Strong demand for Khazanah's third exchangeable Sukuk

The $550 million bond issue, which is exchangeable into shares of Parkson Retail, was combined with a $96.8 million placement of shares in the same company.
Khazanah Nasional last night raised $646.8 million through a combined sale of Islamic bonds exchangeable into Parkson Retail Group, and secondary Parkson shares. If the five-year bonds (with a three-year put) are exchanged in full, the sale will result in Khazanah parting with its entire 9.8% stake in the Hong Kong-listed company, which is the largest nationwide department store operator in China.

The bonds made up about 85% of the combined sale, or $550 million, which translates into about 44 million shares after the premium was fixed at the wide end. This left room for the placement to be increased in size from an initial offer of around $70 million plus an upsize option of $10 million to a final size of $96.8 million (HK$752.6 million), or 10.6 million shares. If the exchange premium had been lower, Khazanah would have had fewer shares left on its books to sell through the placement.

Khazanah, which is the investment arm of the Malaysian government, owned about 54.6 million shares in Parkson before yesterdayÆs transactions, or about a 9.8% stake. It bought the shares at the time of ParksonÆs IPO in November 2005 and, based on the 676% gain in the share price since then, was sitting on a profit of about $465 million on an original investment of $69 million. The realised gain will be even greater, however, since the bulk of the shares are sold at a premium to the current market price.

Sources said Khazanah chose to sell a portion of the shares through a discounted placement because it wanted certainty about the point of exit for part of its holdings.

The bonds were structured to comply with Sharia law and marked the third time in 2.5 years that Khazanah sold exchangeable Islamic bonds to the market. Supported by the Malaysian government, the investment company has been working hard in recent years to develop a market for Islamic bonds, which are also referred to as sukuks, and investors in the Middle East are clearly getting more comfortable with the equity-linked format. This was evident by the fact that the Parkson bond was priced with a zero coupon, despite the traditional liking among Middle Eastern investors for more fixed income-like instruments that pay regular coupons. The deal was marketed with a coupon range of 0% to 0.25%.

The bond floor has also been edging lower with each new exchangeable, from 98% on the first one in September 2006, which was exchangeable into Telekom Malaysia, to 94.5% on the second one into Plus Expressways, and around 90% on yesterdayÆs offer.

ôThe fact that investors are now willing to pay 10 points for the embedded equity option shows how far the Islamic market has come,ö one source says.

Another difference versus the previous two bonds was that the deal was launched and priced on the same night. In fact the books were open for only three hours after the close of the Malaysian market, compared with five days of bookbuilding for the other two transactions. The limited offer period was clearly enough though, since both portions of the deal were covered after just one hour.

By choosing an underlying stock that is listed outside Malaysia, Khazanah was also able for the first time to introduce the possibility of hedging the equity option. It even lent enough shares for the bookrunners to conduct a so-called delta placement to provide the buyers of the exchangeable with sufficient borrow to go short. This would have helped in terms of making investors more willing to accept a higher exchange premium. Since it isnÆt possible to go short on Malaysian stocks, this was not an option on its first two sukuk exchangeables.

The fact that investors can short-sell the stock is likely to have factored in the decision against an extended marketing period, as that would have increased the pricing risk.

The premium was fixed at the top of the 32% to 37% range, while the yield was also set at the most favourable end for the issuer at 0.69%. It was offered in a range up to 1.39%.

According to sources, the bonds attracted about $6 billion of demand, or more than 10 times the final size. There was no definitive breakdown of either demand or the final distribution, but one source says the allocation to Middle Eastern accounts was approaching similar levels to the previous Khazanah sukuk exchangeable when they walked away with about 50%. The demand from these accounts was said to have been almost enough to cover the entire deal.

In all, more than 200 investors bought into the exchangeable, which traded up to about 102-102.5 after the pricing. Observers say the combination of a strong credit - essentially a Malaysian sovereign û the ability to buy the bonds as a volatility trade, and the positive outlook for Chinese consumption stocks made the offering attractive to both CB specialists and outright buyers who wished to make a bet on the equity story.

ParksonÆs stock was under pressure in the first three weeks of January when it fell as much as 32% from a record close of HK$93.95 on New YearÆs Eve, but it has since been edging gradually higher and yesterday closed at HK$76.10. Of the 14 analysts who cover the company, according to Bloomberg data, 10 have a buy recommendation on the stock.

Not surprisingly, given that the equity market remains highly volatile, the demand for the equity placement wasnÆt quite as strong. However, sources say it was still sufficient to cover the deal a few times over and more than 50 predominantly Asian accounts participated. One source said there was some overlap with about one-quarter of the demand for the block coming from investors who also submitted orders for the bonds.

The shares were offered at a price between HK$70 and HK$72.30, which represented a discount of 5% to 8% to yesterdayÆs close. It was fixed just below the mid-point at HK$71 for a 6.7% discount, indicating there was at least some price sensitivity around. This price was then used as the reference price for the exchangeable, which means the actual exchange premium versus yesterdayÆs close was only 27.8%. However, it is quite possible that the price will adjust downward when the shares resume trading.

Some observers suggested that the bonds were offered very cheap, but based on a credit spread guidance of about 125bp by the leads, a volatility cap of 35% and a bond floor of about 90%, the theoretical value came out at about 102.4%, which doesnÆt seem excessive in the current market environment.

The actual implied volatility was about 30%-31%, compared with a 100-day historic volatility of around 60%. The underlying assumptions included a stock borrow cost of 50bp and a dividend protection in case the yield goes above 0.8%.

The bonds can be called by the issuer after three years, subject to a hurdle of 130% of the accreted value.

Deutsche Bank was the global coordinator for both the bonds and the placement, as well as joint bookrunner together with CIMB and UBS. Deutsche also helped arrange the previous exchangable into Plus Expressways, while UBS was one of three bookrunners on the first bond into Telekom Malaysia. Malaysia-based CIMB was a bookrunner on both the previous bonds.

Based on the success of the three issues so far, Khazanah is expected to return with more exchangeable sukuks which not only meet the governmentÆs objective to develop a market for Islamic bonds, but also fit in with KhazanahÆs own long-term mandate to reduce its stake in the companies in its portfolio in an orderly fashion to help improve market liquidity. The idea is to re-invest the money raised from these sales outside Malaysia for a higher return.

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