New issuances in Asia HY credit markets and China property space in Feb 2013

This article is regarding the primary credit markets in Asia and slowdown witnessed in new issuances from the Chinese developers in the HY space.

 

The month of February has seen few junk bonds from the China property sector. Glorious Property Holdings Limited, issued USD 250mn senior unsecured notes maturing in five years with a coupon of 13.25% at par (bonds are rated Caa1 by Moody’s and B- by S&P). The company’s stated use of bond proceeds is to refinance existing debt and for general corporate purposes. There was no perpetual issuance by any property name during the month. There was not a single issuance from Indonesia high yield (HY) property space.
CIFI Holdings, a Chinese property developer, had plans to issue USD-denominated senior notes. The company had hired Citigroup, Deutsche Bank, HSBC, RBS and Standard Chartered to arrange fixed income investor meetings. It marketed 5 year maturity USD-denominated senior notes at low to mid 11%. The proceeds were to be used for refinancing debt, acquisition of new projects and development. However, it cancelled its proposed bond sale, citing unfavourable market conditions.
Far East Consortium International Limited tapped the bond markets in February 2013. It is a small-sized Hong Kong based company with a long track record of operations. The company issued dimsums of CNH 1 billion with a maturity of 3 years and coupon of 5.875% at par (equivalent to a yield of 5.875%). This dimsum bond is a small sized issuance and the deal received high subscriptions from the fixed income investors. The company had earlier planned a USD bond issuance in Nov 2012 which got cancelled then.
February 2013 has been a stark contrast to January 2013, which was a month that saw huge supply in the primary markets in the Asia fixed income space. There was a record amount of issuance from the China property high yield sector. The flow of issuances started with Country Garden Holdings Company Limited and Kaisa Group Holdings Ltd, which issued USD 750mn 10 year maturity notes and USD 500mn notes seven year maturity notes. Even issuers rated in the CCC rating bucket such as Hopson Development Holdings Limited, Powerlong Real Estate Holdings Limited and Greentown China Holdings Limited had tapped the bond markets in January.
Yanlord Land Group Limited is one of the few Chinese property credits not to have tapped the USD debt capital markets in 2012 and 2013. The company recently announced its financial results for 2012. The company witnessed a 15% YoY increase in revenues in 2012. The company’s profitability improved while the liquidity position also looks adequate. The company’s total debt outstanding and net debt declined significantly resulting in an improvement in its credit metrics. Moody’s upgraded Yanlord’s rating outlook to stable from negative while affirming its Ba3 corporate family and its B1 senior unsecured debt ratings. The rating action was driven by Yanlord’s strong performance (both operating and financial) during 2012.
Most of the Chinese companies will announce their 2012 annual results in March 2013 and the Asian secondary bond markets are likely to be active, with these data flowing in.

Solvency II and its impact on existing subordinated bonds of Insurers

Solvency II has been delayed historically, and was earlier planned around 2010. Thereafter, it was delayed till 01 Jan 2013, but again got stretched for one year to 01 Jan 2014. Now in a current development, it is expected to start somewhere in 2016. In the UK, the initial deadline of 2013 is now extended until 31 Dec 2015.
The applicability of Solvency II is dependent upon adoption of Omnibus II directive. The legal power of Solvency II depends upon agreement of Omnibus II by all the three European institutions – European Parliament, European Commission and European Council. The vote on Omnibus II which itself got delayed to November 2012 is now further delayed to March 2013.
We consider the delay in implementation of solvency II as a great risk in the current low interest rate environment. In a low interest rate environment, due to low risk free rates the present value of liabilities goes up. At the other end scarcity of high yielding assets would compel insurance companies to invest in risky assets, thereby increasing the overall risk profile of investments. If the insurance companies try to lock the long term yields on the government bond, then again there is duration risk if inflation kicks in.
The overall returns are dependent on timely implementation of Solvency II, and there are no clear signals on it. As per Reuter’s, it is now expected to go beyond 2016. Implementation becomes complex as the readiness varies from country to country and insurer to insurer. As per a report, 70-90% of British, Dutch, Greek, Polish and Spanish insurers expecting to be ready by Jan 2014, but only 60-70% of Belgian, French, German and Italian insurers will be ready by that deadline. The delays are on account of cost associated with implementation of Solvency II, which has a potential to push pension funds into bankruptcy. Majority of the costs are associated with technology related needs for data governance.
Risks are further expected to increase on account of grandfathering arrangement that would continue to allow the pre-existing subordinated debt as capital, while applying the new rule on the new issuances only. A grandfathering provision would allow insurers to keep subordinated debt as capital till a specified period of time, after which it no longer qualify as capital as therefore could be worth a call. If the grandfathering period is say for a 8-10 years period, then the incentive to make a call goes down for an insurer.
However, there is a high likely hood that in order to match the duration of assets and liabilities, the stronger insurance companies in the market would come forth to replace their subordinated bonds with newer instruments eligible as capital. Also, funds with exposure to equity in their asset portfolios are expected to benefit in a QE driven environment. In this manner, both the assets and liabilities would be in line with the current interest rate outlook. Therefore, investment in subordinated bonds with a nearing call date would reduce the overall risks. The modified duration of 2.6 years for the given fund is attractive in this regard. But duration is based on assumption of call option which depends on progress on Solvency II implementation. Overall, we can expect a call on expensive debt pieces, with high coupon. The fund has a coupon yield of 7.9%, a healthy rate by European standard. Therefore the likely-hood of a call goes up irrespective of a requirement to meet Solvency II, as it would help in matching of asset and liability duration. Furthermore, the discount on these bonds makes them attractive at their higher coupon rates.

Global Bond Markets

Global bond markets in the last six month have been defined by monetary easing stance by central banks across the developed world. The central banks in the EU, the US, Japan and UK continued to expand their balance sheet through easing of monetary policies. The additional money created through these measures flown into bond markets thereby increasing the liquidity and pushing the yields to historically low levels.
Within EU, the bond yields were historically highest during the last quarter of 2011. This led ECB to initiative LTRO in two phases in December 2011 and February 2012, respectively. LTRO supported the banking system with cheap loans with a 3 years maturity. The total LTRO loans were approximately €1 tn. LTRO led to a rally in the bond market on account of declining risk premia coupled with liquidity. The effect of LTRO started to fade after the first half of 2012. Greece election failed to conclude a result after the first vote. In addition, negative signals started to arise from Spain, causing the yield on its bond to rise to historical levels. Spain was badly hit on account of its troubled banking systems. Concurrently, investors lost confident on Italy, the next in line, leading to higher yields on its bonds as well. ECB sensed the direness of situation, and then Mario Draghi came up with its commitment to do “whatever it takes to save EURO”. The yields for Spain and Italy came down after this statement. Spain also received a €100 bn bailout package to support its fragile banking sector. This instilled further confidence in Eurozone. Yields for corporate issuers across the Eurozone benefited from this move, leading to record new issuances. In order to provide some concrete measures to support his words, Mario Draghi unveiled outright monetary transactions (OMTs). OMT stipulated that ECB will support the yields of country applying for a bailout to European stability mechanism (ESM), which was subsequently ratified by the German constitutional court. ECB also clarified that it would buy bonds at the near end of yield curve, i.e. within three years maturity. This ensured that monetary policy stays uniform across the Eurozone and issue of financial fragmentation is addressed properly. Meanwhile, the US came up with its QE3 to bring down its mortgage rates.
These measures on a combined basis have led to a rally across the Europe, making European high yield notes one of the best performers in terms of returns. With these measures in place and elections in Germany due in 2013 we do not expect any volatility in the Eurozone bond markets in the near term. In addition, efforts are underway to create a banking and fiscal union, but that might take a while before adding any tangible benefits are seen.

Trading and Investing in Eurobonds

Diversifying one’s portfolio does not mean investing in different sectors or different financial products alone. A fixed income portfolio could be invested in different currencies and different countries mitigating the downside risks associated with a single currency or country. Investing in Eurobonds gives such an opportunity to the investors.

Eurobonds are bonds issued to investors outside the home country, denominated in non-domestic currency. They have a specific structure as identified by the EU directives. The Eurobonds are not necessarily being issued in the Euro zone, however most of the times the bonds are issued to European markets. Also, the bonds need not be issued in Euro, and are generally issued in US dollar or yen. The bonds are traded mainly in European markets and also traded in markets across the globe, and are available for trading throughout the 24×7. The bonds are generally termed based on the currency they are issued in such as Euroyen and Eurodollar. These bonds are basically of five types depending on their terms and features: Fixed rate bonds, floating rate bonds, subordinated bonds, asset backed bonds, and convertibles. Though the words foreign bonds and Eurobonds are interchangeably used, it should be noted that these are different from each other. Foreign bonds are just bonds issued to domestic market in external currency.

Eurobonds are a way to attract foreign funds into the country and hence in most of the country the bonds are exempt tax. These are attractive to individual investors, as Eurobonds are not subjected to the withholding taxes and are largely free from government regulation. Generally Eurobonds are issued to international entities with sound creditworthiness. These bonds help investors to gain exposure to certain sector or geography, which having any exposure to the currency risk. If a London-based investor wants to invest in real estate sector in China, but without having direct exposure to Chinese Renminbi (CNY), then the investor could buy Eurobonds issued by Chinese real-estate companies. Funds usually operates on mandates requiring them to invest in a category of bonds – investment grade, high yield, sovereign with a focus on geographies such as Asia pacific, MENA, or emerging markets. And hence invest in Eurobonds of these regions.

However, it is important that the investors hire advisors to help them invest in Eurobonds. This is mainly because of the operating structure of the Eurobond market and also the risk associated with Eurobonds. These bonds are first sold in primary market to closed set of investors called syndicate who then sell it to bond investors in secondary market. Since, most of these bonds are held mainly by institutional investors and very rarely by retail investors and more so held for long, the bonds are not liquid. Without financial advisors, it becomes difficult to access the Eurobond market. Apart from the accessibility, the investors need advisors to help them pick the right bonds based on the risk associated with the Eurobonds. To invest in any Eurobond, it is really important to understand the risk attached with the country and sector it operates in. Also, these bonds are influenced by the macroeconomic factors, movement in interest rates, currency rates that will impact the investment in long run.

Tips for Investing in High Yield Bond Mutual Funds

Overview

High yield bond mutual funds are gaining importance these days due to their ability to offer attractive returns and strong diversification benefits. The investment case is also supported by the fact that many investors have suffered huge losses by direct stock investing while these mutual funds have generated equity-like returns with relatively lower volatility.

Although, the name suggests that it primarily invests in bonds rated below investment grade (a.k.a junk bonds), the portfolio risk is minimized because these funds hold a wide range of such securities. Moreover, high yield mutual funds provide better returns than most other conventional bond mutual funds. One other important investment consideration is the lower susceptibility of these funds to interest rate fluctuations compared to investment grade securities, as the former has higher yields compared to the latter. Simply put, prices of high yield bond funds tend to be more sensitive to changes in their issuers’ financial outlooks than to changes in interest rates and therefore can act as a natural hedge against interest rate risk.

Generally, high yield bond mutual fund offers returns equivalent to direct stock investment. These mutual funds are managed by experienced fund managers who have a vast experience in the capital markets. If mutual fund investments are done for a longer term basis, one can get exceptional returns, far more than what can be obtained by just keeping money in the bank.

Investors can invest in a variety of high yield bond funds that are available in the market. Some of the common themes of investments include – 1) high risk – high – return 2) low risk – low return, and 3) the medium risk – medium return. Interestingly, even low risk – low return funds have potential to general substantial return on investments. On the other hand, the main disadvantage of these investments is that lower interest rates do not always result in higher prices of the HY bonds.

Basic steps to follow

Although, investing in high yield bond mutual funds is not very common with individual investors, the steps that need to be followed while investing do not differ much compared to the traditional mutual fund investing.

Investors need to go to the office of the mutual fund provider and meet with investment managers. The manager typically explains the advantages and disadvantages of every fund. Investors and managers can finalize the investment policy statement as per risk appetite and return objectives on investors.

The final stage is security selection. Investors can select a few funds and invest in a fund, which has a good reputation in the market and has given consistent returns to investors over a time.

One important consideration for investors is to remember that these investments are affected by market risks. It is a common phenomenon that investors may see volatility in the investment value and might see negative returns on their investments in the near term. That said, as market conditions improve, these funds rise in value notably.