Khazanah's sukuk exchangeable is a blowout success

Islamic investors take 50% of the deal, which is upsized to $850 million after being 13 times covered.
Khazanah Nasional drew a massive $7.8 billion worth of demand for its second exchangeable Islamic bond, which allowed it to upsize the offering by 42% to $850 million and fix all the terms at the tight end of the marketed ranges.

At that size, this is the largest exchangeable ever out of Malaysia surpassing KhazanahÆs own $750 million Islamic exchangeable into Telekom Malaysia shares completed in September last year.

Aside from the coupon û or periodic payments as it is referred to on the term sheet û the terms were significantly tighter than on the first bond, which may be at least partly a reflection of the efforts by both the issuer, which is the investment arm of the Malaysian government, and the bookrunners to continue to educate investors about these instruments.

What really made this deal a success, though, was the fact that half of the issue was allocated to Middle Eastern buyers, indicating that the exchangeable bond format has become a real investment alternative for Islamic investors who need their investments to comply with Sharia laws. At the same time, the Sharia-compliant structure did not deter other investors who would have been expected to come into the deal had it had a conventional structure.

One observer called the 50% allocation to the Middle East a ôphenomenal outcomeö, especially since it is only the second Sharia-compliant exchangeable by an Asian issuer ever.

The fully-marketed deal was jointly arranged by CIMB, Deutsche Bank and JPMorgan. It also had the full backing by the Malaysian government through Khazanah, confirming the governmentÆs intention to develop Malaysia into a centre for Islamic finance.

The bonds are exchangeable into MalaysiaÆs largest toll road operator PLUS Expressways at a premium of 23% over yesterdayÆs volume-weighted average price of M$3.2054 after being offered to investors in a range of 19% to 23%. PLUS Expressways finished unchanged at M$3.22 yesterday, or slightly above the VWAP which means the effective exchange premium will be slightly lower that 23% in relation to the closing price. If fully exchanged, the bond issue will account for about 15% of the company.

The coupon, or periodic payments, was fixed at the bottom of the 2% to 2.25% range, which is above the 1.25% paid by the first exchangeable Khazanah sukuk. This was seen as a concession specifically to Middle Eastern investors who are more used to investing in fixed-income instruments and like regular coupon payments. Regular Asian CB investors the other hand are perfectly happy to buy zero-coupon bonds that pay all the interest on maturity or when they are put back to the issuer.

The periodic payments are based on dividends paid by PLUS Expressways to get around the fact that Islamic bonds arenÆt allowed to pay interest. The payments arenÆt guaranteed and to protect investors in case PLUS Expressways were for some reason to reduce its dividend payments substantially, there is a sizeable buffer between the annual periodic payments at 2% and the current dividend yield of approximately 4%. Any dividend payments above that 2% will also be put into a so called ôsinking fundö for use towards future annual payments to the bond holders.

However, PLUS Expressway has a stated policy to pay 40% to 60% of its net income as dividend, which means this shouldnÆt be a problem unless its profits were to rapidly deteriorate.

The yield to maturity, or ôyield to scheduled dissolutionö as it is referred to here, was also fixed at the tight end at 90bp below the five-year US dollar swap rate. With the swap rate at 5.48% yesterday, this gives a yield of 4.58%.

The first Khazanah exchangeable sukuk will pay a yield of 5.07% based on a price at par, which at the time of issue translated into a 3bp premium to the five-year swap rate.

The new bonds were issued at par, have a five-year maturity with no put, although investors will be able to sell them back to the issuer if the underlying company fails to stay compliant with the Sharia requirements. There is also an issuer call after three years, subject to a 130% hurdle.

According to sources, the $600 million base offer was 13 times subscribed when the bookbuilding ended yesterday and had attracted over 200 investors û a level of demand made even more impressive by the fact that the bookrunners capped the individual order amount at 10% of the base deal size, or at a maximum $60 million.

There was no indication of the breakdown of demand in terms of Islamic and non-Islamic investors at the time of pricing late last night. However, the fact that 50% of the upsized $850 million deal was placed in Islamic hands suggest a much greater interest than last time when Middle Eastern investors accounted for 20% of the demand and close to 30% of the allocation.

The conventional demand, which would have been partly drawn by the rarity value of the Khazanah credit and the scarcity value of equity-linked paper out of Malaysia in general, was said to have been similar to a conventional deal with a great deal of interest both from European and offshore US accounts. The bonds werenÆt open to onshore US investors.

PLUS Expressways is also in the midst of a regional expansion after recently taking stakes in two toll roads in Indonesia and India. The toll road operator, which is about 66% controlled by Khazanah, is also involved in two new links to the North to South highway that will connect this main artery to the new Kuala Lumpur airport as well as to Singapore. Among the 19 analysts who cover the company, according to Bloomberg data, 14 have a buy recommendation and only two advise clients to sell the stock.

The bookrunners provided no asset swaps as the market for Khazanah credit is quite liquid and transparent. According to CB specialists the underlying valuations are based on five-year credit default swaps at 25bp over Libor. Other assumptions included a 5% stock borrow cost and a dividend protection according to a gradually increasing payout scale starting from M$0.15 per share this year.

This gave a bond floor of 94.5% and an implied volatility of 27.1%. The latter came at a significant premium to the 100-day volatility of 21%-22%.

The success of the second issue clearly built upon the first deal, which was led by CIMB, HSBC and UBS, with the basic structure being largely the same on both offerings. The meant that the new deal could be completed in just over a month from being mandated, while the inaugural issue which had to break new ground with the regulators took about 18 months.

However, the latest issue didnÆt sell itself and the three bookrunners have spent the best part of this month in the Middle East educating potential investors about the structure û initially without revealing what shares the bonds would exchange into.

Having achieved this great an outcome though, there is no question that Khazanah will return with more exchangeable sukuks, observers say. Not only do they meet the governmentÆs objective to develop a market for Islamic bonds, but they also fit in with KhazanahÆs own long-term mandate to gradually reduce its stake in the companies in its portfolio in an orderly fashion to help improve liquidity. The idea is to re-invest the money raised from these sales outside the country for a higher return.

Khazanah currently has holdings in more than 50 companies both in Malaysia and abroad.
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