asia will be vulnerable to an exogenous shock, as it was during the global financial crisis.
An example of Asia’s sensitivity in this regard occurred over three years ago, during the “taper tantrum” when the region’s secondary credit sold off and primary markets shut down for a few months on the back of fears of an immediate withdrawal of the Federal Reserve’s quantitate easing programme. Indeed, there are many market watchers who fear a global financial crisis part 2, particularly those who see the recent run-up in US equities as setting the stage for a market crash.
And tightening of US monetary policy and the potential reflationary impact of president Donald Trump’s economic policies may yet bring an end to the 30-year-odd bull market in US Treasuries. That would cast a shadow over the sunny days Asia’s credit markets have enjoyed since the Asian financial crisis. But they seem unlikely to end in the home-grown manner of 20 years ago.