The spread according to Fan

Fan Jiang, Goldman Sachs head of fixed income research, explains why he thinks MTR and Hutch are mispriced.

What's the basic difference between fixed income research in New York and in Asia?

I used to be a credit analyst in New York, and I mostly had to know the company well and the industry well. But, here, everything is very macro-driven, and if you don't get the macro-economics right, plus get the sovereign and even the demographics right, you might get the company wrong in the end. That's the lesson I've learned from being in Asia for seven years.

Do you think the quality of fixed income research in Asia is as high now as in the US?

No. There are many reasons why. The first problem is the lack of a credit culture here. Asian capital markets are still dominated by commercial banks. Lending is partly relationship-driven and partly credit-driven. A bank loan does not get traded very often here, if at all. How do we assess the loan risk accurately if the asset does not get traded? How can we be so sure where the risk is? This kind of risk valuation process in turn influences the way we price risk in the market. Such a market does not help nurture credit culture.

To make the case a little worse, market technicals have a relatively greater influence over the region's capital market than elsewhere. For example, KCR 09 and MTR 09 are trading more than 100 basis points tighter than the Hutchison puttable bond, and the spread does not seem to justify their respective underlying intrinsic credit quality. I concede that Hutchison needs to pay some premium for being in telecom sector, but probably not 110 basis point of premium. In fact, the market seems to have misplaced some of the underlying credit issues concerning KCR, MTR and Hutchison.

The reason why KCR and MTR trade so tightly relative to comparable Hutchison issues is in no small part due to market liquidity. Any time there is any seller of KCR and MTR on the dip, there will be plenty buyers. Sometimes, it almost appears to be price insensitive. Similar situation exists for the triple-B sector in China and Korea.

Why? Because the commercial banks have a lot of cash that needs to be put into work. We all put our money in the banks, and the banks have to lend. But the borrowing and lending activities have both declined as the region's economies slow down; so the bank's balance sheet is flooded with deposit liabilities on the one hand, and on the other hand, the banks are either reluctant to lend or cannot find suitable opportunities to lend. So what do they do? They go out and buy high quality bonds aggressively as a loan-substitute. Of course, they don't want to buy bonds they don't know, such as Argentine bonds. So they buy high quality bonds like MTR 09 and KCR 09. This has made the price relatively tighter than it would otherwise be.

So with lending decision based on this kind of credit differentiation,does an analyst like me need to study these names as rigorously as I would if I were studying their counterparts in New York or London assuming they are equal in credit quality? I don't think so. I just have to figure out the demand and supply balance and go for A-rated credits where the supply is less. This forces us to think a little more like credit traders than analysts which is what we are suppose to be in the first place.

So it's not credit research at all?

It's more based on market technicals. I am taking an extreme case here. Credit research is demand driven. If investors need the level of details and sophistication, a lot of us in the industry are able to deliver: sensitivity studies on cashflows, projection on demand, property valuations, etc. We actually did this with MTR during the financial crisis. We did a sensitivity study and looked at what would happen if interest rates rose, at what threshold would interest coverage fall to one times.

In our report, we highlighted different scenarios and the risk associated with them. Even though we pointed out that the worst case scenario was the least likely, we thought it was a rigorous approach we should take to help investors assign risk probability. But I know for a fact that the report was one of the least read we have published. Many in the market though it was unnecessary and overdone. In retrospect, I realized they were right and wrong. They were right because investors did not seem to be very keen on issues relating to intrinsic credit quality unless they carry a triple-B minus or double-B credit rating. I do not disagree that KCR and MTR are quality credits, but simply labeling them as quasi-sovereign issues and letting the market technical overtake rigorous credit research, in my view does a disservice to investors and to the issuers.

Another example is Hutchison. Everyone is so negative on Hutchison now because of its involvement in telecoms. I've spoken with some other credit analysts and we all agree it is overdone. But they also concede that it doesn't matter, because that's what the market thinks. We think it is important to look at the company's balance sheet, its cash flow strength and quality especially in port, infrastructure and energy, and the management's ability to adopt and adjust in new market environment and its track record to deliver. But we are running against the consensus that telecom is 'bad'. Although this is not a liquidity issue, but the fact we confirm each other in the market rather than debate each other perhaps is also a reflection of lack of credit culture and discipline.

Yet another example is China Mobile. I can appreciate the fact that the equity market is turning less positive on China Mobile's growth prospects, but does ARPU (average revenue per user) really matter so much for a company whose EBITDA margin exceeds 50%, and has EBITDA interest coverage of more than 20 times? And debt to capital is less than 30%? I am not an equity analyst. I don't care if the company grows 150% or 50% as long as it grows faster than its debt, and grows in a relatively more stable and predictable fashion. After all we are taking credit risks.

But our market seems to have more or less conceded to the equity market: let the equity market taking the leadership. The market performance of many of our credits correlate strongly with the performance of their underlying equity. This may not always make sense. In fact, they should trade inversely with the equities in many cases. But we are sometimes forced to look for guidance from the equity market.

There is nothing wrong in factoring market technicals, following the equity market or even being a conformist, but if we let these peripheral factors overtake fundamental credit research it is a bit concerning in my view. In a way, we credit analysts are not challenged enough by the market, especially in the investment grade sector.

If MTR was a train company in New York and Hutchison was a conglomerate in New York, where would they trade relative to each other?

I think a 10-20bp differential would be justifiable. MTR and Hutch are rated very similarly, but clearly, MTR has more predictable cash flow and the government's indirect support and its role in Hong Kong's economy carries some weight.

Both companies face difficulties of different kinds. Hutchison has to refinance some of its debt in two and a half years - almost $5 billion will come due in 2003-04. Hutchison has to address its capital spending in the telecom sector. And 3G is largely unproven. But Hutch is not a telecom company and its cash flow from ports, infrastructure, energy is quite significant. I find it a little bit frustrating that I have to spend a lot of time explaining that Hutchison is not a telecoms company but few care to listen.

MTR faces its own challenges. Patronage has been declining and the management is still looking for an effective way to reverse the trend. If it was not for a professional, savvy and focused management, the results would have been worse. MTR has some of the best managers in Asia, but they're in a fairly challenging market. It's kind of like being a DRAM chip producer - it doesn't matter how smart you are, because the market has fallen out of the equilibrium and you face over-capacity and price competition.

How do you deal with writing research about two such close Goldman clients?

We are very fortunate to have worked with both companies on the research side, but being close to them should not affect my judgements ultimately. In fact, I find a great deal of mutual respect if I can be straightforward and constructive.

In a recent research report, we recommended investors to go long Hutch 11 and take some profits on MTR 10. It was a relative value call based on fundamental credit research. I got no pressure from the bankers and MTR. I like to think we've been doing relatively okay, in terms of maintaining a balanced research independence.

It's partly because there is a tradition in the Goldman fixed income division of being more sensitive towards research independence. We also face a lot less pressure because winning a bond deal in Asia hinges more on price than it does in the equity markets here. That may have been a blessing in disguise for us. If we are not in the front and centre of securing a mandate, where is the conflict of the interests and pressure?

Is there an example of a piece of research you've written this year where you have seen a correlating market move?

The nearest example was a couple of weeks ago. I made a presentation on the China Mobile exchangeable bond in Singapore and China Mobile's exchangeable bonds tightened almost two points afterwards. I wouldn't credit myself too much. I was just saying the right thing at the right time.

I often see my job as a facilitator. Fund managers and buy-side analysts are quite smart, and my job is to help them focus on the right issues and screen some of the noise. I am not afraid of being in the minority and I like to think investors ultimately favour analysts who have strong convictions on intrinsic credit issues.

Any other successful calls?

We called a switch to high-end investment grade paper, late last year and earlier this year. We made a call to leave BB and BBB and go into high rated paper right before the market started widening. That turned out to be a good and timely call.

What do you find the most effective means of communicating with investors?

I'd be curious to know how my counterparts view this, but I am actually quite disappointed by the printed form. Our reports get disseminated very widely, but I am not sure they get read as much as they could though. Email tends to be pretty effective, but it is diminishing in power thanks to how many emails are being delivered to portfolio managers and buy-side analysts. Many of our clients do read our reports by accessing our website. My company is currently making a substantial investment in revamping the website. Regular users may not be able to recognize it but I think they will find it significantly more user friendly.

Some of the small gatherings we have with investors can be quite effective. We host periodical investor luncheons to exchange our views and discuss some of the pressing credit events and issues. We find the format quite effective and the interactive style mutually beneficial.

One of the most effective ways is remains one-on-one conversation over telephone calls. But that also means we have to stay late because many of our investors are in the US.

Some investors like to be called periodically and others only prefer to be called on the back of significant credit events. There are 25 or so investors that we tend to have a chat with, if not twice a week, then at least once a week. And this group of investors tends to stick around. So that's the core as far as research is concerned.

Some of these are hedge funds?

Actually, I wouldn't really include hedge funds in this core group. In fact, in our research coverage, hedge funds are becoming much less relevant. Presently, the only thing we talk to hedge funds about is Hanvit and Korean sub-debt. Those 25 accounts I spoke of are mostly insurance companies, asset managers and commercial banks.

How often do they trade on average?

It depends. One thing we try to do is help our clients manage their portfolios and meet their return targets. We are working with our salespeople and structuring people to help some of our clients to optimize their returns by re-balancing their portfolio.

Basically, we go to bank A, and say we know you have X billion dollar worth of assets, and we know your credit risk appetite is such and such, and we have the analytical capabilities to help you to achieve X% return without increasing your risk - by helping you to move your portfolio from A to B. That might mean you have to sell 13 credits and buy 17, but that's the way you could get better results without exceeding your risk limits. That's what we're really doing at the moment.