Bond issuers need to innovate, says Donahue

JPMorgan has had a good run this year in the high-yield bond market. Here, Tim Donahue, head of Asia-Pacific leveraged finance, tells us what he believes lies ahead for the sector.
Tim DonahueÆs arrival in Hong Kong last September coincided with many changes at the heart of JPMorganÆs syndicate and leveraged finance (SLF) business.

The appointment of a new head of origination (Tim Donahue), a new head of syndicate (Simon Crisp), a new head of Asia trading (Henry Yoon) and a new head of sales (Simon Derrick) from the more broadly developed markets of the US and the UK allowed the team to grow both in size - it now numbers 19 staff -and in experience.

The re-vamp seems to have borne fruit, since JPMorgan was involved in four high-yield deals in the first half of 2007, namely Parkson, Road King, Indika and Berlian Laju Tanker. This compares to none in the corresponding period last year.

So with such a strong run in this yearÆs first half, it seems pertinent to question Donahue on his outlook for the rest of 2007, considering the challenges of a market rocked by the US subprime crisis.

"ItÆs hard to gauge the market right now, since nothing happens in August anyway," he begins. "But the issue is not whether the markets will open up. The problem lies in the fact that we, and banks around the region, have won mandates at rates that are probably not achievable in todayÆs markets, and issuers may be unwilling to compromise."

ôThe biggest challenge is to manage issuer expectations. But even though rates are back from where they were, in a historical context, itÆs still a pretty good market. If you can get money at 8.5%-9% where historically rates were at 11.5%-12%, thatÆs still pretty enticing, but issuers may not see the wisdom of that argument,ö he says.

Donahue reckons the ôfundamentals are strong in Asiaö argument still holds water. He has no real worries about defaults in the region, since these are still at an all-time low, inflation in the region is under control and growth is still strong. It's the technicals that are a problem.

ôThere is a $100 billion overhang from the US and Europe from LBOs and bridge loans currently on hold. Meanwhile, demand from collateralised loan obligations has dried up. In the meantime, hedge funds have been slammed pretty hard, and are being more careful with their capital.ö

As a result, hedge funds have sold liquid assets to redeem trades, namely high-yield bonds, driving their price down.

In Asia though, the supply side has not changed significantly, since only $1-$2 billion is currently frozen in the pipeline. But in DonahueÆs opinion, roughly 65% to 75% of demand for high-yield bonds in Asia comes from either prop desks or hedge funds.

ôIf they are getting hit in other parts of the world, then their risk appetite here will be diminished, so that will have an impact. But it wonÆt be half as bad as in other parts of the world, since the demand and supply imbalance is not as acute.ö

Another mitigating factor is that the issuance quality here in AsiaÆs high-yield market is made up mostly of double-B credits. ôIn the US, most new issues are CCC-rated, or very low single Bs, that are seven to eight times levered. Here in Asia, proceeds are being used primarily as growth capital in a manner that is much more conservative. So since the quality of the deals is higher, the market has not pulled back as much as in other parts.ö

ItÆs the crisis of confidence that worries Donahue.

ôWe need to get out of this locked-up period where no-one is buying, and no-one is selling. Once some trading occurs on the secondary market, people will see there is a little more liquidity and start dipping their toes in. Once they gain confidence that the market represents value at the current level on the secondary market, we will see primary issuance begin again.ö

But yields will be higher, and itÆs at this point that bookrunners' creativity across the region will be tested. How does one balance lowered investor appetite with issuers who still havenÆt adapted to the new environment?

ôBeing creative is the key. There is a number of different ways that you can package return for investors, whether itÆs through call prices, duration, call protection, warrants, step-ups or step-downs. And the derivatives market can play a role in that.ö

By this, Donahue means using derivatives and rates products to help lower all-end costs to the issuer, whether it is interest-rate swaps, credit-linked notes, or commodities û if the company has commodity exposures. Penny warrants (or free warrants) is another way to enhance the yield.

And for 2007, at least, rival syndicate bankers have recognised JPMorganÆs creativity. After initial scepticism, most grudgingly acknowledged that the offering by Chinese toll-road operator and property developer Road King in May was a successful strategy.

The transaction incorporated only the second high-yield floating rate note in the Asian high-yield bond market û a $150 million FRN - and included a rare short-call option structured to maximise pre-payable debt and allow minimal pre-payment costs. The second tranche was a $200 million fixed note.

JPMorgan, alongside DBS, ignored the ratings downgrade imposed on the company due to the increased gearing ratio as a result of the issue. Instead, they convinced both issuer and investor of the value of a five-year non-call-one $150 million FRN, structured to coincide with the companyÆs plans to spin off the property business with an IPO in 2008.

The funds garnered from the IPO would allow Road King to repay the property-business bonds (issued via the FRN tranche), leaving only the bonds for the toll road business (issued through the fixed note). Since Road King was once an investment-grade company before it ventured into the property market (when its business was toll roads only), the remaining bonds were likely to benefit from an investment-grade upgrade, and therefore increase in value.

Those who bought the paper bought the IPO story, and if the bonds are indeed called after one year, investors will receive a three-point compensation at 103.

ôTaking no heed of the credit downgrade was a daring strategy,ö says one syndicate banker, ôand not one usually seen in AsiaÆs high-yield markets. But it paid off.ö

JPMorgan, with ING, also led PT Indika Inti Energi through its maiden bond offering. The challenge here was persuading investors of the value of a company that owned only 46% of its main asset, the Kideco coal mine in Indonesia. This meant that many investors considered the transaction as more of a margin loan, which most would expect to yield in the area of 11.5%.

So the banks put forward the value of the shareholders' agreement, whereby the three main shareholders effectively control the asset thanks to their veto rights. Bookrunners also stressed the companyÆs ability to control the board of directors.

In the end, investors wishing to gain exposure to an Indonesian coal asset chose between Adaro (yielding 7.2% at the time of pricing), Berau (7.7%), or Indika, a company with a less attractive structure but with a high-quality asset and yielding 8.5%. 160 accounts bought into IndikaÆs deal, generating $3.8 billion in demand, with the company pricing a bond with reportedly the lowest coupon and spread for a B2/B-rated company. Although, to be fair, the deal did price at the peak of the bull-run in high-yield issuance.

ôIÆm not anxious to give away the secret sauce, but we know deals like this are getting done in other markets, we know why they are getting done and how they are structured," says Donahue. "Further, we know the investors who are buying the paper. So we call them up, and ask them what they think of our ideas. If they like them, then we present our ideas to investors out here. The strategy seems to work.ö

This was the point of the new hires. Hiring seasoned professionals with a broad and intimate knowledge of the more developed high-yield markets from the US and the UK allowed a transfer of technologies and strategies that might not be so often used in Asia.

One can add to that a strengthening of the links between JPMorganÆs Asia office and its European and American counterparts. ôA lot of us have worked with, or are friends with, the guys in the US and London. So when we call them up, they are more likely to respond and give us, as a team, the attention we require.ö

By creating a broader cultural and professional mix in the team therefore, JPMorgan succeeded in bridging the gap with the head offices that regional centres so often suffer from.

The next step was education: ensuring that JPMorganÆs own investment bankers spoke about the SLF teamÆs high-yield products to the banksÆ clients. ôOur strengths in Asia lay in equity and mergers and acquisitions, so it took some time before our bankers were confident enough to sell our products.ö

But another key feature to the team is DonahueÆs own dual role. According to Donahue, most banks have one new issue/origination team that pitch for new business, and a syndication team. His job entails both pitching, and selling the deal to investors.

ôThis means I can see where the pockets of liquidity are, who is willing to price what, and who wants what kind of paper. IÆm the guy who pitches to the company and then goes out and sells the deal to the market. So I can sit in a pitch and say exactly how investors with evaluate the deal.ö

So far, JPMorgan's formula seems to work. One banker said: "It was strange. JPMorgan suddenly burst into life. Having initially shown little strategy or direction, the team suddenly executed a bunch of high-yield deals within the space of a few weeks."

It is likely that todayÆs new credit environment will require more creativity and more lateral thinking, and Donahue and his team are clearly keen to play a big role in that.

"Issuing high-yield bonds is not rocket-science in an aggressive market. It's in markets that we have now that the rubber really hits the road."

That means that Asia's bond markets are set to become much more exciting.
¬ Haymarket Media Limited. All rights reserved.

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