Yet another misguided bond offering from Napocor?

Scepticism greets an RFP (Request for Proposals) for a $600 million issue guaranteed by the Republic of the Philippines.

The Philippines power utility sent out an RFP on Friday for submission by Thursday June 6 in the hope of raising $600 million from a hard-underwritten issue out to 20-years, with a possible bridge in the event that the deal does not take place by a scheduled launch date in July. This latest RFP follows a separate request for a $750 million issue with a partial guarantee by the Asian Development Bank, submissions for which are due by this Friday and is scheduled for launch by September.

The new proposal has been prompted by an increased cash shortfall at Napocor as a result of the government's recent decision to reduce its tariff surcharge, but has been greeted with considerable disbelief by market practitioners. All believe that the deal will be extremely difficult to execute given that Napocor's outstanding bonds are trading at a huge premium to the government curve and will consequently end up costing the government up to $228 million in additional interest payments over the course of a 20-year maturity. Most also argue that Napocor's repeated failure to adopt a similar strategy over the past few years will also harm the credibility of the Arroyo government, which has done so much to repair its reputation in the eyes of international bond investors.

At issue is the fact that while Napocor's bonds historically tended to trade at a 40bp to 60bp premium to the sovereign, they are now as wide as 190bp over. For example, Napocor has a $300 million December 2006 issue, which was bid at Asia's close yesterday (Monday) at 420bp over Treasuries, equating to a yield of 8.8%.

Sandwiching the issue are two sovereign bonds. The Bangko Sentral ng Pilipinas has a November 2005 bond quoted on a bid yield of 6.42% or 321bp over Treasuries and the Republic an April 2008 bond bid at 7.54% or 309bp over Treasuries. In yield terms, Napocor is, therefore, trading 238bp wide of the BSP on a one-year longer maturity and 126bp wide of the Republic on a 1.25 year shorter maturity.

The situation is also similar at the longer-end of the curve where Napocor has a 2028 bond outstanding. This was bid yesterday at 12.58% compared to a 10.6% yield for a 2027 bond issued by the BSP.

The huge spread differential is partly a reflection of illiquidity. The power group removed a large chunk of its outstanding bonds in 2000 through an exchange offering and as it is in the process of being privatized, investors appear to have accorded a further premium on the basis that it will shortly cease to exist as borrower in its own right. Thus while new bond supply may go some way to addressing the issue of illiquidity, it will not alter the fact that Napocor will soon cease to be a regular borrower.

But observers argue that the main reason for the differential stems from investors fundamental dislike of and problem with the credit. On a stand-alone basis, Napocor's financials are very weak and having done little to establish a successful track-record in the bond markets, investors remain wary of potential downside rather than hopeful of prospective upside.

As one DCM head puts it, "This new bond is a crazy idea. You only have to look at the outstanding curve to see what investors will think of it. Napocor has a credibility problem and even though its bonds are sovereign-guaranteed, there is a premium being applied for the execution risk of the guarantee not being paid in a timely fashion in the event of a default."

And a second adds, "Every single bank will pitch for this deal, but they'll only do so because they need the business and dare not tell the borrower what they really think for fear of losing the mandate. But you can almost be certain that whichever banks win the RFP, they will then spend the next month trying to persuade the sovereign to issue in its own name instead."

Many have similar reservations about an issue with a partial ADB guarantee. Based on past supranational guarantees, this is likely to cover principal re-payment, while the sovereign will issue a guarantee to cover coupon payments. Yet bankers argue that although the structure will result in an overall cost saving in comparison to a stand-alone Napocor issue, it would still make much more sense for the Republic to borrow the money itself and then on-lend the proceeds.

"The Philippines is not the kind of credit which needs ADB backing to complete a successful and cost-effective bond offering," says one banker. "It makes it look weak and sends out the wrong signal."

And another comments, "These kinds of hybrid issues are never very popular with investors because they're neither fish nor fowl and never trade. The Philippines normal investor base wont buy it and neither will the ADB's."

Where the $600 million issue is concerned, the deal will cost the Republic an additional $11.4 million per annum in interest payments based on a 190bp spread premium. Over 20-years, this could amount to up to $228 million and over 10-years, $114 million. Why then is the Republic not issuing in its own name and then on-lending some of the proceeds similar to January and March?

In January, it raised $750 million from a 15 put 10 issue and on-lent $250 million of the proceeds and in March, it raised $1 billion and is believed to have on-lent about $500 million. In this latter instance, it was forced to enter the markets after the failure of a $500 million seven-year deal for Napocor that was supposed to carry political risk insurance.

This latter deal, led by Bear Stearns, had also been roundly criticised right from the outset and investors ended up completely pulling the structure apart and then tried to leverage their pricing advantage to the hilt. In the event of a new stand-alone offering, bankers believe they will be able to wield the same pricing power again to the detriment of being able to tighten the spread closer to the sovereign.

But there is also an acknowledgement that the sovereign lies in a particularly difficult position at a time when it is determined to contain its budget deficit. So too, the Department of Finance is likely to be highly protective of a yield curve, which it has successfully re-built after following a policy that has helped spreads to halve from their September 2001 levels. The Republic's benchmark 9.875% March 2010 bond, for instance, has come in from a post September 11 high of 600bp over Treasuries to 277bp over at Asia's close yesterday. The government is likely to be keenly aware that new supply could threaten these levels.

At the beginning of the year, analysts estimated that Napocor had a 2002 funding shortfall of $1.5 billion to $1.65 billion and this amount will increase following news of a further $300 million to $400 million shortfall resulting from an 85 centavos ($1.7) government-imposed cut in the group's Ps1.25 tariff surcharge (per kilowatt hour). The rest of the shortfall stems from a projected Ps34 billion ($680 million) loss because of additional cost relating to its privatization and a drop in power purchased by its major client, Meralco.

On top of this, analysts estimate that the group has $530 million of foreign currency debt falling due during 2002. Based on September 2001 figures, the group is said to have total debt of $7.3 billion, of which about 2% to 3% is denominated in Pesos. Based on EBITDA of $681 million, this equates to a debt/EBITDA ratio of 10.7 times.