The Philippines curious debt exchange

The Republic concludes a liability management exercise that leaves many market participants baffled.

The Republic of the Philippines completed a sovereign debt exchange on Friday, accepting $1.2 billion of bonds tendered and issuing a new $1.3 billion global offering with a seven-year maturity.

Critics of the exchange had two main issues. Firstly, a number could not understand why the sovereign was doing an exchange offering at all. Given the large amount of funding it needs to raise in a year of heightened political risk, should it not be more mindful of finding available market windows rather than waste time tinkering with its yield curve?

And secondly, many could not understand the point of an exchange that barely extended the Republic's maturity profile and did not diversify its investor base away from the domestic banking market.

This is the third Brady bond exchange the sovereign has completed and was led by Citigroup, Deutsche Bank and JPMorgan. However, the current exchange differs from the past two market outings, because it also incorporates some of the Republic's outstanding eurobonds.

Back in 1996, the sovereign raised $690 million on the back of a JPMorgan-led exchange that removed 33% of its Brady pool and extended the yield curve out to 20-years.

In 1999, it returned again with a new exchange via Chase and Morgan Stanley. This time it raised $1.006 billion from an exchange that removed 40.7% of the outstanding Brady pool and incorporated a 25-year maturity with a put option in year seven.

At the time bankers said a 25p7 structure had been used to bring in buyers of both long and shorter-dated paper. This bond was submitted into the third exchange since it now trades to the put.

One of the main problems with any Philippines exchange is that most of the country's shorter-dated paper is held by domestic banks, which are never keen to extend very far down the maturity curve.

The Republic believed banks would not submit bonds into an exchange that was coupled with a long-dated deal. Some banks had suggested the Republic complete a tender offer rather than an exchange and concurrently raise funds from a long-dated bond.

But the Republic shied away from the idea on the basis that markets are volatile and it might not find enough buyers at an acceptable price for a longer-dated deal. It believed that while many local banks would tender their bonds, they would not want to participate in a long-dated deal, thereby holding the Republic hostage to the kind of pricing premium demanded by US investors.

Bonds eligible for the third exchange were three eurobonds and six Brady bonds. The former comprised: $1 billion par value of its 9.5% 24p06 bond; $1 billion of its 8.875% 2008 bond and $1.3 billion of its 8.375% 2009 bond. The latter comprised: its Par A and B bonds; its Flirb (Floating Rate Interest Reduction) A and B bonds and its DCB (Discount Coupon Bonds) A and B bonds.

Taking out more of its Brady bonds made sense from a cost perspective as these issues all have high coupons, but since the outstanding pool is now much smaller and quite illiquid, it was never likely that many bonds would be tendered. Hence the Republic decided to include some of its eurobonds as well.

Yet as one banker argues, "To take any bonds out of the market, the sovereign has to a pay a premium to the current secondary market price. Then to convert what's offered into a new bond, it has to pay a new issue premium and fees to the lead managers. It's paying out all this money and for what, a two to five-year extension of its maturity profile."

News of the exchange also steepened the shorter-dated end of the Philippines yield curve by up to 40bp according to one banker. The three eurobonds, for example, were all bid up nearly one point between February 10 and February 12. The Philippines 24p6, for example, went up from 109.63% to 110.13%.

Together with an improved market tone following Greenspan's Humphrey-Hawkins testimony, this allowed the Republic to offer less of a premium to secondary market levels than had been expected. In 1999, the Philippines paid a 1.5 point pick-up over secondary levels for its Par bonds and a one point pick-up for the Flirbs and DCBs. This time it paid 0.75%.

Clearing prices were set as follows: 109.231% for the 2008 bond; 105.75% for the 2009 bond and 105.75% for the 24p6 bonds; 94.75% for the Flirb A bonds; 94% for the Flirb B bonds; 90.50% for the DCB A bonds; 91.50% for the DCB B bonds; 97.25% for the Par A bonds and 97.50% for the Par B bonds.

In a research note, Barclays said the exchange held good value for investors because it provided, "an opportunity to switch out of the expensive front-end of the curve into a slightly longer seven year sovereign, which should provide good carry and roll-down over the next two years into the five year area of the curve."

The exchange was completed via a modified Dutch auction and observers report total offers amounting to $1.6 billion of the outstanding $4.4 billion par value. The Republic accepted all of the non-competitive offers ($1.2 billion) and none of the competitive offers.

It had also set a new cash amount of $500 million, but only put $120 million into the new global, which was priced at 99.5382% with a coupon of 8.375% to yield 8.465% or 490bp over Treasuries. In terms of the Brady pool, the Republic managed to take out a further 19.2%, leaving $1.318 billion principal amount outstanding.

This is a far lower ratio than either of its past exchanges, but hardly surprising given the small size of the outstanding pool.

In defending the exchange structure, some specialists argued that 2011 was the right tenor for the new global, because the government believes it will be able to balance its budget by 2009. If this is the case, why pay up for a far longer-dated bond?

However, very few if any economists believe the Philippines has any hope of achieving this target and particularly if former movie star Fernando Poe wins the upcoming Presidential election.

This looming political risk is one reason why bankers are so concerned by the Republic's slowness in raising new funds so far this year. A number point out that the sovereign missed out a good market window in early January and blame a change over in Finance Secretary from Jose Camacho to Juanita Amatong.

"I don't understand their current thinking," says one banker. "They seem to think they have time on their side and spreads will tighten back once concerns about Poe subside. But what if the election is really messy and they don't tighten, or he wins?

"Interest rates are likely to rise during the second half of the year," he adds. "And with only six months to raise a whole year's funding, investors will think they're well and truly in the driving seat. Department of Finance officials could end up with the backs against the wall if they're not careful?"