What were they thinking?

Who would launch an international bond issue on the day that a record overshoot of the government''s budget deficit is announced?

Enter the Republic of the Philippines.

The sovereign failed to cover itself in much glory yesterday (Thursday) after it sprung a $300 million re-opening of its 8.375% March 2009 bond on the market.

The deal got done and lead manager JPMorgan got extremely lucky, being able to clear the deal at 292bp over Treasuries - the level it had agreed to hard underwrite it the previous day. However, no-one in the market had anything positive to say about the whole process and most suggested that if the Republic wants to re-access the international bond markets later in the year, then this was not the way to go about it.

And in an increasingly familiar pattern, the most extraordinary aspect of the deal was the fee. At 13bp, it not only slashes anything that the Republic has paid before, but that of any non triple-A rated public deal by an Asian borrower as well.

The current transaction marks the Republic's third this year and while the first deal led by Credit Suisse First Boston and Morgan Stanley in January paid 65bp all-in (the standard fee for a non-investment grade BB+/Ba1 rated borrower), the second in March paid 32.5bp gross and 28bp net fees under the lead of Deutsche Bank, HSBC and JPMorgan.

But if anyone thought that JPMorgan was insane to risk so much capital for so little (or potentially no) reward, then it should be borne in mind, that two other bulge bracket firms of the roughly nine banks which bid are said to have submitted hard underwritten proposals at an even lower level.

As one observer reflects, "In the current environment, this is unfortunately what it takes to be competitive and it's what we've all decided we have to do."

Key to the eventual success of the deal was the Republic's sensible decision to downsize the amount from the $500 million it initially envisaged to $300 million. Following the convening an emergency Monetary Board meeting to approve the issue first thing on Thursday, the lead immediately began due diligence and pre-marketing and was able to catch a couple of accounts in New York before marketing the deal in earnest across Asia.

Not surprisingly the vast majority of paper was said to have been placed in the region, with 70% of bonds syndicated in Asia, of which most went into the Philippines and the balance largely Europe, with a couple of orders from the US. About 30 accounts in total participated and receptivity from the Philippines itself was said to stem from a combination of abundant domestic liquidity and less sensitivity to more bad news about the budget deficit.

International accounts on the other hand were far more circumspect. As one investor says, "This was just not the right day to launch a bond issue. They should have waited for a few days to let the market digest the news and then come back."

The government's ability to maintain a Ps130 billion ($2.58 billion) deficit this year was dealt a heavy blow yesterday when it announced that for the first time since 1985 it had recorded a deficit in April, the one month of the year when increased tax collections should ensure a surplus. Year-to-date, the deficit now stands at Ps82.9 billion, compared to Ps28.1 billion over the same period last year. For April itself, the deficit totaled Ps21.76 billion ($429 million) against a Ps9.8 billion surplus in 2001.

And as UBS Warburg concludes in a research report published last night, "In order not to exceed the target, the government will have to run an average monthly deficit of Ps5.9 billion for the remaining eight months of the year, compared with an average monthly deficit of Ps14 billion in 2001 and Ps20.7 billion so far this year."

Pricing of the deal came at 102.05% just inside the 102% to 102.25% bid/offer cash level where the 2009 was trading on pricing. In spread terms, this equated to a level of 292bp over Treasuries, one basis point inside the existing bid/offer spread of 293bp/289bp.

Banks had originally been asked to submit proposals for either a three to five-year issue, or a re-opening of the 2008, 2009 or 2010 bonds by 9am on Wednesday morning using the New York Treasury close of the previous night as the reference price. Bids could either be on a best efforts or hard-underwritten basis.

Later that day banks were asked to re-fresh their bids and JPMorgan was later informed that same night it had won. All agreed that re-opening the 2009 made the most sense for the borrower since it was trading on the lowest cash bid of three existing issues - 102% compared to a 106.2% cash bid for the 2008 and 111.63% cash bid for the 2010.

At the time of acquiring the mandate, the lead's bid was about 2bp inside the outstanding bid of the 2009, but going into Thursday, spreads widened on news of new supply and it slipped to within a basis point of the offer level. Having gone out with pricing around the 290bp area, many then thought that JPMorgan would have to widen pricing out to 295bp to clear the deal, at which point it would have lost all its fees and made no money on the trade at all.

At its lowest point, the 2009 slipped to 101.5% but recovered late afternoon when the deal was downsized and it became obvious it would clear, leaving competitor banks scrambling to cover their shorts. And as one banker comments, "I think one thing the execution of this deal shows is that a wise investor goes to the lead manager and buys the re-offer rather than wait and hope to buy bonds a couple of basis points cheaper from a rival bank, only to find that it's impossible to lift any paper in size because all the shorts have been covered."

For the Philippines, one consolation is that it has completed a bond issue at a record tight spread and does at least now have the cash in the bank. Many also have considerable sympathy with the dilemma facing the Department of Finance.

"As a government official struggling to contain a deficit and initiate spending cuts, it's very hard to justify paying higher fees or risk a high spread when banks are prepared to cut their throats to win business," says one observer.

But equally, many argue that a credit like the Philippines needs to maintain continual access to the markets and engage in a proper dialogue with investors. Most also believe that there is plenty more paper to come, potentially pressurising the middle point of the curve.

Proceeds do not now look like they will be on-lent to the National Power Corporation (Napocor) and this means that the power utility will either return to the market in its own name, or more likely let the sovereign borrow for it. Proposals for a $600 million 15 to 20-year issue were due yesterday and initially coverage officers questioned why the group needed to raise so much.

The government has already on-lent the group $750 million and a further $600 million is scheduled to be raised from an ADB co-financing. This should have covered the group until the government's recent surcharge reduction, at which point the shortfall was said to amount to $300 million to $400 million. Bankers report, however, that Napocor is now saying it may need to raise up to $1 billion from the new deal.

For the Philippines, this latest bond issue must seem like a depressing reflection of how quickly the market can turn against you. Two months ago, the borrower could do no wrong and its spreads were the best performing of any in Asia as investors rewarded the Arroyo government for its ability to manage the economy.

Now as one New York-based commentator concludes, "It's a shame, it really doesn't have to be like this every time for the Philippine government. Even with an experienced banker running the DoF, they have yet to establish a sustained dialogue with the markets. Three weeks ago when their spreads first hit record tights, they were recommended to tap while the market felt good. Now Napocor needs more money than expected, Congress is in disarray and the exchange rate and attendant volatility has spiked up. Hard for research analysts to be anything but bearish."

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