Asia is widely accepted as the most enticing market for asset management growth in the coming decade and beyond. It’s little surprise, then, that the region also hosts a vibrant market for M&A transactions.

This can take a number of forms. One is international businesses seeking to acquire local enterprises, or – where regulation requires – to form joint ventures with them, as is most commonly the case in China. Alternatively, local businesses often acquire one another, or conduct mergers of equals, in order to achieve scale – something that is prominent among the Australian industry funds landscape, for example. Drivers of M&A can include regulatory change and the framework of the institutional investment industry that these fund managers seek to support.

China and Australia dominate M&A in asset management, and China generates by far the most attention.

There are several reasons for this. Firstly, China is obviously the region’s main prize, not so much for the market it represents today but what it is likely to turn into tomorrow. Even after considerable slippage since 2007, the public mutual fund industry in China had RMB2.027 trillion under management at the end of the third quarter, and in brighter economic circumstances is likely to soar. It’s still very clearly an important industry to have a foothold in. Retail mutual funds represent only about 3% of retail investor portfolios, according to research group Z-Ben.

Plenty, though, have already done more than secure footholds. When Essence FMC was established in November, it became the 69^th fund management company active in China. For anyone new seeking to get involved, they must wait for a new licence, and, although six have been established this year (only one of them a JV), it is very hard to know how many more will be licensed and at what pace. A rule of thumb is to wait three years for a new business to be licensed and launched. For foreigners, it can make more sense to find an existing joint venture (there are 36 active) with a foreign partner who wants to exit.

On top of that, regulatory change has driven M&A activity. No domestic fund management company can be 100% owned by one company (although a local company can hold more than 49% in a Sino-foreign JV, in some cases going as high as 80%). Instead, no shareholder can own more than 49% of a domestic fund manager. Consequently many of the bigger local groups have had to sell stakes – either domestically or internationally – and in some cases have opted to change their structure to a JV.

These three trends (potential scale, need to enter an established industry, and regulatory change) are what has made China such fertile ground for M&A.

Perhaps the most striking in 2011 involved China AMC, the biggest local asset manager with almost 10% of all industry assets under management, owned by CITIC Securities. Being the biggest made the China AMC stake difficult to sell, and for some time CITIC found itself in violation of local law because of the size of its shareholding. Eventually, China AMC was banned from new launches until it redressed the problem.

So in 2011, it created five tranches for auction. First, 10% went to Shandong Rural Economy Development and Investment Company, for RMB1.6 billion, and then an 11% stake to South Industry Asset Management Company for RMB1.76 billion. But the most significant sale was the third, in August, since it went to Power Corp, a Canadian financial services firm, for CAD276 million (which at the time was RMB1.78 billion) for a 10% stake. This sale to a foreign house has turned China AMC into another joint venture.

While China AMC, as the biggest, is the most striking example of Chinese M&A, there have been many others besides. Bohai International Trust bought an 18% stake in Orient FMC in 2010, while ICBC announced that Cosco – a shareholder in the ICBC Credit Suisse joint venture – would sell its 20% stake to the bank, with Credit Suisse selling 5 of its 25% stake. The 20% piece cost RMB258.2 million. Southwest Securities, based in Chongqing, bought a 20% stake in Yinhua, another fund management company. Analysts expect other bank-backed JVs, such as CCB Principal, Bank of Communications Schroders and ABC-CA, to see the banks try to up their holdings in future.

The following charts look at the composition of the joint venture businesses in Chinese asset management today.

[Contact Cerulli to see version with charts]

In Australia, one of the main drivers is the pension fund (or superannuation) industry, and in particular industry funds. In an open and highly competitive market for funds, there is a clear need for scale. In early 2011, five separate industry fund mergers were underway simultaneously: First State Super with Health Super, AustralianSuper with Westscheme, LGSuper with City Super, Equip Super with Vision Super, and Non-Government Schools Superannuation Fund with Cue Super. There have been others besides.

While the quest for scale is understandable, it may not always be in the best interests of members. Russell Investments launched a paper in August saying that the cost efficiencies and economies of scale from mergers are not necessarily serving the members of the fund. Issues raised by the paper include ensuring member equity in addressing differing exposure to liquid and illiquid assets between merging funds. Handling varying member balances and managing transparency and accountability principles also raise difficulties. Members are often not given a detailed analysis of expected costs, so can’t then hold their trustees accountable.

Outside these two markets, M&A volumes are lower, but there are several interesting trends underway. India deserves close scrutiny, partly because its own asset management industry has similar demographic potential to China. Here, acquirers of stakes in local businesses, or creators of new joint ventures, have been a widespread group in recent years, from homegrown ambitious businesses like Religare to international heavyweights like Robeco, Nomura, T Rowe Price and most recently Goldman Sachs.

The chart below demonstrates how many of the leaders in international asset management are well represented in ventures of various forms in India today. As with China, a number of different approaches are possible. Some entities carry the name joint venture but are in fact 100% foreign owned, such as those established by Morgan Stanley, Franklin Templeton, ING, HSBC, BNP Paribas, Fidelity and JP Morgan, though the last of those was set up in 2006. Since then, full foreign ownership has also been possible, but they are now termed private sector entities: this approach describes the ventures owned by AIG, Mirae, Daiwa and Goldman Sachs, among others. Still others are true JVs in which the foreign partner ties up with a local, sometimes in a majority stake, sometimes a minority; this is the approach for BlackRock (tied with former Merrill Lynch partner DSP), Sun Life (with Birla), Standard Life (with HDFC), Prudential (with ICICI), and Nomura. Finally groups like T Rowe Price – which holds 26% of a venture called UTI Asset Management – and Robeco and Pioneer (with stakes alongside Canara and Bank of Baroda respectively) have taken a model termed bank-sponsored.

As with China, movements in stakes in these businesses can often be driven by events outside of India. So, for example, Daiwa Asset Management is there not because Daiwa bought in but because it acquired fellow Korean Shinsei Asset Management in 2010. Others change hands because of mergers elsewhere; just as BNP found itself with stakes in three Chinese JVs and was obliged to sell out of two of them following its various financial crisis-era mergers and acquisitions, in India it ended up with two and had to sell its stake in Sundaram BNP Paribas in October 2010.

There is not scope in this article to go into Taiwan and Korea in detail, but both are also important markets for M&A, as the charts below demonstrate.

That’s the backdrop. But should a foreign party acquire a business, or a stake in one, rather than building organically?

There are clear arguments on both sides. It can be extremely hard to launch a greenfield business in many emerging markets. The process of licensing can be opaque and time-consuming, and, once achieved, it is very difficult to start from scratch in an intensely competitive field – none more so than China, but also in established markets like Korea and Taiwan. That’s a clear argument for buying into a business or JV: access to existing client base, infrastructure, and local knowledge, with the opportunity to revamp or improve an existing product range, rather than having to launch and market a whole new one.

On the negative side, it can be frustrating to be the minority partner in a joint venture – and in several markets, China among them, that’s as good as it’s going to get in the near term. There is no opportunity to exercise leadership and to drive the direction of a business. That’s not so much of a problem if the local partner has the right strategy. But no venture ever takes place without some internal friction. Additionally, in competitive markets like China, the costs of acquisition are getting steadily higher, as the China AMC sales show; in a slowing market, no matter how much potential it has, that’s a difficult situation in which to thrive.

China, it’s widely agreed, is the new engine of world growth. But it’s an engine that might need some tuning. As one industry after another – banking, telecoms, resources – gains new global champions from mainland China, some less esteemed names and practices are being pulled into the international spotlight along with them.

Bankers are watching this with some alarm, but really it’s international accountants who have most to worry about. So far this year, three of the big four accountancy groups have either been caught up in controversy about their overseas-listed clients’ accounts, or have stepped away from a client out of growing concern about their books.

The biggest incident involved Sino-Forest, a Chinese timber company that listed on the Toronto Stock Exchange in the 1990s and grew to become one of the largest forestry groups listed in Canada. It appeared a success story, raising more than C$3 billion in debt and equity over the years and reaching a market capitalization of C$6 billion by March this year, reporting almost C$400 million in profit for 2010 from a 780,000 hectare forestry portfolio in China. But following a damningly negative research report from a hedge fund, triggering a share price plunge, it was suspended from trading by the Ontario Securities Commission in August for acts intended to “perpetuate a fraud” – specifically, that it didn’t have the assets it said it did, nor the profitability. It’s now also being investigated by the Royal Canadian Mounted Police. Ernst & Young has been named in two class action lawsuits around Sino-Forest.

Elsewhere, big four accountants have started to become wary of their own clients. In May Deloitte stepped aside as auditor of Longtop Financial Technologies, a financial software provider from Xiamen, citing concerns about its accounts. In what is surely one of the most self-abrasing press releases ever assembled, Longtop itself said Deloitte had quit after identifying false financial records on cash and loan balances, the deliberate interference by Longtop management in Deloitte’s audit process, and the unlawful detention of Deloitte files. Deloitte itself has been sued by the SEC over turning over documents on Longtop, but says it has not been allowed to do so by Chinese regulators; Longtop itself is now facing administrative proceedings from the SEC.

And in January KPMG said it had found possible irregularities in the books of China Forestry, which is listed in Hong Kong; China Forestry’s shares were then suspended. Other problematic examples include Nasdaq-listed RINO International, which makes pollution control equipment, but admitted in March that two previously reported contracts didn’t exist (it has since been delisted); and Duoyuan Global Water, listed in the US, which has been suspended after it borrowed money from related parties and booked it as sales.

It’s hard to say how widespread this problem is, but some estimates are troubling. A Moody’s report in July assigned red flags to the corporate governance of 61 rated Chinese companies, including some big names like Hong Kong-listed Winsway Coking Coal. It spoke of “the inherent challenges in assessing these Chinese companies: their short history of operations, their diverse industries with limited peers for comparison, their concentrated family ownership structures, and their high-growth environments.”

But however widespread, it is causing a major challenge for the bankers and, in particular, the big four accounting firms who have worked long and hard to build businesses in China. Auditing Chinese firms who are readying themselves for international listing is a lucrative source of revenue. But at what risk?

At the very top level, there’s no obvious problem; corporate governance at some Chinese blue chips is in line with international best practice. The problem comes in smaller companies, often private sector seeking to float on the rising tide of investor interest in the China story. Here, auditors face a challenge: stick with the big names they are comfortable with, and forsake other revenue? Or spread the net wider and run the risk of it catching unscrupulous companies?

“My personal view is that the big four may step away from some high risk Chinese clients for the sake of their own reputation,” says Helen Yang, lecturer in accounting at Victoria University, who is working on a study of Chinese convergence with the IFRS international accounting standards. “If you look at those cross-listing companies controlled by the central Chinese government, a majority of them have the Big Four as auditors. To protect themselves, perhaps in the future they should have their own niche targeting these big Chinese companies rather than focusing on revenue accumulation only.”

But that would be to abandon a vast source of revenue: the private sector constitutes an ever greater part of the potential revenue pool for accountants in China. All four of the big four names declined to comment on this story; however, before they all stopped talking, Paul Winkelmann, the partner in charge of risk and compliance for PWC in Greater China, was quoted as saying “costs have gone up, fees have gone down, as competition for fees is enormous. You can easily see there is a real risk of an audit firm failing.” Another big four auditor in China, asking not to be named, says: “I wouldn’t say we have changed our procedures exactly. But people are being careful.”

The generous interpretation of recent malfeasance is that it represents teething problems in Chinese corporate engagement with the world. “The way we read what’s going on in China among these smaller companies is that clearly many of them are relatively new to being listed, and aren’t entirely sure what they should be doing,” says Jamie Allen, founder and secretary-general of the Asian Corporate Governance Association. “We see some companies listing in Hong Kong, private Chinese companies that have only been in operation for a few years. If you look at governance, track record and continuity, it often raises lots of questions. If these are to be allowed to list on overseas exchanges, then it is absolutely to be expected that some are going to run into problems.”

Allen says this is not new – several years ago many companies listed on Nasdaq were sued for disclosure problems. “There has been a certain history of Chinese companies listing in the US then not fully disclosing material events and issues, then being sued through class action law suits.” But one of the things that is new is the scale of institutions that are being caught up, and that is turning it into a matter of concern for international regulators. Fidelity, for example, held 14.5% of Longtop’s stock as of its last filings on March 31, with major hedge funds also well represented. John Paulson, famous for spotting the problems in mortgage- backed securities early and making a fortune from them, was a Sino-Forest investor – selling out before suspension but at a heavy loss.

It has been sufficiently alarming for the US audit watchdog, the Public Company Accounting Oversight Board (PCAOB), to send a team to Beijing in July, for what was subsequently billed the “Sino-US symposium on audit oversight”. This pledged closer cooperation, and arranged for Chinese officials to come to the US in October; beyond that, PCAOB spokeswoman Colleen Brennan told IFR: “The PCAOB does not talk about any open enforcement investigations. Our recent trip to China was to talk about opening China to PCAOB inspections of auditors that are registered with us.” Elsewhere, the Ontario Securities Commission is to review all companies listed in Canada with significant business operations in emerging markets, focusing on roles played by auditors and underwriters.

One common pattern in all of this has been that companies have often listed through reverse takeover, or back-door listing, which have less onerous standards than a whole new listing; this was the case with Sino-Forest, for example (although not Longtop, which raised US$210 million in an IPO in New York). PCAOB published a study in March which identified 159 Chinese companies that had listed on US capital markets alone through reverse mergers between January 2007 and March 31 2010 – and that’s without looking at Toronto, which has many more. That’s almost three times as many as the 56 Chinese companies that launched US IPOs during the same period. Between them, the 159 back-door listed companies had a market capitalization of $12.8 billion as of March 31 2010.

While the US and Canada allows this approach, Hong Kong has banned any attempt to get around listing requirements through a reverse takeover. “The US allows back door listings, which effectively means you do get much riskier companies,” says Allen. “In Hong Kong we started controlling these back in 2004. If you do a back door listing the exchange is not simply going to let that through; it treats it as an IPO and holds you to the same standards.”

“In the US there is a whole cottage industry of investment banks, accountants, auditors and law firms who specialise in these back door listings,” he adds. “Our problem with that is, they effectively undermine the IPO process and investor protection.”

The problems have come at a time of dramatic evolution in China’s domestic accounting industry. China is in the process of entering a new accounting regime, called Chinese Accounting Standards for Business Enterprises, which are largely in line with IFRS. CASBE was announced by the Ministry of Finance in 2006, and a roadmap for further convergence with international practice was released in 2010.

Are challenges in Chinese disclosure related to this evolution? Professor Colin Clark, also at Victoria University and co-author of the Chinese accounting study, says that the varied quality of reporting is “a consequence of the stage of development of the profession. There are issues in the adoption of IFRS, issues around translation into a foreign language, and the shift from a more prescriptive basis of standard setting to a more principle-based system.” This inevitably gradual process of on-the-ground transition is a bigger problem than the regulatory infrastructure above it. “I don’t think the problems we’re referring to are problems of an absence of professional framework. The standards are in place. The problems are around implementation and enforcement.”

On top of that, there are clear issues around staffing. “The challenge is enormous,” says Clark. “The industrialization of the country has meant there has been enormous demand for accounting professionals, and a real challenge in producing sufficient graduates.” Other issues may be cultural – less willingness to speak out in a hierarchical structure, for example. (The Chinese Institute of Certified Public Accountants refused to answer IFR’s detailed written questions on the profession and what is to be done about disclosure issues.)

Even if big four groups are expected to have world-class standards in their accounting, there is some sympathy even at this level for those who have been duped by dishonest companies. “Even among state enterprises there have been significant frauds where bank statements or invoices are fraudulent, where a whole web of fraudulent deals has been set up with suppliers, customers and banks,” says Allen. “If you’re auditing that, it can be extremely difficult. On a typical audit you assume the documents companies are giving you are legitimate, so you’re cross-checking the trading and transactions the company is doing with the bank statement. Most are not forensic audits; that would cost a lot more money and effort.”

It should be said, too, that big four accountants resigning from auditing their clients’ books is not really a bad reflection on the accountants themselves; indeed, it’s what they should do. But nevertheless they find themselves in a challenging position with some tough decisions to make around, expansion, revenue, reputational risk and strategy. The coming years will be interesting.

Sidebar: The muddy waters of disclosure

A central character in recent Chinese accounting issues is a man called Carson Block, who founded a research firm and investment manager called Muddy Waters. The name comes not from the blues singer but a Chinese expression: Muddy waters make it easy to catch fish. In other words, there are opportunities to make money when things are opaque.

Block’s strong sell recommendation on Sino-Forest on June 2 set in motion its share price collapse and subsequent investigations and law suits. He really doesn’t pull his punches: the report, at a time when the company’s stock was riding high, said:  the company “was aggressively committing fraud since its RTO [reverse takeover] in 1995”, and was “a multi-million dollar ponzi scheme, accompanied by substantial theft.” More specifically, it claimed the company had dramatically overstated its forestry holdings and passed revenues through a host of intermediate companies in order to confuse auditors.

A look at the Muddy Waters research list shows only strong sell recommendations, in all cases on companies where fraud or at least mismanagement is alleged: Orient Paper, RINO, China MedicaExpress, Duoyuan Global Water. In Block’s view, fraud is widespread in China, and the big four firms face great challenges in detecting it. One of his central points is that a company can, in a sense, fake transparency, in that it provides a great deal of information but not the right sort. He argues that auditors might be looking for aggressive accounting, but not a situation where the underlying business doesn’t even exist.

There is another side to this coin though. Block is not just a good governance advocate in the mould of renowned Hong Kong gadfly David Webb, or Allen’s ACGA; he is there to make money, and in every instance has built a short position in the stocks he then hammers in his reports, profiting from their subsequent share decline. Block is open about this: whenever interviewed, he points out himself that he is conflicted.

But the power of raising a red flag can be very destructive. Raising doubts about accounts is all but guaranteed to knock a share price hard, providing gains to anyone shorting the stock. The latest name to appear is Silvercorp Metals, a Toronto-listed company, accused by an anonymous whistleblower in early September of a “potential accounting fraud” worth $1.3 billion. Silvercorp has strongly denied this, publishing many documents to support its accounts; it has retained analyst support, such as broker BMO, which maintained an outperform rating on the stock after the allegations; it has apparently come out of a KPMG forensic audit looking clean; and as yet the Ontario Securities Commission has taken no action. No matter, the share price fell 10% in a day anyway when the allegations were made; its management said there had been a dramatic increase in short positions on its shares in the previous two months.

And this is a central point: there’s actually nothing new in irregularity in accounts for overseas-listed stocks. What’s changed is scrutiny. “The difference is people like Muddy Waters and other hedge funds are realising there are problems, short selling, putting out reports and publicly criticising,” Allen says. “They are essentially taking advantage opportunistically of a problem that is real, but I don’t think you would necessarily find in every PRC company listed in the US.”

TENCENT

Chinese internet group Tencent Holdings completed a $600 million deal this week – the first internet company from anywhere outside the US, never mind China, to sell a dollar bond – in a transaction that was impressive for being completed in a difficult market, but baffling for its timing.

The issue of five-year bonds priced at 375 basis points over Treasuries, the tight end of 375-387.5 guidance, but widened significantly after launch.

Tencent is an interesting and exciting company. While the sense of ‘China’s Google’ has proven an appealing draw in the equity markets, Tencent is actually a more diversified group, earning roughly half of its revenue from online gaming and being particularly well known for an online instant messenger product, QQ, with over 700 million subscribers – not far short of Facebook’s subscriber base. A search engine is a large part of the company’s potential, but advertising represents only 7% of Tencent’s revenue compared to over 20% for Google. “There is a huge captive audience already, and the company will look forward to better synergies between product lines,” said someone familiar with the company.

None of that is in doubt, but few in the market could understand quite why a cash-rich internet company, a debut borrower, in an uncharted sector, would pick this of all markets in which to launch a bid for non-essential funding. “It was never clear to me why an internet company needs that much money,” said one banker, not on the deal. “They wanted $750 million [believed to be the initial target] for what exactly? General corporate purposes was the stated use of proceeds, but I don’t get that.”

Those close to the deal agreed the need for funding was not obvious, but said it makes sense in the context of global peers. “These companies are typically incredible cash rich,” said one. “Microsoft did its debut bond in 2009”, whenit had $25.3 billion in cash and short-term investments. “Bill Gates was asked why he was issuing, and he said as a tech company you prefer to have loads of cash on the balance sheet.” Google, similarly cash-rich, has also issued. “It’s the same reason Tencent is doing this: there is a rates environment that offers them the opportunity to lock in funding at a compelling coupon.” This banker also noted that Tencent has operations offshore – it has bought businesses in Thailand, for example, and has operations in India – and the movement of cash offshore from China is not straightforward. “The bond gives the ability to fund mature operations offshore, and also repays some offshore loans and short term debt. Beyond that, there are potential acquisitions as well. It’s a mixed bag.”

But why now? “With $2 billion available [its net cash position is $2.4 billion], this is not a company that needed the money,” agreed one banker close to the deal. But, since the completion of a global roadshow several weeks ago, the company had been watching the markets closely. “In Europe you see windows open and close with maybe one day a week that’s superb for issuance, and the rest pretty negative. They were looking towards next year and saying: what’s the chance that January is going to be any better? There are a lot of big redemption spikes coming for sovereigns in Europe.

“Could they have waited six months and had another window? Potentially, but a trade was on the table at a price that was OK for them, and they managed to achieve $600 million. For a debut borrower, that’s a big-size transaction.”

The deal certainly stood out from the other deals that have thrived in difficult markets in recent weeks, chiefly top-drawer Koreans and other big names such as ICBC or the Indonesian sovereign, all of which have long track records in the dollar markets and loyal followers in the investment community. “This is an interesting time of year to be bringing a new sector and debut borrower,” said one banker. “For China overall, it was incredibly front-loaded in the first half of the year. Then you had the problems in May around Sino-Forest, and so on. China had an interesting ride this year, with corporate governance being the focal point; fair play to management in overcoming that difficulty and being the first Chinese corporate to issue [in dollars] since May.” And the internet sector is not even well-trodden by European issuers, let alone Chinese. “It was an entirely new sector for emerging market investors as well, who obviously haven’t bought the likes of Google and Microsoft.”

In the circumstances, although the $750 million-$1 billion levels mooted during the roadshow were not achieved, joint global coordinators Goldman Sachs and Deutsche Bank (with joint bookrunners Credit Suisse and HSBC) did well to get the deal away at all; pricing, with no obvious comparables, took in mind a range of reference points from US internet players to Chinese SOEs and major shareholder Naspers (a South African company with 35% of the company). The deal eventually sold 45% to the US, 45% to Asia and 10% to Europe. “This is an emerging market buyer base: you’re looking at the big macro EM funds,” said one banker.

But once out of the blocks, things quickly turned south. After pricing at 375 basis points it went as wide as 392 basis points after pricing, and yesterday [Thursday] was being bid at around 388. Partly, this is mitigated by deteriorating conditions as the deal was being concluded. “We priced this at 4.30 in the morning on Tuesday Asia time; S&P had come out with a negative outlook on the 15 European sovereigns at 2.30, so at the back end of the process there was negative sentiment in the market,” says one banker close to the deal. “The follow-through after that wasn’t too bad, but the initial reaction was pretty negative.” That said, the bonds widened further than the broader market after launch, before improving yesterday morning. “It’s slightly wide of re-offer, but at this time of year when liquidity is pretty think, that amplifies problems,” said one banker. “This is a different type of credit, and banks have significantly downsized credit trading in Asia.”

The transaction was also interesting for highlighting variable interest entities, or VIEs – fairly commonplace in Chinese deals but increasingly in the spotlight given the governance issues at many Chinese companies this year. In offshore listed companies like Tencent, which is listed in Hong Kong, VIEs hold the licences necessary to conduct business. There is some concern about what happens if there are regulatory changes in this area, and in particular if foreign owners could find their assets (notably intellectual property assets or licences) moving from one structure into another without their control. To mitigate this concern, Tencent included a change of control clause for any change of law around VIEs.

These issues have become increasingly important in China this year. “For any deal, ultimately the closer you are to the asset and the more transparent the ownership structure, the better,” said Bryan Collins, portfolio manager for fixed income at Fidelity. “If you do not get that level of comfort, then you need to be sure you are getting adequately compensated, and if not then you should question whether to participate.”

Others had different concerns. “I didn’t participate in Tencent,” said one investor. “The risk of this bond was not in the issuer’s business fundamentals, which are in fact quite strong, but with the likelihood of a follow-on acquisition and the potential for more debt issuance. That is what turned us away because at this time it is not possible to gauge the size of these material risks.”

The bond had a coupon of 4.625%, reoffered at 99.74 to yield 4.684%. The change of control clause involves a put at 101 if any party, Naspers aside, builds a stake of more than 35% of the company.

HANA

The appetite for top Korean financials was illustrated once again on Thursday morning, Asia time, as Hana Bank’s books were almost nine times covered on a $500 million, 5.5-year trade.

The Reg S/Rule 144a senior notes tightened heavily from guidance of 370 basis points over five-year treasuries to price at 345bp. The notes carried a coupon of 4.25% and priced at 99.458 to yield 4.362%. Like many recent deals, this one was completed quickly. “This was perceived to be a one-day execution, with almost no rolling off into the next day; that’s consistent with almost everything we’ve seen this year,” said one person close to the deal. “The issuer had a preference to do something this side of Christmas, and possibly to take advantage of a let-up in supply.” It also benefited from reasonably benign sentiment towards Europe, and also from a Standard & Poor’s upgrade for Hana Bank on the morning of the deal.

Initial guidance was, one banker said, “a fairly generous starting point,” which after allowing for about 15 basis points to cover the difference between a 5-year benchmark and a 5.5 year deal, equated to a new issue concession of about 40 basis points. Final pricing was more like a 15 basis point concession. “Starting as we did [with generous terms, then tightening guidance] is in line with how you’re seeing deals getting done,” said one banker. “Hyundai Motors last week had to do a similar thing to get books up to a decent size.”

The books in the end were more than decent. Like Hyundai Motors, this was capped at US$500 million; aided by the scarcity value, the books eventually closed at $4.4 billion from 259 accounts, although not all of that book represented investors who stayed in at lower pricing. By region, 67% went to Asia, 18% the US and 15% Europe; by investor type, 62% went to funds, 14% banks, insurance 9%, central banks and public institutions 7%, private banks 4%, and others 4%.

Barclays Capital, Bank of America Merrill Lynch, Citi and HSBC were joint bookrunners on the deal. In aftermarket pricing yesterday it was being quoted at 344 bp, marginally inside its launch price.

FUTURE

So, is that it for the year? Issuers and investors do not expect many more significant trades before Christmas, although some may squeeze through.

Of well-flagged deals, the only outstanding one from Asia is an expected deal from Reliance Industries, covered in previous editions of Euroweek. The Indian issuer has appointed Bank of America Merrill Lynch, Citigroup and UBS on a deal widely expected to be a 10-year bond raising around US$1 billion, but those close to it were coy about its likely timing yesterday.

And time is running out for anything to be launched quickly. “Hana was definitely one of the last on our calendar,” said one banker. “There are always things on the backlog, but the reality of getting something priced next week becomes more difficult.” Anything that does price next week will have a settlement date in the week of the 19^th, when many people are leaving the office and shutting down books.

Investors are not expecting much more issuance. “I expect the primary markets to be generally quiet as we move further into December,” said Scott Bennett, head of Asian credit at Aberdeen Asset Management. “There will likely be another few deals from existing issuers that offer a good new issue concession, but I wouldn’t expect an inaugural issuer.”

Another investor added: “Any new issues between now and the end of the year are likely to be opportunistic in nature.”

That said, a piece of good news from Europe would open a window for a fleet-footed borrower. Friday’s EU Summit will again be crucial for market sentiment. “Tonight will be the start of what promises to be a volatile yet fascinating journey for the single currency,” said Stan Shamu at IG Markets [speaking yesterday, ahead of the ECB’s rates decision]. “There are many highlighting that the next few days are pivotal, not just for the fortunes of sovereigns, but the entire banking system.”

Elsewhere, there is a sense that there is still room for one or two more dim sum borrowers to access the market before the year-end, even though the supply-demand dynamics have shifted markedly in that market during the course of the year. Dim sum issues have frequently managed to get away despite bad news from the eurozone.

ICBC

A long-awaited deal from ICBC successfully cleared the market late on Wednesday, enticing investors with the first true exposure to a mainland Chinese bank in an international bond market.

The US$750 million 10-year senior unsecured bond, issued by a vehicle called Skysea International Capital Management, was guaranteed by ICBC’s Hong Kong branch. This is a crucial distinction: Hong Kong is a full branch and represents exposure to the parent, whereas all other deals from mainland Chinese banks in the dollar markets have been through subsidiaries such as ICBC Asia or Bank of China (Hong Kong), giving exposure instead to Hong Kong subsidiaries. “This transaction provides the market with the very first direct exposure to the Chinese banking space,” said someone close to the deal. “All the other names are quasi, pseudo Chinese banks.”

Perhaps for this reason, the deal was marked by far higher than usual participation from Asian insurance companies. 95% of the deal went to Asia – Europe and the US represent no happy hunting ground at the moment – with insurers representing 33% of the book. “It’s not common at all to allocate one third into insurance,” said one banker. “They are buy and hold, high quality accounts, so we wanted to give as much bonds to them as we could, and we managed to find quite a number of anchors from insurance companies.”  Banks took 29%, fund managers 25%, private banks 8%, and corporates and others 5%. “It’s a unique opportunity for insurers to get direct exposure to the Chinese banking sector, and there are not many 10 year issues – insurance funds prefer that longer duration to match their liabilities,” the banker said.

For some weeks, market talk has been about ICBC’s willingness, or otherwise, to accept the price necessary to issue in such a challenging market. In the event they came at 310 basis points over Treasuries, inside guidance of 320, and proved popular, with an orderbook of over $2.25 billion from 160 accounts. “The issuer clearly has been very price conscious,” said one banker close to the deal. “They did the roadshow back in October and they have been monitoring the markets. It’s been very volatile.”

UBS, Barclays and ICBC International were joint global coordinators, alongside HSBC and Standard Chartered as joint bookrunners, on the Regulation S deal, which carried a 4.875% coupon with a re-offer price of 97.708%.

This week has looked brighter for debt markets after a miserable and volatile spell, although it remains to be seen how long it lasts. “I think the window has been open since the start of the week,” one banker said. The global joint intervention by central bankers is felt to have had a bigger impact on equity markets than debt markets, but “in the credit market we do feel better as well,” a banker said. ICBC moved in about 10 basis points on Thursday morning from launch, in line with the broader market.

An illustration of the improved conditions was a deal in the market as Euroweek went to press for Hyundai Motor Company, through its Hyundai Capital America vehicle. This 5.5 year 144a/Regulation S deal was capped at $500 million, and expected to raise that amount, in a deal through Bank of America Merrill Lynch, BNP, HSBC, JP Morgan and Morgan Stanley. It was being offered at guidance of 345 basis points over five-year treasuries as of Thursday afternoon, Asia time. The 5.5-year tenor is becoming more commonplace in Asia; KDB launched a $1 billion deal of that duration in October, and a subsequent bond from Bank of East Asia was 10.5 years with a call at 5.5.

Other deals expected from the market do not appear ready to launch. Reliance Industries has appointed Bank of America Merrill Lynch, Citigroup and UBS as lead managers on an expected US$1 billion 10-year; someone close to the issuer said they were “still watching and waiting” last night. And Chinese internet company tencent has completed a worldwide roadshow, concluding in New York, for a Reg S/144a dollar deal of its own through Deutsche, Goldman Sachs, Credit Suisse and HSBC, but yesterday the leads were “continuing to monitor the market”.

DIM SUM

The dim sum bond market continues to break new ground after last week’s landmark Chinese corporate issue from Baosteel. This week brought a new issuer and the first mandate to Latin America, even as the CNH deposit base in Hong Kong declined.

The new issuer was BMW Australia Finance, whose RMB400 million one-year deal was the second from an Australian corporate after Fonterra, which launched a RMB300 million three-year deal in June.

The deal paid a coupon of 2.4% and was re-offered at 2.4%. BNP Paribas was sole bookrunner on the deal.

Further ahead, the Mexican telecommunications group America Movil will hit the road next week for a dim sum bond of its own – the first from Latin America. It is understood the company, owned by Carlos Slim, will meet investors in Singapore on Monday and in Hong Kong on Tuesday, with HSBC as sole arranger.

While demand for these securities has generally outweighed supply in the market’s brief history, in October the CNH base – RMB deposits in Hong Kong – declined modestly. Deposits stood at RMB618.5 billion, down 0.6% from RMB622 billion in September, in a reversal of the often exponential growth in deposits over the last two years that has frequently hit 10% per month. That said, analysts had expected worse, with HSBC calling the decline “not as much as we originally expected” and saying “the fact that CNH deposits and trade settlement activity only declined modestly gives some comfort about the overall resilience of the offshore RMB system, as a vehicle for RMB internationalization.”

The deals follow last week’s RMB3.6 billion dim sum bond from Chinese state-owned steelmaker Baosteel, the largest corporate dim sum bond to date and a clear illustration that no matter how bad the global macro picture may become, there is stout appetite for the right Chinese names in RMB. That deal included three tranches from two to five years, all of them oversubscribed and all at the tight end of guidance. It attracted a total book of almost RMB9 billion from 200 orders.

Baosteel was the first example of a group that are expected to be regular issuers: PRC state-owned companies issuing in their own legal form rather than through an offshore company or vehicle.

GLP

Singapore’s Global Logistics Properties, a company backed by the GIC sovereign wealth fund, launched a S$500 million perpetual hybrid on Wednesday in a deal marketed carefully around its name appeal to Singaporeans.

The deal, which priced at a 5.5% yield, went mainly to Singaporeans – who took 92% of the paper – and within that, mainly private banks, who accounted for 78% of the deal, well ahead of fund managers and banks with 10% apiece. The coupon equates to 420 basis points over five-year swaps.

GLP is considered an exceptionally strong name in Singapore because of its GIC links; its 2010 IPO in Singapore was one of the biggest ever in the city state, despite the fact that its holdings are all industrial and logistical properties in China and Japan with little connection to Singapore. Those close to the deal claim the pricing was as much as 3% lower than would have been achieved in the dollar bond markets, if a deal could have been done at all. “If you look at an investment grade name like China Resources Power as a guide, then [for GLP in dollars] it would be very high single digits now, 8% plus,” says one banker. “In fact this deal couldn’t have been done in dollars at all a couple of weeks ago, or before this week’s central bank liquidity measures.”

From the local investor perspective, perpetuals offer much better yield than many fixed income alternatives in a low interest environment – Cheung Kong was another recent example of a Singapore dollar perpetual issuer. JP Morgan was sole global coordinator, with Citi, Goldman Sachs and DBS joining it as joint bookrunners.

“An insight gained from Cheung Kong was that it was clear private banks were going to be a dominant part of the distribution,” said someone close to the deal. “In this deal, we enhanced the appeal to the institutional investor base, which played a greater role in this than in Cheung Kong.” It was challenging to find a suitable comparable to price from; one approach was to calculate what the borrower would pay for senior debt in Singapore dollars, and then add suitable yield for the paper’s subordination. “Investors were looking for direction from us on pricing,” said one banker. “But Singapore accounts are very happy with 5%-plus yield and a good investment profile. They have money in the bank earning zero: if they want to earn 5%, they can take a flyer on a risky name, or buy subordinated paper from a name they are comfortable with.”

The deal cannot be called in the first five years but is very likely to be redeemed thereafter, as the bonds lose their 50% equity treatment from April 2017, at which point they will no longer be helping the issuer to reduce their debt to equity ratios.  After 10 years there is a 100 basis point step up, but the bonds are highly unlikely to be outstanding beyond that date.

KOREAN AIR

Korean Air closed a US$300 million asset-backed deal this week to enliven what has been a quiet period for securitizations from Asia.

Standard Chartered was lead manager and sole arranger on the issue of secured floating rate notes, the first dollar securitization of passenger ticket sales by the airline. Most of the receivables are from KAL’s North America routes. KDB was credit facility provider and swap provider on the deal, a move that clearly helped in this volatile environment, giving investors comfort that they were effectively taking KDB risk.

The transaction matures in October 2014 and offers a floating rate coupon of one month dollar libor plus 200 basis points. Standard Chartered’s global head of structured financing solutions, Warren Lee, called it “very competitive pricing despite the continuing market turmoil.” The receivables have a weighted average life of 1.5 years, and the notes were rated A1(sf) by Moody’s. The notes are listed on the Irish Stock Exchange.

KAL is a reasonably familiar name in the asset-backed markets despite never having issued in dollars before; the transaction is its sixth cross-border ABS deal, and follows five previous deals in yen. Moon Kwon Oh, general manager and head of the financing team at KAL, said it was “meaningful for the company that this transaction is backed by USD denominated assets for the first time.” The deal is understood to have had considerable overlap with the investor base of KDB’s own $1 billion 5.5-year global bond in October.

Observers found two points of significance in the deal. One was that a dollar securitization was taking place at all in such difficult markets, although it was not clear that there was a pipeline of similar deals looking to follow. The other was curiosity about the approach of KDB, whose role as credit facility provider on this deal follows a guarantee on a $350 million bond for Doosan Heavy Infrastructure last week. It will be interesting to see if KDB offers further guarantees and facilities as a means of raising additional fee revenue in the months ahead.

DIM SUM

Issues from Orix, Baosteel and Shougang Corp this week showed that there is still appetite for dim sum bonds, even as world capital markets turn increasingly nasty.

Yesterday Baosteel, the Chinese state-owned steelmaker, raised xxx in a three-tranche issue lead managed by Deutsche Bank and HSBC as joint global coordinators and bookrunners, with China Merchants Securities, DBS, ICBC and Standard Chartered as joint bookrunners.

The deal was significant because it was the first mainland company to issue an offshore RMB bond. Numerous mainland entities have issued offshore, but until now always through an offshore vehicle. A recent change of regulation permitted onshore borrowers to raise funds in this way, and bankers expect to see many more issues from mainland enterprises in this market.

Its success was hearting to investors, with a total book size of xxx. “It was enormously well received,” said someone close to the deal. “There was standing room only at the roadshow lunch in Singapore, 130-odd people in Hong Kong. Baosteel is huge, one of the pre-eminent producers in China, and being owned by SASAC it’s seen as a strategic company.”

The deal was made of three benchmarks. A two-year deal was offered at a range of 3.125% to 3.375%, and priced at x; a three-year bond came with guidance of 3.5% to 3.75% and priced at x; and a five-year tranche was offered at 4.375%-4.625%. Yesterday morning there was talk of a deal as big as RMB6.5 billion, since the company had been given approval to raise up to that amount, but those close to the deal said a more realistic target had been about RMB4 billion.

The bonds, expected to be rated A3/A/A- by Moody’s, S&P and Fitch in line with the borrower rating, carry a change of control clause with a put at 101% if state ownership (through SASAC) falls to 50% or below.

Also yesterday, another steelmaker, Shougang Corp, priced an offshore Reg S reniminbi bond in Hong Kong, raising RMB1 billion in a two-year transaction. This deal priced at 4.875%, in line with guidance, and was lead managed by Bank of China International, Citic Bank International, DBS, ICBC Asia, JP Morgan and Wing Lung Bank. The deal was unrated.

The Baosteel deal followed a RMB500 million three-year issue from Japanese Orix Corp earlier in the week. This was Orix’s second issue in the market, and being a repeat issuer clearly helped the deal get away smoothly, but attracted inevitable comparisons with its outstanding paper: Orix priced at 4%, while outstanding bonds due March 2014 were paying 3.35% – having been launched at just 2%. Joint bookrunners on this deal were ANZ, BNP Paribas, Credit Agricole, Daiwa, Mizuho and Standard Chartered. “Orix were cognisant of the new issue premium payable and it was not a problematic trade of any sort,” said one person close to the deal. “A well known name, repeat issuer; a nice easy one to get away.”

52% of the paper went to Hong Kong, 39% to China/Taiwan and 9% to Singapore. Insurers were the largest group by investor type, taking 49%, followed by private banks (24%), funds (19%) and banks (8%).

HYBRIDS

Australia’s regulator yesterday warned consumers about dangers in hybrid securities, in a move that seemed timed to coincide with the delay of a hybrid issue from Origin Energy.

On Tuesday, Origin began a bookbuild process for a A$500 million hybrid notes issue through ANZ, Commonwealth Bank of Australia, National Australia Bank, Macquarie Bank and UBS. The offer was due to open for retail investors the following day, but instead Origin announced that ASIC had extended the exposure period for the prospectus by seven days – that is, increased the length of time for study of the prospectus before the formal opening of the deal. Origin said: “The extension will allow ASIC to consider further the terms in the prospectus, including aspects relating to the mandatory deferral of interest payments.”Origin said it had received “very strong investor demand” for the notes, and said it and its advisors were “in discussions with ASIC with a view to resolving this matter as soon as practicable.”

Then, just before 6pm Sydney time, yesterday, ASIC put out a statement asking consumers to make sure they understand the conditions and risks of hybrid securities and unsecured notes before investing. “With considerable volatility in equity markets, many investors are looking for alternative investments, including debt and fixed interest securities,” said ASIC. “However, some of these alternatives need close scrutiny before the decision to invest is made.”

The announcement quoted ASIC chairman Greg Medcraft as saying: “In some cases investors are taking on equity-like risks but only receiving bond-like returns. Investors need to understand the conditions of these offers, such as terms and conditions that allow the issuer to exit the deal or suspend interest payments, and long term maturity dates of several decades.” The Origin notes have a 60-year maturity but are callable from 2016, with a 100 basis point step up if they have not been redeemed after 25 years.

Approach by Euroweek, an ASIC spokesman said: “We have no comment about the Origin deal specifically.” But market participants said it was telling that the ASIC warning specifically highlighted deferral of interest payments – saying it “could leave investors temporarily out of pocket” and “the security’s market price may also be damaged by the decision to hold back interest payments” – when that was also explicitly stated as the reason the Origin issue was delayed by the regulator for further study.

ASIC also warned about market price volatility, the subordinated ranking of hybrid securities, early termination rates that apply to the issuer but not the investor, and the increased risk of extremely long timeframes.

The Origin deal was originally intended to close on December 12 for the shareholder and general offers and December 19 for the broker firm offer, with issuance on December 20.

DOLLAR DEALS

The market is watching two Asian issuers to see if they are prepared to brave the treacherous dollar markets next week. Chinese internet company tencent has completed a roadshow in the US, while Reliance Industries is pondering a benchmark deal of its own.

Of the two, tencent is closest to issuing. A roadshow that began in November 15 in Hong Kong before moving to Singapore and London concluded in the US on Wednesday ahead of the Thanksgiving holidays. If market conditions oblige, a Reg S/144a dollar deal should follow next week, although it appears a crushingly difficult market in which to raise a debut bond from a Baa1/BBB+ rated internet services provider with no obvious comparable to price against. Goldman Sachs and Deutsche bank are joint global co-ordinators on the sale, alongside Credit Suisse and HSBC as joint lead managers and bookrunners; those close to the deal describe the mood around the roadshow as “positive”.

Reliance Industries is somewhat further away. Market talk is of a two tranche deal with 10 and 30 year tranches in dollars, but at the time of writing the issuer had still not confirmed the lead managers, nor given the green light to a deal going ahead at all. Mandates were proving characteristically competitive. As one banker put it: “We are standing very close to it, and shouting that we should be on it, and others are doing the same, while the company is playing one off against the other. There are more players being told the deal is theirs to lose than there are seats at the table.”

Another spoke of the issuer “getting commitments from bookrunners on terms that aren’t exactly commercial.” And yesterday afternoon one banker said “it looks like it’s not going anytime soon.”

Bank of China (Hong Kong) continued the flood of new issuance from Asian borrowers in dollars with a US$750 million issue of five-year senior notes last night. But a widening of the deal in the secondary market reflecting a toughening of market conditions in light of uncertain news from Greece. The sense is that the issuer may have been lucky to get a deal out in a window that has now closed.

The bond, led by BOC International, Citigroup and Deutsche Bank as joint bookrunners, tightened from price guidance of around 290 basis points over Treasuries to price at 280 during the US working day on Monday. But in early Asian trading the bond approached 300 basis points – one banker says it was briefly bid as wide as 302 – before settling around a 293 bid by lunchtime, 13 basis points wide of its price at issue.

Those close to the deal feel that the widening of the bond was in line with the broader market, and that the shock announcement yesterday that Greece will seek a referendum on the European rescue package had caused the widening. Relevant benchmarks behaved similarly, as did recent new issues, with KDB – which issued a US$1 billion benchmark last week – having moved from a 272 bid to 295 in a day, and being 14 points wider than its previous close at the time when BOCHK had widened 13. But others in the market grumbled at a deal they feel may have derailed the positive investment sentiment of the last two weeks that had allowed a number of benchmark deals to get away. “Trading 20 basis points wider by the morning is a shock with a new issue,” said one banker. “Yes the market was weaker overnight. But it printed late: it was pretty clear by then the market was heading south and there are ways for banks to defend an issue. It doesn’t help the capital markets to see such execution.”

One very striking element of the deal was its distribution: despite being a Rule 144a/Regulation S combination, 80% of the book went to Asia and just 4% to the USA, with the remaining 16% selling to Europe. (By investor type, the book was more typical, with 37% fund managers, 39% banks, 8% insurance and 16% private banks.)

The distribution clearly reflected the changing macroeconomic mood as the deal was sold. During the early Asian day, conditions appeared reasonably positive, before a more bearish tone caused the European market to open 2% down and the US 1.5% down. “4% going to the US was lower than we would have hoped for, but we had the referendum announcement in Greece,” said someone close to the deal. “Macro dynamics played a big part in the distribution of this deal.” The announcement of another Regulation S deal by ICBC also hit demand; Nomura’s trading desk, for example, was understood to be advising institutional investors to avoid the Bank of China deal in favour of ICBC.

While the deal attracted a $2 billion book, the issuer did not increase the size of the deal, perhaps mindful that it had probably already been lucky generating heavy demand from Asia just before the issuance window closed. “With $2 billion they could have looked for bigger, but they wanted to size it in the context of the macro backdrop we were in,” says one banker.

Where asset markets grow, mutual funds follow. As the CNH, or dim sum, bond market develops around offshore issues in RMB, an increasingly well-diversified asset management industry is taking shape alongside it.

Hard data is difficult to come by, but Asiamoney is aware of almost 30 separate mutual funds or similar investment structures investing mainly in offshore RMB bonds. Already, there is a market with several clearly defined strategies: some focus on credit, others high grade, while some combine bond exposure with deposits and futures, and still others bolster their portfolios with Asian dollar high yield deals which they swap back into RMB.

At one end of the market are the big international names one would expect to see in any new debt market: HSBC, Schroders, UBS, Barclays. Alongside them are a host of home-grown Hong Kong or Chinese names: Haitong, Hang Seng, Citic, Ping An. Some are on their second or third funds. HSBC already has a US$500 million Cayman-domiciled fund, the HSBC RMB Bond Fund, and has just launched a UCITS-compliant fund domiciled in Luxembourg to broaden the reach to a wider audience, particularly clients in Europe. It is launching an RMB currency fund in North America and will look at other structures too. “It’s fair to say that Hong Kong is the home of the offshore RMB, and the home market of HSBC,” says Geoffrey Lunt, director and senior product specialist for fixed income at HSBC Global Asset Management. “For other fund managers this may be a peripheral activity; for us it’s at the very centre of what we do.”

Any discussion about offshore RMB quickly reaches the subject of the supply and demand imbalance: RMB deposits in Hong Kong reached RMB609 billion at the end of August and have at times routinely grown by 10% per month. The need for these assets to be invested in more yield-producing assets has created an imbalance that has, in the past, allowed some very average credit to raise money at very low rates. But every fund manager spoken to by Asiamoney described a relatively easy time allocating the funds they raise, and getting access to the bonds they want.

“We have not had significant trouble investing that money,” says Lunt of HSBC’s $500 million fund. “We are very happy with the way the market has developed and we’ve been able to cope with a lot of the demand we’ve seen for the product.”

Chris Faddy, Head of Distribution at Barclays Capital Fund Solutions for ex-Japan Asia, says fund managers on Barclays’ Renminbi Bond Fund – launched in Singapore in April – have had no problem getting the securities they prefer. “We are extremely aware of the discussion around liquidity,” he says. “However, our experience has been that we have got a full or 80% allocation of every single primary issue we have participated in. The key to participation is relationships: either the fund managers like ourselves that are part of an investment bank, or those with strong relationships with the key brokers, will get the better access.”

Similarly at Singapore’s Fullerton Asset Management, Patrick Yeo says Fullerton’s offshore RMB fund – with US$245 million under management – “could easily go up to $400 or $500 million” without running into problems with allocation. Again, it’s about relationships, he says. “One of our strengths is that we have pretty good relationships with our counterparts,” he says. “Temasek [which owns Fullerton] is an investor in a lot of the Chinese banks such as Bank of China, which is one of the major players in the CNH market, so if they bring in deals and we participate, we tend to get very good allocation.”

And the many local Chinese players report a similar experience. Ben Rudd is executive director and head of overseas investment at Ping An Asset Management (HK), which has seen its RMB fund climb from RMB205 million at inception to RMB1.55 billion, with precisely one day of net redemptions along the way. “Although competition is quite intense in the new issuance market, based on existing relationships with both Chinese and international banks and our strong brand and team, we are normally able to get a high allocation for our issues in primary deals of 80 to 100% of the desired size,” he says in written responses to questions from Asiamoney.

Getting in at the primary market level is crucial, because demand is pushing the secondary markets to much less appealing levels, where there is liquidity at all. “We can’t be buying on the secondary market all the time – that would reduce yield,” says Faddy at Barclays. “The difference between primary and secondary on an issue could be over 1, 1.5%. We picked up Air Liquide on the primary market; those types of securities are trading 100 points under on the secondary market.” That said, secondary market activity is improving; where average ticket size in secondary trading was around $3-5 million at the end of 2010, it is now more like $10-30 million, Rudd says, and in some cases as high as $75 million, a function of increased issuance and the appearance of new trading desks. “Clearly liquidity has surged dramatically for the last nine months,” he says.

There are three reasons concerns about allocation and liquidity have eased. One is that many funds have been smart about the amount of assets they are prepared to accept. “At no stage did we want to compromise our clients by promising too much capacity to them,” says Lunt. “We have been very careful about the growth of our funds in this area.” Faddy makes the same point: “We have been very deliberate in building our asset base slowly. To actively participate in the primary market we need to make sure we don’t grow our assets too quickly.”

Another reason is that the market has now reached a decent size: just over RMB200 billion at the time of writing. It has become reasonably diversified by industry, credit quality and geography – though not yet really by maturity – and this has made life easier for managers trying to pursue a particular strategy rather than just having to buy assets in order to get something. “It has not been too difficult to diversify the portfolio,” says Rudd. With size has come a certain resilience; Lunt notes how encouraging it was to see two-way pricing maintained in the market throughout the recent global volatility. And there’s little reason to expect supply to fade. “In the last few weeks of market disruptions, this [offshore RMB] was one of the few that was effectively still open,” says Suanjin Tan, portfolio manager at Blackrock, which invests in offshore RMB for its regional products and plans to launch a dedicated RMB fund. “We’re quite comfortable with the supply pipeline in this market. The expectation is for RMB30-40 billion in the last quarter of the year: there are lots of Chinese banks, Chinese quasi-sovereigns and multinationals planning to issue.” Others think the figure could be higher.

But the third, and perhaps the most important, is that investor attitudes towards offshore RMB have changed. Where once investors appeared to be prepared to buy anything regardless of cost, quality or investor protection, times have changed, and clearly for the better.

“Initially the market was characterized by some poor quality issuance, given the excess of demand over supply,” says Lunt. “I don’t necessarily mean that the companies were bad, just that the covenants on the bonds were not tight and the yields were far too low, with disclosure below what you would hope for in developed markets.”

Investor patterns have been of particular interest to BlackRock as they prepare their fund. “Most participants looked to the market just for FX appreciation until recently,” says Tan. “There was not a lot of differentiation on the credit quality of companies in the market. But with volatility investors have started to realise that one credit is not necessarily the same as another, and have tried to work out what is the correct premium for that level of risk. That is a very healthy development.”

Changed expectations about currency appreciation are one reason for this shift, but there’s also perhaps a realisation among issuers that they need to pay more for their money in a difficult global environment. “Fund managers like ourselves are more cautious, worrying that if investors get jittery about this market they might pull funds out,” says Yeo at Fullerton. “We are adopting a wait and see attitude. But things have settled down: it’s a matter of issuers coming to terms with having to offer a higher yield to the market.” When Khazanah priced a RMB500 million deal in October, for example, it initially sought to pay a 2% coupon on its three-year deal, but accepted it would have to pay closer to 3% in the end. “When the market started, ICBC was issuing a two year bond at 1.1% and the market was lapping it up,” he says. “That will no longer be the case. Otherwise investors like ourselves are prepared to look away, buy in the Asian dollar space, and switch it back to RMB.”

Fund managers have taken a number of different approaches to the RMB market. Many of the earliest players were local, and these have tended to be more comfortable with credit. Haitong International Asset Management, for example, launched the first RMB fixed income mutual fund in Hong Kong in August 2010, following it with a private placement fund and has announced a dedicated high yield bond fund, with classes in RMB for Hong Kong investors and dollars for overseas, targeting a yearly return of 7-8%. (Haitong did not respond to requests for an update on the fund’s progress before Asiamoney’s deadline.)  Citic Securities International launched a hedge fund structure in this area, the CSI RMB Fund, which takes on multiple strategies including foreign exchange, interest rate and fixed income securities in RMB.  Earlier this year it was talking about 15-20% annual returns, including the currency appreciation; however Citic told Asiamoney it was no longer allowed to talk about the fund for regulatory reasons.

Some internationals have opted to go to the other end of the spectrum and stick with high grade. Barclays is an example: its UCITS-compliant fund will always be investment grade, on average. “There were a lot of funds launched between November 2010 and March of this year, many of them out of Hong Kong from onshore Chinese managers with a presence offshore,” says Faddy. “A lot of them are credit funds, looking to pick the eyes of the high yield market. There was a time when a lot of companies who were finding it difficult to source funding onshore could do so offshore – you could get almost anything you wanted away at a price – and several funds were set up around what was happening in the market at that time. We took a different route.” In his view, the opportunity is among deposit holders who want to get a bit extra without risking the lot. “We are really looking to provide depositors with an alternative,” he says. “Depositors have been attracted to the letters RMB, but the bank deposits carry low rates; the next iteration for those depositors in their investment life cycle will be looking for yield. A high quality portfolio of the bonds is the best alternative for depositors.”

Still others will venture into high yield, but with strict criteria around what they buy. “We would consider any bond that comes on to the market,” says Lunt at HSBC. “There are very good high yield issues available in CNH.”  But “We are absolutely determined not to invest in anything we don’t fully understand. Unrated issuance isn’t necessarily of a lower quality, but it’s very important in this market to have a very strong credit analysis platform and process.”

That will also be the attitude of the BlackRock fund when its new fund arrives. “It’s less that we feel that every high yield issuer is going to face problems; it’s more that there are some names that offer good value, and others that are less compelling,” says Neil Weller, portfolio manager.

Some internationals have taken the approach of mixing RMB bond exposure with other opportunities. In this respect, the UBS RMB Fixed Income Fund is interesting. The fund can only invest in investment grade bonds, and must maintain an average duration below three years. “Based on these two investment restrictions, we can cut down the credit and interest rate risk in the portfolio,” says Ben Yuen, head of fixed income for pan-Asia, at UBS. But against these restrictions, it can put up to 20% of its assets into US dollar Asian investment grade credit, and hedge it back to RMB. “Why? Because the market is quite green, and the universe is small for the offshore RMB bond market.” At the time of writing 18% of the fund’s NAV was used in this way.

Another distinguishing factor is that the fund can invest in RMB deposits, allowing it to invest in futures when they provide a better potential return for the portfolio. This is useful because of the way the market has been behaving: the spread between a five-year government bond in CNH and CNY is about 1.8%, but as recently as July stood at 3.4%. That sort of movement creates opportunities in futures markets.

This approach is helpful when there is high demand for primary securities. “We are not going to force ourselves to invest all our assets in bonds,” says Yuen. “We are holding short term paper to allow us to pick up higher CNH interest rate opportunities in futures. Our short-duration strategy seems quite effective in this market environment.”

Not everyone is sure these arbitrage gyrations are the right place for fund managers to be. “It’s something you’ve got to be very careful with,” says Weller at BlackRock. “The positioning is prone to get very stretched, and at times of illiquidity we’re all aware of what can happen when everyone is positioned the same way around.”

UBS’s approach of allowing some investment in Asian dollar paper is also used at Fullerton. About 25% of the fund is invested in this way. “It gives us a bit of enhanced liquidity, as I the dollar market is more developed,” Yue says. Unlike the UBS product, though, Fullerton can and does invest in high yield, and even unrated bonds; like HSBC, Fullerton assigns a credit rating to any security, and will do so through internal credit work if external ratings are not in place.

The market continues to face teething problems; one widespread complaint is that there is no investable benchmark available. But as the market develops, issues like this will be ironed out. The next characteristic is likely to be a growth in UCITS structures, reflecting increasing demand for these assets progressively further afield from Hong Kong. RMB is, increasingly, a global story.

BOX: RMB and gold

As the offshore RMB bond market has developed, more and more investment classes have grown around it. In October another was added: gold.

The Chinese Gold & Silver Exchange in Hong Kong launched the world’s first offshore RMB-denominated spot gold contract in order to attract some of the RMB circulating outside mainland China. “This product will help with that circulation, rather than the money having to stay in deposits,” says Haywood Cheung, president. Trading has to go through an exchange member – of the 171 members of the exchange, 27 had registered to trade this new contract as of late October – suggesting that initially much of the interest may be from people who physically need the gold, such as goldsmiths and jewelers. That said, there is an electronic platform for trading too, with leverage available of up to 20 times – and the ability to leverage RMB may prove the most attractive element to mainstream investors.

Part of the appeal is that both gold and RMB are perceived as safe investments. “Investors recognize gold as a safe haven, and if the gold is denominated in RMB they are double safe-guarded, because the RMB at this moment is a stable currency,” Cheung says. “It’s a win-win case.”

In the offices of Hong Kong’s banks and fund managers, a transformation that will shape the world economy is in its early stages. This is the slow but steady process of turning the Chinese renminbi (RMB) from a heavily restricted currency to one that is open and internationally traded. The endgame, many believe, is an international reserve currency to rival the US dollar – and is perhaps not far away.

China today is at a halfway house between restriction and openness: a middle ground in which the current account is open and the capital account closed. It’s a situation that has created some quirks – one currency behaving in a wildly different way depending on whether it’s onshore or offshore – and a host of opportunities besides. The big topic of discussion in Hong Kong, and elsewhere in Asia, is where it goes from here.

To see this article as it ran, click here: Half open door

[Subhead] Slowly opening the door

For most of China’s modern history, the RMB has been a purely domestic currency, tightly controlled by the central bank, the People’s Bank of China (PBOC). When Chinese companies conducted business with foreigners, the trade would be denominated in US dollars and pass through the PBOC.

The first hint of a change of heart came in 2003, when personal banking services in RMB were permitted for Hong Kong residents – a largely symbolic gesture that went no further than deposit accounts and a handful of credit cards. The next came in 2007, when a handful of mainland Chinese financial institutions, starting with the China Development Bank, were allowed to issue RMB bonds in Hong Kong; the next year a handful of foreign banks incorporated in China, such as HSBC, were allowed to do the same. And in July 2009 China tried out a pilot trade settlement scheme, allowing five coastal cities to settle their trade with Hong Kong, Macau and southeast Asian countries in RMB.

But the big steps came in 2010. First, the Hong Kong Monetary Authority – Hong Kong’s central bank – said that any institution permitted to issue a bond in Hong Kong (that is, more or less anybody) would also be permitted to do so in RMB; shortly afterwards, limits on Hong Kong-based companies converting RMB, or launching investment products in the Chinese currency, were removed. At a stroke, this created a whole new capital market: the so-called dim sum bond market.  In the three years up to June 2010, when only policy institutions and the big banks could issue, a total of RMB34.3 billion in bonds were launched; 12 months later, gross issuance had quadrupled to RMB138 billion (outstandings were RMB175 billion as of early September). “Over the next three to five years, the total size of the market might reach RMB1 trillion, which would be close to 50% of the whole Hong Kong dollar debt market,” says Linan Liu, Greater China rates strategist at Deutsche Bank.

On the trade settlement side, the original five-city pilot scheme has been steadily extended – first to 20 cities, then wider again, and finally in August 2011 to the entire country. So any transaction between a Chinese and an international partner can now be settled, outside China, in RMB.

The latest round of liberalization came when China’s Vice Premier Li Keqiang came to Hong Kong on August 17 this year. It was a pivotal moment: what he said would give a clear indication about whether China was comfortable with or alarmed by the pace of internationalization of its currency, and where it would go next. The vote came down firmly in the positive. “Not only is Beijing still comfortable with the rapid pace of offshore RMB market development, but it is taking the process to the next stage,” says Donna Kwok, economist at HSBC. Among other things, he said that Hong Kong enterprises would be allowed to invest RMB back into China through foreign direct investment. This is crucial, because until now, while it has become increasingly straightforward for money to leave China, it’s been rather difficult for it to find any way to go back in again and serve any useful purpose.

So that’s where we stand today. But what don’t we have? The main thing that’s missing is convertibility in the capital account, which is one of the reasons that so far most of the flow across borders in RMB has been in one direction, outwards from China. And this arrangement is having some peculiar effects.

[Subhead: The strange case of the RMB]

Onshore and offshore RMB are referred to in a shorthand in the Asian financial industry: CNY for onshore, CNH for offshore. And ever since people started to distinguish between the two, they’ve been behaving in radically different ways. Offshore, interest rates on RMB-denominated assets are low, and have been falling, because there is far greater demand for ways to invest the currency than can currently be met. Onshore, interest rates have instead been rising. Traders have spotted an arbitrage, but it’s already making some bankers uneasy. “CNH doesn’t exist except in our heads,” says an Asia country head of a major western bank. “We are all for helping China in what I think it means to do, which is to make the RMB an international currency of trade and settlement. But the arbitrage… I’m saying to our wealth management people, be very careful, because if all this unwinds, you’ve got nowhere to turn.”

The sense of a strangely artificial environment also exists in foreign exchange. There are now three separate FX markets for exactly the same dollar-RMB trade: the onshore market; a non-deliverable forward market, which is how foreigners used to trade the currency before this process of liberalization; and now CNH, or offshore RMB. And there are pricing discrepancies between them, which again traders are seeking to exploit – probably not what China had initially intended.

But the biggest impact of this halfway open door has been an intense supply-demand imbalance which has had a major impact on the way the offshore RMB bond market has developed. At its heart is the pace with which RMB deposits have accrued in Hong Kong: from just RMB90 billion in June 2010, they had risen to RMB572.2 billion by July 2011, according to the HKMA. Before a recent slowing, they had been growing consistently at 10% per month.

These deposits need somewhere to go: they earn almost no interest sitting in the bank, so the holders of this cash are anxious to find a return. And this is the dynamic that underpinned the growth of the offshore RMB bond market: the dim sums.

[Subhead]The dim sum boom

In the early days after the July 2010 liberalization, the issuers were natural borrowers: Hopewell Highway Infrastructure, McDonald’s (which needs RMB for mainland expansion), China Resources Power. But as the sheer level of demand and pricing power became clear – the Ministry of Finance paid just 1% for a three-year bond in November 2010, in a deal that was still 10 times oversubscribed by institutions – more and more companies decided they should issue too. By the end of the year, issuers had included Galaxy Entertainment Group – an un-rated Macau casino developer – and the Russian bank VTB. While there’s nothing necessarily wrong with either of these names, they were able to raise money at dramatically lower yields then they would have had to pay in the dollar markets. At the same time, low-rated Chinese issuers (or generally their Hong Kong subsidiaries), particularly property developers, began to jump in. The market had gone from top-ranked government-backed banks to high yield issuers within a matter of months.

It didn’t take long for this to become alarming. Lawyers who have dealt with Chinese high yield issuers in the dollar markets are familiar with many dangers in buying their debt; in particular, investors often find they have absolutely no security over assets in China. “Exactly the same issues in relation to taking of security arise whether the bond is denominated in RMB or not,” says Joseph Tse, partner at Allen & Overy in Hong Kong. “But with RMB bond issuance there is an extra layer of regulatory issues separate from the security issues,” particularly around repatriation of proceeds. Yet investors, so keen to get a decent return on their money, didn’t seem to be seeking any covenants from issuers. “The market seems to have accepted that it can get comfortable with no security from these companies, particularly those which are listed,” Tse says. Another lawyer is more blunt: “Some of the deals coming out of China earlier this year were restructurings waiting to happen.”

Why the clamour? Investors aren’t just after the yield on the bond: they also believe strongly that the RMB is going to continue to appreciate against the dollar, and they factor that expectation – commonly 3-5% or so per year – into any decision about buying a bond. But the supply-demand imbalance is not really healthy for anyone. “Growth of 400% in the past 12 months [in offshore RMB deposits] is pretty spectacular, and that created the demand side of the supply-demand imbalance which is how the market developed,” says Eric Greenberg, managing director, financing group and head of leveraged finance in Asia ex-Japan at Goldman Sachs. “Out of the gate, because offshore RMB was receiving such low interest rates from the banks, it made RMB offshore bonds that much more attractive for investors. That meant an inefficient market, with longer tenor, loose covenants, and at rates below which one could borrow in onshore RMB.”

This is one reason that the August announcement around allowing RMB back into China as foreign direct investment is so important: by finding a way to recycle the Chinese currency back onto the mainland, it may relieve some of this supply-demand pressure. Already, bankers feel that some balance is returning to the market. “In the last few months the market inefficiencies have started to narrow as there has been some pushback from investors and the forward curve for RMB appreciation has come down,” says Greenberg. While retail and private banking clients have focused on enhancing their deposit yields, Greenberg notes a stronger price and covenant discipline among institutional buyers now. On top of that, one of Vice Premier Li’s other announcements in August was that all Chinese companies will now be able to launch offshore bonds, which should help to increase the available pool of issuers, creating more competition, higher yields, and a better deal for investors. “The demand and supply situation is beginning to correct itself,” says Rita Chan, an executive director at Goldman Sachs. “That is reflected in more scrutiny around whether the bonds are rated by international agencies, how liquid the bonds are, and whether the issuer is listed. We’re moving towards a true Regulation S standard rather than – as it was in the first half of this year – everything can sell.”

Another shift that might help to redress the balance is if investors’ views on the currency change. Expectation of a climb in the RMB is near universal, but as the world economy has deteriorated – hitting Chinese exports – expectations of the pace of that climb have become more conservative. “Earlier this year, people were expecting 2 to 3% appreciation per year for the next five years,” says Chan. “That was one reason they were so enthusiastic about investing. But over the past few months the forward curve has shifted around.” Greenberg adds: “Currency movements have helped to evaporate some of the market inefficiency.”

From an investor perspective, the allure of RMB assets remains very clear, and any change in supply-demand imbalances is in their interests. ““For investors in CNH, just like elsewhere, you need to form an opinion about the strength and quality of the investment,” says Li Cui, chief China economist at RBS. “In particular a lot of bondholders are attracted by the longer-term strength of the currency. What’s attractive about the RMB is China’s economic and trade size, the potential growth, much healthier balance sheet, and importantly macro stability, which bolsters confidence in the currency.”

And investment in these bonds is no longer just restricted to Hong Kong retail investors and institutions with a backlog of the currency to put to work. Across Asia, the private banking community is finding ways to get positioned.

“Given what is happening in Europe and the US, I think that is ultimately going to force the Chinese to speed up the internationalization of the RMB,” says Dr Lee Boon Keng, head of the investment solutions group in Singapore for Swiss private bank Julius Baer. He expects continuing RMB appreciation, more and more foreign institutions issuing offshore RMB debt, and a much faster liberalization of the capital account than many expect: “maybe a couple of years, instead of a couple of decades. It makes the Chinese growth story that much more compelling.” He considers the loosening of the Chinese currency “a megatrend.”

In positioning his clients for it, he has worked with Asian bank DBS to launch a fund that invests in offshore RMB bonds, and is also encouraging investors to look at the Chinese stock market. “I’m telling clients that the equity market is at valuations last seen in 2005. This is a great opportunity. Why are you waiting for that minus 10 or 15% potential drop before you dip yourself into the water? We may have bottomed out already.”Julius Baer has QFII quota from China – a system by which foreign institutions are permitted to invest a set amount in the mainland Chinese market – and is using it to launch a fund investing in both A-shares (Chinese domestic securities in RMB) and H-shares (Chinese companies listed in Hong Kong and traded in Hong Kong dollars).

Another opportunity that will evolve for investors is RMB-denominated IPOs in Hong Kong. There has only been one so far, a real estate investment trust (REIT) issue for Hui Xian REIT, a subsidiary of Hong Kong conglomerate Cheung Kong Holdings, in April; it didn’t go especially well. But in due course this will likely evolve into another major market. Elsewhere, mutual funds built around RMB assets are beginning to spring up, while in the other direction, Chinese clients will soon be allowed to invest in exchange-traded funds (ETFs) in Hong Kong.

[Subhead] The future

So where is this all heading? There are still some who don’t believe that China is looking for full convertibility. “Allowing Hong Kong to develop RMB offshore product doesn’t necessarily mean China wants to open the capital account,” says Christopher Wood, strategist at Hong Kong-based brokerage CLSA and author of the influential Greed & Fear Report. He describes the growth of the market as “more from the political desire to give Hong Kong a new toy.” He won’t be convinced full liberalization is coming until banks are able to lend RMB offshore, and in any case doubts that full openness would be in China’s interests anyway. “The PBOC will lose control of the whole system if they open the capital account.”

He is, though, in something of a minority. “I strongly believe full convertibility is the goal of internationalization,” says Liu at Deutsche. “Post financial crisis there is a growing recognition that growth should be less dependent on the US dollar in trade, the pricing of commodities and reserve management.” She thinks that there are “five to 10 years of structural reforms needed in the domestic market” before China will be ready for full openness, to address issues around the onshore banking sector, but that at the right time “I would definitely look to the RMB to become a global reserve currency. Not to challenge the dollar or euro, but to be one of four major currencies in the global FX system [the other being the yen], with the RMB hopefully one of the main currencies for emerging countries.”

Some feel that this ambition – a reserve currency, strongly reducing China’s exposure to a declining dollar in which it already holds more than $3 trillion in reserves – is why China is willing to tolerate the oddities and arbitrages that inevitably come with the process of gradual opening.

Others think that far-fetched. Cui at RBS says the RMB as a reserve currency is “still quite some time away,” and not really the point of liberalization. “In the near term, the main aim is to boost its role as a vehicle currency for trade and investment.”

She says a lot needs to be done in the domestic financial system before full convertibility will appear sensible to China, and others agree with her. “For the RMB to be fully convertible, we have to make sure China’s financial market is ready,” says John Sun, executive director, fixed income, at Citic Securities International. “All the banks must become fully market-driven businesses, as with convertibility the financial system will be opened to foreign markets directly. At this moment, the financial market in China is not robust enough to do that. It’s not going to happen in the next three or four years.

“And if the RMB cannot be fully convertible, then it cannot become a reserve currency for a relatively long period of time. I don’t see the possibility in five years or even longer.”

Still, the wild card in all of this is how the deterioration of the US economy and currency is seen in China, and whether it may force the country’s hand to move faster than it had at first intended. “I still have confidence in the US economy: it is still two and a half times larger than China’s,” says Sun. “Having said that, there is a global problem with US dollar depreciation, because of the trouble it causes in commodity prices and export inflation from the US to other countries. No currency, including the RMB, can replace the US dollar, but a lot of countries are going to try to find a better way to make their financial markets more stabilised.” And that could be a catalyst to faster change, and a new world currency.

ENDS

KNOC

Korea National Oil Corp (KNOC) launched a US$1 billion five-year bond early Thursday morning (Asia time), which some billed as a market re-opening deal, and others as an opportunistic use of a brief window.

This was the first dollar benchmark from Asia for more than a month, since fellow Korean borrower Kexim raised US$1 billion. Its reception was closely watched, and considered successful, though some in the market suggested the issuer may have overpaid.

The deal, led by Barclays Capital, Bank of America Merrill Lynch, HSBC, KDB and Royal Bank of Scotland as joint bookrunners, was about eight times subscribed during a 12-hour bookbuild with bids from more than 400 accounts. It priced at 310 basis points over Treasuries, which was inside initial price guidance of 330bp over; yield was 4.137%, based on a 4% coupon and a re-offer price of 99.387.

KNOC is a powerful, closely-watched and state-backed institution, but not a truly top-tier borrower in terms of rating; it is rated A1 by Moody’s and A by Standard & Poor’s. Nevertheless, any state-backed investment grade name borrowing in size is an influential trade, particularly since investors tend to see KNOC as exposure to the Korean state in general. “With the strong credit profile and strategic importance to Korea and the Korean economy, KNOC was able to successfully access the US$ market while a number of other Asian issuers in the pipeline remain sidelined,” said someone close to the deal.

Rival bankers were pleased to see a deal of this size get away, though there was some carping about whether the initial price guidance was wider than it needed to be, and opinions varied on the true significance of the deal.

“This is a market re-opening trade for Asia,” said someone close to the deal. “It was the first trade in benchmark size in hard currency for about six weeks and it has provided a lot of confidence to the market. It left a positive taste in everyone’s mouth.” Another added: “The transaction marks the reopening of the Asia ex-Japan US$ public primary market.” One bookrunner said that there was “certainly a good number of issuers looking at the markets” in light of the deal’s success, while noting that the timing was key. “Today’s market was on the back foot again,” he said, speaking on Thursday afternoon, Asia time. “The transaction would not have worked in the same shape or form today.”

But others were not so sure about its long-term impact. “It is good to see this get away, but the problem is you still don’t have any certainty about what is going to happen next in Europe, and one bad headline can destroy any confidence in the market,” said a banker. Another said: “I wouldn’t go so far as to say that this reopens the market for everybody.” Bankers both on and off the deal agreed that the outcome of Sunday’s summit on the eurozone would be key to subsequent issues.

On pricing, KNOC’s existing bonds due 2015 were trading at around 270 basis points when the deal priced, meaning that the initial guidance in particular – if not the final price – constituted a considerable new issue premium. “That initial guidance was a new issue premium of 60 basis points – that’s very, very wide,” said one banker. “That’s a no-brainer for investors. A book of $8 billion for $1 billion of issuance is insane. So could they have got away with starting out at a tighter price?” The deal tightened in the aftermarket and was trading at around 298 bp over Treasuries, a tightening of 12 points, on Thursday afternoon.

Those close to the deal defended the pricing, noting that a tightening of 20 basis points from guidance was impressive given the market conditions. “The initial pricing point was partially based on investor feedback, and partly based on what we have seen in the markets globally in terms of new issue premiums, in the 144a space and global emerging markets as well,” said someone close to the deal.

The deal sold chiefly to Asia (44%) and the USA (40%), with European investors more subdued (16%). More than half the book went to fund managers (57%), with the remainder being taken up by insurers (18%), banks (14%), retail (6%) and central banks and other public institutions (5%). The senior unsecured deal carries a put at par if at any stage the Korean government’s level of ownership drops below 51% of the company. The transaction formed part of KNOC’s global MTN programme, recently expanded from US$4 billion to US$6 billion. It followed a non-deal roadshow in September that took in global fixed income investors in Asia, Europe, the Middle East and the US.

Investors continue to show interest in commodity-related businesses, seeing them as resilient to market shocks; last week Standard & Poor’s issued a note saying that “the recent downturn in crude prices may be discomforting for Asia-Pacific oil and gas companies, but it’s unlikely to affect credit ratings.” Many oil and gas companies achieved solid earnings in the first half of the year, the report said, creating a buffer if cash flows decline over the next 12 months.

S$

The Singapore dollar bond market enjoyed a flurry of activity this week, with new or tap issues from Wharf and Cheung Kong (Holdings), and a third issue underway from Standard Chartered. The deals reflect the relative stability of the Singapore dollar as a funding market despite global volatility.

The Cheung Kong deal, one of two from Hong Kong heavyweights during the week, was a tap of an earlier S$500 million perpetual issue launched in September. The tap raised a further S$230 million through DBS and JP Morgan, who were also joint bookrunners on the original deal.

The tap attracted S$300 million in a one-day accelerated book-build. In keeping with many Singapore issues, the largest part of the buyer base was private banks, accounting for 75% of the allocation, followed by asset managers with 11%, insurers 10% and banks 4%. By region, it was overwhelmingly locally placed, with 92% staying in Singapore.

Bankers are turning to the Singapore dollar as its safe haven status and a steady investor base protects it from turmoil in the US dollar markets. “After the initial Cheung Kong deal [in September] there were a number of negative events out of Europe, and the credit market by and large shut down for new issues,” said someone close to the deal. “But I would say the Sing dollar perpetual from Cheung Kong was one of the securities that held up reasonably well. Since late last week the market has staged a rally in credit, and the perpetual is back up to par. So it was very opportunistic, from the borrower’s perspective, to see market stability and to go back to the bond again.”

Earlier in the week fellow Hong Kong group Wharf Holdings had priced a S$250 million issue of seven-year bonds, increased from an initial target of just S$100 million after the books were three times covered. The deal, also led by DBS, paid a coupon of 4.3%, representing the low end of guidance. This deal was even more heavily dominated by Singapore buyers than Cheung Kong, selling 96% locally, although in this deal banks were the biggest part of the book at 41%, followed by 27% insurers, 20% private banks and 12% asset managers.

And on Thursday, Standard Chartered was in the market for a 10-year non-call five Singapore dollar benchmark, although the size of the bond was unclear as Euroweek went to press. Guidance was around 4.25%. Investors said they considered this as equivalent to a 35 basis point new issue premium versus fair value, and therefore attractive.

Why the activity? “Between the major markets in the Asia credit space – primarily the Singapore dollar, CNH and US dollar – the markets that are functional are the CNH and the Sing dollar,” says one banker. “There, you are still seeing trades getting done at the right price. It’s a contained market, anchored by strong local bids from private banks or insurance money; there are not many investors but it’s resilient.”

Dim sum

The CNH “dim sum” bond market sprung back into life this week after a three week hiatus. A RMB3 billion two-tranche raising by China National Petroleum Corp (CNPC), which owns PetroChina, was the most significant deal and is likely to herald a round of new issues.

The CNPC deal was made up of a RMB2.5 billion two-year tranche and a RMB500 million three-year. The two-year had a 2.55% coupon to yield 2.6%, and the three year 2.95% to yield 3%. HSBC and Bank of China were joint global coordinators, joined by Deutsche and ICBC as joint bookrunners.

CNPC was seen as an ideal name to reopen the market after a brief hiatus; it is rated Aa3/AA-/AA- and is the highest-rated Chinese corporate to have sold RMB-denominated bonds in Hong Kong. “It’s viewed very much as the next best thing to the sovereign,” said someone close to the deal. “It’s about as good a name as you’re going to get in Asia to start the market off again.”

The market had become slightly becalmed in previous weeks following a flurry of issuance from names including BP, Tesco, Air Liquide and BSH Bosch und Siemens. “At that point, the CNH market suffered what G3 markets had been suffering,” says one banker. “You had had a couple of weeks where the CNH market was working when other markets were not; at that point investors said ‘enough’s enough’ and took a big step back.” The CNPC deal had to move quickly when markets improved: a decision was made on Monday, then two roadshow teams presented simultaneously on Tuesday, one each in Singapore and Hong Kong. Work began on Wednesday with a 6.30am call with the issuer before bookbuilding began, concluding late on Wednesday night following lengthy debate on allocations. The deal was almost three times covered and received almost 100 orders.

While the deal was a success, those close to it notice that a change has taken place in investor sentiment towards CNH bonds, partly because of changed expectations about the likely performance of the currency itself. “Investors were previously saying they don’t mind a very low coupon and bond yield because they were expecting 3, 4, 5% of currency appreciation. That was a generally accepted view of the markets in the first half of the year,” said one banker. “It’s not the case now.” Alongside that, investors have become more cautious. “It’s a good thing for the market, because it means investors are starting to look at credits and comparing one against another: they like this name at this level, don’t like that name at that level. Earlier in the year, it was: I’ve got loads of CNH I need to put to work so let’s buy loads of credit bonds, because something is better than nothing.”

The CNPC deal followed a landmark dim sum sukuk from Khazanah Nasional, covered in Euroweek’s daily coverage on October 14; it raised RMB500 million in a three-year deal. The question now is what other issues will follow, since many bookrunners report a full pipeline representing a variety of credit quality.

First impressions are that strong and familiar names will appear soonest. For example, approvals have been passed for up to RMB40 billion of RMB-denominated subordinated debt by China Construction Bank, although clearly not all of that would be expected to appear in the dim sum markets; and Baosteel Group has received approval to issue up to RMB6.5 billion of dim sum bonds. But bankers suggest a range of potential issuers. “Will the next issues just be the good quality names? The first one or two, maybe, but there’s quite a lot in the pipeline at the lower end of investment grade,” says one DCM banker.

Another adds: “I don’t think this is a fully reopened market. I don’t think the floodgates are open and the whole pipeline will pop out in the next two to three weeks. But having had a correction, and with levels readjusted, investors do have money they are willing to put to work.”

Covered bonds
The long-awaited Australian covered bonds market has reached the starting line. Key legislation is now in place, with two of the country’s biggest banks preparing to hit the road to market landmark new issues.

Last week the Australian Banking Act Amendment, the enabling legislation for covered bond issuance from Australian deposit-taking institutions (ADIs), passed through parliament, receiving Royal Assent earlier this week. This concludes the legal side of the process. “The legislative approvals have now happened,” says Pierre Katerdjian, global head of credit markets at Westpac. “It basically means that Australian ADIs are able to issue covered bonds.”

That is not quite the whole picture, however. “The other leg is the prudential piece: APRA [the Australian Prudential Regulatory Authority, Australia’s banking regulator] has to amend APS 120, to create a framework for banks to issue,” says Katerdjian. “There will probably be a draft out in mid-November with a formal release in the new year.” But the fact that APRA’s prudential standards are not yet out is apparently not enough to stop issues beginning. “What APRA has said to the ADIs is basically: you can issue, but be mindful that we’re still finalizing the new APS rules.”

Banks have taken this to heart, and National Australia Bank and Commonwealth Bank of Australia are already preparing to market new issues. Both are expected to travel to the US and Europe, raising the prospect that they may make their maiden issues with tranches in both euros and dollars. NAB is understood to have arranged meetings starting from October 31, through Deutsche Bank, JP Morgan and NAB itself; Commonwealth Bank of Australia will be one week behind it, led by BNP Paribas, Morgan Stanley and CBA.

Neither is yet clear on the likely launch date for a deal, nor the size or currency. But the market expects to see them sooner rather than later. “I expect lawyers are drafting program documents and you will probably see the first deal launched in mid- to late November, subject to market conditions and regulatory approval,” Katerdjian says. “Into which jurisdiction they [CBA and NAB] issue is not yet clear given the early stages of the roadshows, but you would expect ADIs to issue covered bonds in both currencies over time.”

Both banks, and Australians generally, are likely to find a warm welcome in markets that have otherwise become somewhat cynical about the health of the banks who try to borrow from them. “It is very significant, first of all because the Australian banking system is in good shape and one of the safest banking systems in the world,” says Ted Lord, head of European covered bonds at Barclays Capital. “At a time when you have extreme market volatility and talk about a forced recapitalization of certain banks, it is nice to have a potentially large market open up where these issues are not the focus of attention. Investors are very keen, and Australians have a history of tapping into different capital markets around the world.”

Legislation limits covered bond issuance to 8% of total assets by any one Australian bank, but that still represents an extremely large potential pool of capital raising. “It depends on how successful the first issues are,” Lord says. “If you add up the assets that could potentially be raised, you have a potential issuance volume of around A$125 billion before you reach the ceiling – there’s a lot of scope there. Also the Australian covered bond market offers one of the few markets with the potential to build full curves in a variety of currencies.”

However, Katerdjian adds that Australian banks will have to make careful considerations around their volumes of issuance into a new offshore market, since that is already an area of scrutiny in a review of the Australian banking sector underway by rating agencies. “The expectation is, given market dynamics and liquidity treatments offshore compared to domestically, that we will see most ADI covered bond issuance go offshore. Balancing this has to be the hot topic of the offshore vs onshore wholesale funding mix for ADIs, particularly given the pending ratings agency reviews,” he says.

In the market’s favour is the fact that the Australian government is likely to support it if it means a better outcome for the local consumer.  “This is a market that should not only have legs but continue to grow,” Lord says. “It should be seen not just as a strategic move for banks who want to issue covered bonds. The government is realising that this is a viable market that could help with funding, and hence help the Australian population with lower mortgage rates.”

China, it’s widely agreed, is the engine of world growth, today and for the foreseeable future. But it’s an engine that might need some tuning. As one industry after another – banking, telecoms, resources – gains new global champions from mainland China, it seems that some less esteemed names and practices are being pulled into the international spotlight along with them.

So far this year, three of the big four accountancy groups have either been caught up in controversy about their overseas-listed clients’ accounts, or have stepped away from a client out of growing concern about their books.

The biggest incident involved Sino-Forest, a Chinese timber company that listed on the Toronto Stock Exchange in the 1990s and grew to become one of the largest forestry groups listed in Canada. It appeared a success story, raising more than C$3 billion in debt and equity over the years and reaching a market capitalization of C$6 billion by March this year, reporting almost C$400 million in profit for 2010 from a 780,000 hectare forestry portfolio in China. But following a damningly negative research report from a hedge fund, triggering a share price plunge, it was suspended from trading by the Ontario Securities Commission in August for acts intended to “perpetuate a fraud” – specifically, that it didn’t have the assets it said it did, nor the profitability. Ernst & Young has been named in two class action lawsuits around Sino-Forest.

Elsewhere, big four accountants have started to become wary of their own clients. In May Deloitte stepped aside as auditor of Longtop Financial Technologies, a financial software provider from Xiamen, citing concerns about its accounts. In what is surely one of the most self-abrasing press releases ever assembled, Longtop itself said Deloitte had quit after identifying false financial records on cash and loan balances, the deliberate interference by Longtop management in Deloitte’s audit process, and the unlawful detention of Deloitte files. In late August Longtop said it could face legal action from the US Securities and Exchange Commission for violating disclosure rules.

And in January KPMG said it had found possible irregularities in the books of China Forestry, which is listed in Hong Kong; China Forestry’s shares were then suspended. Other problematic examples include Nasdaq-listed RINO International, which makes pollution control equipment, but admitted in March that two previously reported contracts didn’t exist (it has since been delisted); and Duoyuan Global Water, listed in the US, which has been suspended after it borrowed money from related parties and booked it as sales.

It’s hard to say how widespread this problem is, but some estimates are troubling. A Moody’s report in July assigned red flags to the corporate governance of 61 rated Chinese companies, including some big names like Hong Kong-listed Winsway Coking Coal. It spoke of “the inherent challenges in assessing these Chinese companies: their short history of operations, their diverse industries with limited peers for comparison, their concentrated family ownership structures, and their high-growth environments.”

But however widespread, it is causing a major challenge for the big four accounting firms who have worked long and hard to build businesses in China. Auditing Chinese firms who are readying themselves for international listing is a lucrative source of revenue. But at what risk?

At the very top level, there’s no obvious problem; corporate governance at some Chinese blue chips is in line with international best practice. The problem comes in smaller companies, often private sector seeking to float on the rising tide of investor interest in the China story. Here, auditors face a challenge: stick with the big names they are comfortable with, and forsake other revenue? Or spread the net wider and run the risk of it catching unscrupulous companies?

“My personal view is that the big four may step away from some high risk Chinese clients for the sake of their own reputation,” says Helen Yang, lecturer in accounting at Victoria University, who is working on a CPA Global Research Perspectives project on China’s convergence with IFRS international accounting standards. “If you look at those cross-listing companies controlled by the central Chinese government, a majority of them have the Big Four as auditors. To protect themselves, perhaps in the future they should have their own niche targeting these big Chinese companies rather than focusing on revenue accumulation only.”

But that would be to abandon a vast source of revenue: the private sector constitutes an ever greater part of the potential revenue pool for accountants in China – and the majority, it should be stressed, are legitimate businesses. It’s a debate that is troubling accountancy groups. All four of the big four names declined to comment on this story; however, before they all stopped talking, Paul Winkelmann, the partner in charge of risk and compliance for PWC in Greater China, was quoted as saying “costs have gone up, fees have gone down, as competition for fees is enormous. You can easily see there is a real risk of an audit firm failing.” Another big four auditor in China, asking not to be named, says: “I wouldn’t say we have changed our procedures exactly. But people are being careful.”

The generous interpretation of recent malfeasance is that it represents teething problems in Chinese corporate engagement with the world. “The way we read what’s going on in China among these smaller companies is that clearly many of them are relatively new to being listed, and aren’t entirely sure what they should be doing,” says Jamie Allen, founder and secretary-general of the Asian Corporate Governance Association. “We see some companies listing in Hong Kong, private Chinese companies that have only been in operation for a few years. If you look at governance, track record and continuity, it often raises lots of questions. If these are to be allowed to list on overseas exchanges, then it is absolutely to be expected that some are going to run into problems.”

Allen says this is not new – several years ago many companies listed on Nasdaq were sued for disclosure problems. “There has been a certain history of Chinese companies listing in the US then not fully disclosing material events and issues, then being sued through class action law suits.” But one of the things that is new is the scale of institutions that are being caught up, and that is turning it into a matter of concern for international regulators. Fidelity, for example, held 14.5% of Longtop’s stock as of its last filings on March 31, with major hedge funds also well represented. John Paulson, famous for spotting the problems in mortgage- backed securities early and making a fortune from them, was a Sino-Forest investor – selling out before suspension but at a heavy loss.

It has been sufficiently alarming for the US audit watchdog, the Public Company Accounting Oversight Board (PCAOB), to send a team to Beijing in July, for what has since been billed the “Sino-US symposium on audit oversight”. This pledged closer cooperation; beyond that, PCAOB spokeswoman Colleen Brennan told IntheBlack: “The PCAOB does not talk about any open enforcement investigations. Our recent trip to China was to talk about opening China to PCAOB inspections of auditors that are registered with us.” She also says Chinese officials have agreed to come to the US in October. Elsewhere, the Ontario Securities Commission is to review all companies listed in Canada with significant business operations in emerging markets, focusing on roles played by auditors and underwriters.

One common pattern in all of this has been that companies have often listed through reverse takeover, or back-door listing, which have less onerous standards than a whole new listing; this was the case with Sino-Forest, for example (although not Longtop, which raised US$210 million in an IPO in New York). PCAOB published a study in March which identified 159 Chinese companies that had listed on US capital markets alone through reverse mergers between January 2007 and March 31 2010 – and that’s without looking at Toronto, which has many more. That’s almost three times as many as the 56 Chinese companies that launched US IPOs during the same period. Between them, the 159 back-door listed companies had a market capitalization of $12.8 billion as of March 31 2010.

While the US and Canada allows this approach, Hong Kong has banned any attempt to get around listing requirements through a reverse takeover. “The US allows back door listings, which effectively means you do get much riskier companies,” says Allen. “In Hong Kong we started controlling these back in 2004. If you do a back door listing the exchange is not simply going to let that through; it treats it as an IPO and holds you to the same standards.”

“In the US there is a whole cottage industry of investment banks, accountants, auditors and law firms who specialise in these back door listings,” he adds. “Our problem with that is, they effectively undermine the IPO process and investor protection.”

The problems have come at a time of dramatic evolution in China’s domestic accounting industry. China is in the process of entering a new accounting regime, called Chinese Accounting Standards for Business Enterprises, which are largely in line with IFRS. CASBE was announced by the Ministry of Finance in 2006, began implementation for listed companies in 2007, and has since grown to cover local state-owned enterprises, commercial banks and insurers. A roadmap for further convergence with international practice was released in 2010.

Are challenges in Chinese disclosure related to this evolution? Professor Colin Clark, also at Victoria University and co-author of the CPA study, says that the varied quality of reporting is “a consequence of the stage of development of the profession. There are issues in the adoption of IFRS, issues around translation into a foreign language, and the shift from a more prescriptive basis of standard setting to a more principle-based system.” This inevitably gradual process of on-the-ground transition is a bigger problem than the regulatory infrastructure above it. “I don’t think the problems we’re referring to are problems of an absence of professional framework. The standards are in place. The problems are around implementation and enforcement.”

Naturally, no transition to international best practice takes place immediately. Yang says: “Because Chinese convergence with IFRS only started in 2007, it takes time for Chinese accounting professionals to catch up with international practice, and it is a steep learning curve for them to get used to IFRS.” And on top of that, there are clear issues around staffing. “The challenge is enormous,” says Clark. “The industrialization of the country has meant there has been enormous demand for accounting professionals, and a real challenge in producing sufficient graduates.” Other issues may be cultural – less willingness to speak out in a hierarchical structure, for example. (The Chinese Institute of Certified Public Accountants refused to answer IntheBlack’s detailed written questions on the profession and what is to be done about disclosure issues.)

There’s an issue here for the big four, because the near-monopoly they have held in being able to audit companies listing overseas appears to be ending. With convergence, it is understood that Chinese local accounting firms will also be allowed to do the auditing services for internationally listed companies. They will become direct competitors, and with much lower auditing fees. “The challenge for the big four is rising market competition in accounting services from local Chinese firms, and the need to localize their practices to be aware of the social and political context of China. Accounting reform in China goes hand in hand with economic reform.”

Even if big four groups are expected to have world-class standards in their accounting, there is some sympathy even at this level for those who have been duped by dishonest companies. “Even among state enterprises there have been significant frauds where bank statements or invoices are fraudulent, where a whole web of fraudulent deals has been set up with suppliers, customers and banks,” says Allen. “If you’re auditing that, it can be extremely difficult. On a typical audit you assume the documents companies are giving you are legitimate, so you’re cross-checking the trading and transactions the company is doing with the bank statement. Most are not forensic audits; that would cost a lot more money and effort.”

It should be said, too, that big four accountants resigning from auditing their clients’ books is not really a bad reflection on the accountants themselves; indeed, it’s what they should do. But nevertheless they find themselves in a challenging position with some tough decisions to make around, expansion, revenue, reputational risk and strategy. The coming years will be interesting.

Sidebar: The muddy waters of disclosure

A central character in recent Chinese accounting issues is a man called Carson Block, who founded a research firm and investment manager called Muddy Waters. The name comes not from the blues singer but a Chinese expression: Muddy waters make it easy to catch fish. In other words, there are opportunities to make money when things are opaque.

Block’s strong sell recommendation on Sino-Forest on June 2 set in motion its share price collapse and subsequent investigations and law suits. He really doesn’t pull his punches: the report, at a time when the company’s stock was riding high, said:  the company “was aggressively committing fraud since its RTO [reverse takeover in 1995”, and was “a multi-million dollar ponzi scheme, accompanied by substantial theft.” More specifically, it claimed the company had dramatically overstated its forestry holdings and passed revenues through a host of intermediate companies in order to confuse auditors.

A look at the Muddy Waters research list shows only strong sell recommendations, in all cases on companies where fraud or at least mismanagement is alleged: Orient Paper, RINO, China MedicaExpress, Duoyuan Global Water. In Block’s view, fraud is widespread in China, and the big four firms face great challenges in detecting it. One of his central points is that a company can, in a sense, fake transparency, in that it provides a great deal of information but not the right sort. He argues that auditors might be looking for aggressive accounting, but not a situation where the underlying business doesn’t even exist.

There is another side to this coin though. Block is not just a good governance advocate in the mould of renowned Hong Kong gadfly David Webb, or Allen’s ACGA; he is there to make money, and in every instance has built a short position in the stocks he then hammers in his reports, profiting from their subsequent share decline. Block is open about this: whenever interviewed, he points out himself that he is conflicted.

But the power of raising a red flag can be very destructive. Raising doubts about accounts is all but guaranteed to knock a share price hard, providing gains to anyone shorting the stock. The latest name to appear is Silvercorp Metals, a Toronto-listed company, accused by an anonymous whistleblower in early September of a “potential accounting fraud” worth $1.3 billion. Silvercorp has strongly denied this, publishing many documents to support its accounts; it has retained analyst support, such as broker BMO, which maintains an outperform rating on the stock; and as yet the Ontario Securities Commission has taken no action. No matter, the share price fell 10% in a day anyway; its management said there had been a dramatic increase in short positions on its shares in the last two months.

And this is a central point: there’s actually nothing new in irregularity in accounts for overseas-listed stocks. What’s changed is scrutiny. “The difference is people like Muddy Waters and other hedge funds are realising there are problems, short selling, putting out reports and publicly criticising,” Allen says. “They are essentially taking advantage opportunistically of a problem that is real, but I don’t think you would necessarily find in every PRC company listed in the US.”