Does the Asian high yield market need to tone up?

Asian high yield specialist Will Clay discusses the development of a broad-based market in the region.

The Asian high yield market appears to be taking off as an issuance tool for companies and as an alternative asset class for investors. What steps need to be implemented to ensure that the asset class grows and matures to its fullest?

Is the Asian high yield market different, or does it need to evolve like the US high yield market in order to remain healthy? Before examining potentially helpful steps, it may be illustrative to look at high yield markets a year ago in the US and Asia; contrast the conditions, and look at why the markets diverged so significantly in the summer of 2002.

Divergence between the US and Asia

In July and August of 2002, sitting on a corporate trading desk in New York felt like "Shock and Awe". Every day seemed to bring a new disaster, and certain BBB rated credits were just coming unraveled. Investment grade credits - autos, airlines, speciality finance companies, and others were dropping daily onto the high yield trading desks from investment grade trading desks.

To be sure, US high yield declined too, but the US high yield market felt more orderly than many sectors of the investment grade market. A jaded view would be that high yield in the US held its bid better than investment grade bonds because there was no high yield bid!

The reality was that high yield investors were used to volatility and did not panic. Investment grade accounts were being forced to exit the "fallen angel" credits. Selling, at times, was indiscriminate. To their credit and fortune, high yield investors snapped up the BBB and higher rated corporates at yields that were too good to pass up.

The Asian high yield markets were behaving radically better during the same period. They had already begun to rally in the summer of 2002, and held up very well against declines in the US.

Significant out-performance was partly due to the fact that there were so few issues (and strong local demand for those that did come) and partly because certain sectors so prominent in the US decline had not really got going in Asia, and thus the market was spared those disasters. In addition, Asian "name credits" had been the predominant borrowers, most of whom had continued access to capital and never appeared to be stressed like the US credits.

Some of those "names" had dominant franchises (like certain wireless companies), or had other positive distinguishing features. Finally, since local Asian investors had been the main buyers of Asian high yield paper, the large US investors were simply not in there selling Asian names in the summer and fall of 2002. If they did, they found good bids (the "Asian Bid")

The markets now

Things are far different in the US today and the markets are generally very healthy. The US corporate bond market (investment grade and high yield) has produced spectacular returns over the last 12 months. It is no secret in the press that the US high yield market has been a star performer since last summer, when it bottomed with new issue yields at 12% to 14% in some cases, versus today's 6% to 8%. Prices in the non-distressed area of the market went from the 70's and 80's to well over 100% in many cases. Certain well-known and high profile investors have made this asset class very popular.

Asian high yield returns have been excellent as well, with far less volatility. Prices are well above issue levels in most cases. Investors must not feel that Asia is immune to the type of events seen in the US last year, but it is certainly not! However, the Asian high yield market thus far shows signs of discipline and exhibits continuing strong investor demand.

Are steps needed to foster the growth of Asian high yield?

If the market is to be no more than a "one-off" financing vehicle; then it is just fine for now. But I think it will be much larger than that.

The Asian high yield market's price appreciation can to some extent be tied to: 1) the relative lack of new deals and 2) large pools of money looking for new investments. Once the deal flow becomes much larger, and/or other credit and investment alternatives emerge (equities, convertible bonds, loans) the currently strong market technicals may erode.

It would be helpful, before that happens, to have already broadened the market to include new dedicated Asian high yield funds, Collateralized Debt Obligations and other pools of capital that could neutralize any potential decline in bank and private bank demand for High Yield. New investors will prefer to purchase more liquid and standardized securities. Broadening the potential investor base may require a bit of maturation and general "toning up" of the market. Three tools are discussed below that could help the market "tone up".

Market standard covenants

Just like certain standardization within the credit default swap market, standard high yield covenants (Asian style) should add liquidity, definition, and structure to the high yield market. Some high yield deals in Asia have excellent covenants, but the creation of a standard package, would extend good market practice.

Efforts should now be made to create market standard covenants for Asian high yield issued as Eurobond (Reg. S) securities. My assertion is based on the assumption (not recommendation) that the Asian market will continue to use Eurobonds (Reg S) as the predominant issuing vehicle.

If the market used the 144A or registered model, covenant standards already exist that are easily adapted to Asian borrowers, and have been used in several true Asian high yield financings (I am excluding 144A bank capital from the definition of "true high yield").

In my experience, issuers in the region (and their bankers) sought to minimize or avoid the traditional difficulties (time and expense) associated with SEC registration and filing, conversion or reconciliation of company accounts to US GAAP, and other activities that are associated with either a Publicly Registered or a 144A bond issue. Investors don't seem to care that the securities are not 144A or SEC registered, so unless something changes, Eurobonds (Reg S) may continue to be the predominant vehicle for Asian high yield.

Why covenants? Investors should always be cautious since high yield can be "equity-like", given the financial leverage employed by many borrowers. Investors must recognize that effective and sensible covenants can become useful tools that protect them when leveraged companies are stressed.

It is no surprise that US high yield traders keep stock prices and news alerts on their computers, even though they are trading bonds. Company-specific news and events can move the prices of entire capital structures 10% to 20% in one day. Covenants and seniority play an important role in how individual securities (within a capital structure) react to news. Whether one issue of bonds has a better covenant package than another; materially affects relative trading prices during times of stress.

Consents, tenders, and other liability management tools

To broaden the market, a full complement of procedures, standards, and entities should evolve to assist issuers in dealing with "after-issue" amendments to their outstanding bonds. In the US, it is routine for high yield issuers to seek changes to their indentures.

Liability management tools in the US allow for the efficient early retirement of debt, relatively straightforward changes to indentures, exchange offers, tenders and consents. There, one goes to the DTC, in combination with private information agents to gather up the names of beneficial owners who may then be contacted via a written "solicitation".

Asian high yield bonds that are SEC Registered or 144A work the same way, but to my knowledge, there is not a terribly efficient protocol for doing that with Asian high yield bonds issued in the Eurobond style. Until there exists a more efficient method of finding and addressing beneficial owners of Asian placed Eurobond style high yield bonds, there will likely be limitations on corporate buy-backs, tenders, and liability management.

Enhancing the means of identifying, contacting, and negotiating with whole classes if bondholders in Asia would make the Asian high yield market more robust and liquid.

Credit research

It cannot be said enough, that high yield securities are often very "equity-like". High yield thus demands rigorous company research, focused not only on the balance sheet and income statement, but on the industry and business conditions- like equity research. In general, the credit skills necessary to evaluate investment grade bonds will not adequately serve the high yield investor.

That is why most individuals in the US, purchase high yield (if at all) through mutual funds. Institutions often have their own credit research teams, but in a newly-developing market like Asia, that may be less common. Most research has some value, and some has great value.

For the Asian high yield market to flourish, credit research must become very robust. Issuers and bankers are well served to ensure that investors are kept updated by companies: information creates trading and liquidity. Of particular importance to regional institutions will be the development of investor-oriented high yield research, which may range from simple trade ideas from sell-side trading desks (but whose ideas are sound and thoroughly researched) to stringent (paid- for) advice from independent research boutiques.

I realize that this is an obvious argument, but credit research is a fundamental pillar in the high yield market.

Conclusion

The Asian high yield market is showing impressive growth. It has delivered good returns (in the last 12 months) to investors with seemingly less volatility than the US. It is fair to say that high returns and low volatility do not often coexist for long, but those investors who do their homework have an exciting and potentially rewarding asset class to analyze and in which to potentially invest. Caution is warranted by investors because high yield is complex and carries significant risks to investors.

Steps taken to standardize covenants and to enhance the liability management framework will serve to broaden the market. Credit research will add credibility and liquidity to the market. These three steps will likely ensure that the Asian high yield market grows and becomes a much more important tool for borrowers and investors.

The author is a high yield capital markets professional and salesperson, who first came to Asia in early 2000 to develop the sector for a large investment bank. He returned to New York to sell high yield bonds in late 2002 after a transfer with his bank and can be reached at [email protected].

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