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.

Hyundai Capital demonstrated the appetite that remains for the right Asian names with a 10-times subscribed $500 million deal that caught a mood of improved investor sentiment.

Hyundai Capital America, a vehicle guaranteed by Hyundai Motor Company, set out yesterday [Thursday] for a maximum of $500 million in 5.5-year senior notes through a five-strong bench of joint bookrunners: BNP Paribas, JP Morgan, HSBC, Bank of America Merrill Lynch and Morgan Stanley.

It did so on the back of rare positive news from Europe, with a coordinated injection of liquidity by leading central banks. When China further improved the mood by reducing the reserve ratio by 50 basis points, effective December 5, it was clear that the issuer had timed its run perfectly. Those close to the deal say the Regulation S/Rule 144a transaction’s books had topped $1 billion by lunchtime in Asia; by the time US accounts were active, the book crossed the $5 billion mark, with 320 participating accounts. Having been offered with guidance of 345 basis points over US Treasuries, it was launched at T+315. The 4% notes came at an issue price of 99.551%.

A slight majority went into the US, with 54%, followed by Asia with 34% and the European Union 12%. This was a stark contrast to a $750 million bond from ICBC just 24 hours earlier, which hold sold 95% into Asia with almost no participation from investors in the west. Fund managers took 60% of the Hyundai deal, with banks and private banks 20%, insurers and pension funds 11%, and corporates and others 9%; this too was notably different to ICBC, where one third of the book came from insurers.

“This is a great name to bring to the market at any time, and especially in the choppy conditions we have been seeing,” said someone close to the deal. “We’ve only seen the best names being able to get things away: Indonesia, PLN, KDB. This name has been well followed in the US, Europe and Asia for a long time, and we were watching the market with them looking for the right window.”

While Hyundai could clearly have raised far more, it had capped the issue at $500 million since that was all the funding it needed; this may have contributed to the size of the book as investors, expecting to be scale back, bid for more than they needed.

The deal has tightened around 10 basis points since launch, on an otherwise generally flat day in the equity and debt markets after yesterday’s exceptional rallies.

It is not clear, though, whether this window will prompt many other new issuers to launch. Bankers point out that the end of the year is close by. “You may see one or two more trades potentially, but I wouldn’t put it at any more than that,” said one banker.

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.”

The Korea Development Bank illustrated the renewed optimism in dollar markets overnight with a tightly-priced US$1 billion 5.5-year benchmark.

The deal’s six joint bookrunners – Bank of America Merrill Lynch, Credit Suisse, Daiwa, Goldman Sachs, KDB Asia and Mizuho – had initially suggested a deal of at least $500 million, with pricing around 300 basis points over Treasuries. Instead, the deal raised US$1 billion and was still six times oversubscribed by over 350 accounts, pushing pricing to a revised range of 280-290, and eventually locking in at the tight end of that range. Whereas Korea National Oil Corporation (KNOC) had paid a new issue premium of at least 30 basis points in its market-reopening US$1 billion bond a week earlier, those close to the deal suggested that the re-offer spread on the KDB bond represented a new issue premium of just five basis points – the lowest in all emerging markets since May.

Several things worked in the deal’s favour, most obviously the sense of progress in Europe’s sovereign debt crisis. The issuer had originally been talking about a deal next week, but moved quickly to take advantage of positive sentiment, without bothering with a global roadshow. Books were closed at 9.30am New York time when the level of demand became clear. “It’s a confidence game,” said one banker. “Nothing matters except Europe at the moment when it comes to investor sentiment.”

Another may have been the fact that KDB is expected to be privatized with an IPO next year, at which point its paper is expected to become subject to an explicit government guarantee. KDB is already rated flat to the sovereign (A1/A/A+).

Almost half (48%) of the 3.875%, SEC registered, senior unsecured deal went to Asia, with 37% to the US – a traditional stronghold of demand for Korean bank paper – and 15% Europe. 39% went to asset managers, 23% to banks, 20% to corporates, 10% to private banks and 8% to insurers and pension funds. There were several anchor orders of $100 million or more from Asia.

Euroweek: Bank of East Asia

Bank of East Asia completed a US$500 million bond late on Friday to continue the revived momentum in the Asian dollar bond markets.

Hot on the heels of a $500 million issue from Sun Hung Kai Properties and $1 billion from Korea Development Bank, Bank of East Asia followed their lead by tightening guidance dramatically and issuing a well-received benchmark.

The 10.5 year Regulation S bond, callable after 5.5 years, pays 400 basis points over 10-year treasuries – a remarkable inward revision from initial price talk of 500 basis points plus or minus 12.5 points. Guidance then moved to 450-475 basis points over treasuries, before settling fully 50 points inside the tight end of that range. Those close to the deal report an orderbook of $4.4 billion – enough to cover it almost nine times over – from over 230 accounts.

The bond carried a 6.375% coupon and priced at 99.849 to give a yield of 6.395%. Asia led the support for the deal and accounted for 83% of the book, with Europe adding 11% and offshore US (this being a Reg S deal) 6%. Fund managers accounted for 36% of demand, private banks 25%, banks 21%, insurers 12%, and corporates and others, 6%.

The subordinated bond, rated A3 by Moody’s and BBB+ by Standard & Poor’s, was lead managed by Deutsche Bank, Citigroup and UBS. After 5.5 years, the coupon resets to a fixed rate equal to five year treasuries plus the initial spread.

Qantas The Australian Way, October 2011

Two South Korean soldiers stand facing north, fists bunched, in a taekwando stance, staring straight ahead. A few metres away a North Korean soldier looks straight back at them. More South Korean soldiers join their colleagues and glare with them, their intended sense of menace enhanced by sunglasses that leave only the rictus clench of their jaws from which to guess their expression. Time seems to stand still. But the moment passes; an everyday standoff.

And the 20 watching tourists file away.

Welcome to Panmunjom, also known as the Joint Security Area (JSA) – the border of North and South Korea. Bill Clinton once called this “the scariest place on earth,” and he was on to something: the tension is everywhere in this extraordinary location, the only place where you can see what’s left of the Cold War up close and personal. It’s a stark illustration of one of the most dangerous potential flashpoints on earth, a mental and sometimes physical conflict that has held fast for more than half a century. But it is also, improbably, the heart of a burgeoning tourist itinerary.

To see the article as it ran in the magazine, with photography, click here: qa1011_Korea indd

Three Seoul tourist operators – only three have been licensed – specialize in tours to both Panmunjom and the broader demilitarized zone (DMZ), a 4 kilometre wide, 241-kilometre long coast-to-coast no-man’s-land along the border that was the basis of the 1953 armistice at the end of the Korean war. And if it seems an absurd thing to do with a free day in Seoul, think again; it’s hard to think of a tour that could teach you more about the threat and tension that Koreans face every day.

A typical tour takes one of two approaches, or combines them into a single long day. DMZ tours focus on one of the four North Korean tunnels that have been discovered in the South’s territory since the 1970s, each one bigger and more sophisticated than the last. The third of them – the biggest and the closest to Seoul, having reached just 44 kilometres from the city – has been opened to tourists as an attraction, and a popular one too.

Donning a hard hat and heading down a slope 73 metres into the ground, visitors reach a dark tunnel that runs 1.6 kilometres, of which they can walk a few hundred yards. It is an extraordinary sight. Officially it’s two metres by two, although it never really feels that high; apparently that’s big enough to get a full infantry battalion through in an hour. At the end of the section that’s open is one of three concrete blockades, each protected by coiled razor wire. It is chilling to think what’s beyond them and what these tunnels were intended to do.

It also demonstrates the way that these tours combine the terrifying with the somewhat surreal. When South Korea discovered this tunnel by boring in 1978, the retreating northerners set about coating the walls in coal dust, so that they could claim they had been looking for coal; to this day, all you have to do is rub your finger against the wall and find your finger coated black but a solid block of coal-less granite behind. In fact, the whole idea is somehow preposterous: this instrument of invasion has been turned into a lucrative money-spinner for the South Korean state, which is nothing if not making the best of things. Guides say that the north has since, in all seriousness, asked for a share of the proceeds, since it put the effort into digging the tunnel in the first place.

The DMZ tours usually take in the Dora Observatory too, where there is a viewing platform with binoculars allowing a clear view into the North. From a distance, it looks surprisingly beautiful: a range of pleasing peaks, often covered in snow. From here one can clearly see two of the tallest flagpoles in the world, one on each side of the border, a game of one-upmanship eventually won by the North Koreans whose flag files some 160 metres high.

It’s no surprise that visits into places like these come with some eccentricities. Most nationalities (but not South Koreans, who must undergo a separate approval process) can do the tour, though you will have to sign a disclaimer warning of the “possibility of injury or death as a direct result of enemy action”. Photography is complicated too. At Dora, there is a painted yellow line some distance back from the viewing platform; you can’t take pictures any further forward, thus rendering any useful picture of the north impossible. (It may be, though, that this is to stop cameras being mistaken for weapons by alert snipers. “We had to close this observatory recently because you are a target for North Korean soldiers,” says our guide. “But I think it should be OK this week.”) Elsewhere, you can’t take a camera into the tunnel, but can buy a jigsaw of a photo of the tunnel in the gift shop, right next to the DMZ baseball caps and the officially endorsed DMZ barbed wire gift sets; and you can’t take a lens any bigger than 100mm into Panmunjom.

Still, the Panmunjom visit – the alternative to the DMZ tour – does illustrate clearly why tour guides take precautions. When one is facing North Korean soldiers with binoculars barely 50 metres away, it is best not to give them any reason to think you are armed. Photo-opportunities here are strictly moderated, and the trip is preceded by a detailed briefing at nearby Camp Bonifas – named, if a reminder of the gravity of the place was needed, after one of two US soldiers hacked to death with axes after attempting to cut down a poplar tree that was interfering with the view between two checkpoints.

There is, though, plenty to see here – far more than one might expect. The border is straddled by a series of blue UN buildings in which official meetings are still often held, and you can enter one. Since the border bisects the main table (upon which three microphones record every word that is spoken), this is the one place where one can wander unrestricted into North Korea, or at least a few metres of it. Next to the building, you can see a small concrete line that marks the border. Also in the JSA, you can see the so-called Bridge of No Return, one of two locations (the other being the Freedom Bridge at the south of the DMZ, covered on both tours) where prisoner exchanges have taken place over the years.

The whole area is full of surprises. There is a town practically on the border on the South Korean side, called Daesong-dong, and apart from the constant threat of imminent invasion it’s not such a bad place to live: there are no taxes, no national service, and the land is free, while farmers raise ginseng, rice and beans. Also, since nobody in their right mind (Daesong-dong apart) has built within the DMZ for more than 50 years, it has evolved into a wildlife reserve, with flocks of birdlife, and wild deer skipping within sight of the tour buses.

There is a hope that, when reunification comes, this will remain an environmental haven. But the truth is reunification is much further away now than it was eight or nine years ago. And for all the perplexing novelty of a border tour, it’s also a sober reminder of the brutality of the Korean War. They call it a fratricidal war: that is to say, brother against brother. A glimpse of the border in action provides both a reason for hope that it will never be repeated, and an illustration of the fear that it might.

BOX: You went where? Five destinations to brag about

1. North Korea. It’s actually not that hard to visit North Korea for real. The established experts are Koryo Tours, a westerner-staffed outfit in Beijing; in particular they specialize in getting people in to the stunning Mass Games, among the most remarkable things you will ever see. It’s safe, too – apart from the flight in.
2. Darvaza. In the 1950s, Soviet gas explorers accidently collapsed the roof of a cavern in the desert. Within, they smelled methane, so decided to burn it off before continuing exploration. They thought it would take a day or two; it’s still going after half a century. Now in Turkmenistan, camping next to this vast, flaming crater is like the gates of hell – which occurred to the locals too, since Darvaza means Gateway.
3. Chernobyl. Remarkably, Chernobyl is now a tourist attraction run by the Ukrainian government. The 30-mile exclusion zone is now open, although some areas are still considered too dangerous to visit.
4. Anthrax Island. Gruinard Island, off the magical Scottish highlands, has a sinister past as a hope for biological warfare testing  in 1942. But after decontamination – including the entire island being drenched with formaldehyde – it was declared clean in 1990 and is now openly promoted to tourists, as well as harbouring plenty of healthy sheep.
5. Everywhere else. When you think about it, the world is full of macabre attractions predicated on suffering of some form or another, from Alcatraz to the Tower of London, Changi prisoner of war camp to Mandela’s cell on Ryker Island. And if you think Australia’s different, just pop over to Sydney’s Pinchgut Island.

Covered bonds globally have just enjoyed a record January, with Eu45 billion of supply in the European markets alone. The market grew 45% in 2010 to US$311 billion, on Thomson Reuters numbers. But what of Asia Pacific? Oddly, this part of the world – so important in global GDP and trade, and increasingly in capital market flows – has completely missed out.

But that might be about to change. In Australia and New Zealand, covered bonds – collateralized against set pools of assets on the issuer’s balance sheet which can be claimed by investors in the event of a default – are starting to appear from foreign issuers, while legislation is underway to allow domestic borrowers from those countries to start issuing them. In the rest of ex-Japan Asia, activity has been limited to a couple of experiments in Korea, but it would make sense to see several markets take a look at the asset class in a post-financial crisis world.

They do, after all, have a lot to recommend them. “For banks, they are not only a way to get cost-effective funding at a good price and tenor, but also a great way to tap into a global investor base,” says Ted Lord, managing director at Barclays Capital. “With the financial crisis, in some cases, it has been prohibitive for banks to issue senior unsecured debt. This is a good way for them to move to a more supportive market.”

Issuers launching covered bonds can expect to reach investors who were otherwise out of reach. “The central banks are typically looking to invest in safer credits, with stable secondary performance and preferably with AAA ratings,” says Sean Henderson, head of debt capital markets at HSBC Australia. “The covered bond market therefore helps issuers access these deeper pockets more effectively.

“The other buyer base that covered bonds help with are the bank balance sheets, again because of the AAA rating which makes them more capital efficient,” Henderson says. Covered bonds, he says, “are looking to be more of a rates-type instrument: lower volatility, safer, higher ratings.”

And so there’s a clear investor base to support a new market. Lord adds: “For investors, given some of the changes we’ve seen in the banking landscape, if they can get a good yield and tenor and have the bond collateralized by a bank’s best assets, it is an attractive proposition.”

Activity so far has been from foreign, and predominantly Canadian, borrowers. Covered bonds of this kind do have a pre-crisis track record in Australia, but it has only recently revived.

First, in October, Canadian Imperial Bank of Commerce launched A$750 million of three-year bonds through ANZ, HSBC and UBS, with CIBC World Markets as a joint lead without books. In January, Bank of Nova Scotia completed an A$1 billion covered bond issue through HSBC, Scotia Capital, UBS and Westpac. The Bank of Nova Scotia deal priced at 46 basis points over semi-quarterly swaps, with a yield of 5.9%; CIBC paid a 5.75% coupon and a yield of 5.89%, equating to 48bps over swaps. Both had the backing of CMHC, Canada’s national housing agency, and are secured against fully insured residential mortgage loans. “We learned [from the Canadian issues] that the engagement across the market has been a lot broader, across multiple investor types, than our initial sense,” says Dean O’Hara, head of fixed income syndicate at UBS in Australia. Both deals are believed to have gone roughly 50-50 to bank balance sheet and real money investors. “We were pleasantly surprised by the uptake from the real money side from what has traditionally been perceived as a bank balance sheet product.”

For issuers like these, it’s natural that the A$ market should be appealing: issuers see the Australian dollar as a method of diversification; there’s a ready investor base keen on the additional protection; and covered bonds are seen as an increasingly preferable alternative to asset-backed securities. On top of that, the basis swap is working in favour of Australian issuance. Spreads can be as much as 50% inside the cost of senior unsecured debt if the swap is favourable. “The Australian dollar investor base for covered bonds has been developing rapidly, including a strong local bid,” says Henderson. “With the CIBC and BNS trades there was a pretty intensive education process among the Australian investor base, talking through the covered bond concepts, the structuring, secondary trading performance of the product, and so on.” With that education completed, there is a strong investor base ready for foreign issuers. “There is a pipeline: not exceptionally heavy, but certainly a good number of interested parties looking at issuance in Australian dollars.” Dexia Municipal Agency is also expected to launch covered bonds in Australia, as is Royal Bank of Canada.

What’s in the works now, though, is something new: Australian issuers. In December, Treasurer Wayne Swan announced reforms across a range of areas, including proposals to allow all banks, credit unions and building societies to issue covered bonds. This change was part of a broader policy called the Competitive and Sustainable Banking System reforms, which included support for the RMBS market and trading of government bonds on exchanges.

Getting to this point has taken six years, and the prompt may have been Basel III. Until now, the Australian Prudential Regulation Authority (APRA) has blocked any moves to develop a covered bond market, because doing so would have required it to change the Banking Act, and more specifically the provisions which give depositors precedence over any other creditor, including debt holders. From APRA’s perspective, they have been forced to rethink because of the increased liquidity requirements imposed by Basel 3: it is now beneficial, and perhaps vital, to increase the range of available funding sources for Australian banks.

“The liquidity requirements under the new regulatory framework for banks are going to require more and more paper,” says Pierre Katerdjian, global head of credit markets at Westpac. “Covered bonds fit into that space. There is a natural home for that product among some of the biggest fixed income buyers in this market.”

But these are not straightforward matters for regulators or parliaments. “To get covered bond legislation up and running and put the program in place takes time,” says Lord. “Parliamentarians have to understand the basis of what is being done. Don’t forget that covered bonds are great for a covered bond investor but they create a dilemma for a regulator, because in insolvency the best assets of a bank are collateralized and subject to a priority claim by covered bond investors. It means there might not be so much left for depositors or unsecured lenders.”

Fergus Blackstock, head of DCM at UBS in Australia, says that covered bonds have been notable by their absence in Australia in recent years: a market with big banks, strong balance sheets and prime assets, perfect for covered bonds, yet unable to issue them. “The deposit protection in the banking act was the big regulatory obstacle, but when markets dislocated, covered bonds proved a stable form of funding,” he says. “When you are looking at funding a banking system, you want as many avenues for funding as you can. Everyone has had another look at covered bonds in the context of the crisis.”

Suggestions are that Swan will limit covered bond sales to 5% of total Australian assets, similar to the 4% limit in the UK and Canada (in New Zealand it is 10% – see below). Some analysts believe the market could therefore be as big as A$120 billion. Nomura’s Ben Byrne has said that, at 5%, “we expect covered-bond issuance to amount to approximately one full year of each bank’s term funding requirement, or around 20%-25% of the term funding requirement on an ongoing basis.”

It’s not there yet, though. Although Swan has announced his intentions, the industry and APRA are still in discussions about how best to build a suitable framework, and the legislation must still clear parliament – not easy in a country where the government holds the slimmest possible majority, and even then only because of alliance with independents. “We think the changes to the banking act could happen in the next month or two, that piece is imminent,” says Katerdjian at Westpac. “The expectation is high that it will get through: both political parties appear to be in agreement, and if there’s a delay I expect it will be because it’s been caught up in the politics around the other broader banking regulatory changes being discussed.” Once agreed, royal ascent will take “a couple of months,” he says, and then “a covered bond framework needs to be developed in Australia, which could take another six months. But the reality is that once the Banking Act is changed, APRA may well say to the majors: go ahead and start issuing.”

Certainly, APRA is making more positive noises about the market than used to be the case, with chairman John Laker telling a Senate inquiry in December that it would work with government and industry on the proposals provided that depositors remained suitably protected. “It is early days but negotiations are very constructive and making good progress,” says Blackstock. “We don’t have a draft regulation out yet, but we expect it to be a 2011 development.”

When issuers come, they’re likely to find a receptive global audience no matter which currency they launch in. “It helps if you have strong banks, and Australian banks are among the world’s strongest. Australia’s financial system was one of the most sound coming out of the financial crisis,” says Lord at Barclays. “Do you have a fairly big mortgage market? Yes you do. Do you have many high-quality public-sector borrowers? Definitely. The ingredients are there for a promising and growing Antipodean covered bond market.”

“Domestic issuers, most people are revving their engines,” adds Katerdjian at Westpac. “They are keen to go, particularly the majors, and are just waiting for the legislative changes to go through.”

New Zealand is already one step ahead. In November, Bank of New Zealand – a unit of National Australia Bank – launched the country’s first covered bonds in a Eu1 billion seven-year deal through Barclays Capital, Deutsche, JP Morgan, RBS and National Australia Bank, and has also issued in New Zealand dollars. It instantly demonstrated the cost advantages of the asset class: at 2.125% and 62 basis points over mid-point swaps, they priced well inside the same issuer’s existing senior unsecured bonds. A seven-year New Zealand dollar bond had priced at 112 basis points over mid-swaps just a few months earlier.

At the time of writing, Westpac New Zealand was completing a roadshow to issue in euros through its Westpac Securities NZ vehicle. The issue, part of a Eu5 billion covered bond program set up last year, was expected to be rated AAA, compared to Westpac itself (AA) or Westpac NZ (Aa2/AA). Barclays Capital, BNP Paribas and UBS are leading the deal. “Feedback was very strong on the roadshow,” says Blackstock at UBS. “The market is very open, not only to this region because it had a ‘good’ crisis, but because of the diversification it is going to offer. The covered bond market is big and deep but has a lot of repeat borrowers; there is good appetite for a new jurisdiction coming on stream.”

New Zealand has set criteria for covered bond issuance from its banks, limiting issuance to 10% of total assets. The limit will be reviewed over the next two years. Grant Spencer, the deputy governor of the Reserve Bank of New Zealand, said the limit “will allow banks to develop covered bond programmes, whilst providing a conservative ceiling on issuance in the short term.”

There are, though, limits to how far the market will go. “It’s important to bear in mind that covered bonds are not apples and apples,” Katerdjian says. “The underlying ratings have to support the issues. While they will get some funding benefit from this new product, there’s not really going to be a huge direct impact for the smaller financial institutions in Australia: if you’re BBB+ you simply aren’t going to get the same ratings uplift benefit as a major AA issuer.”

And while it’s tempting to see Australian and New Zealand as the vanguard of a new wave of legislation across Asia, it should be remembered that they are something of a special case. “The Australia and New Zealand angle is slightly differentiated from the rest of Asia,” says Sean Henderson at HSBC. “Australian and New Zealand banks are all very high quality already with deep and liquid senior curves, and they fund quite a lot in the international markets. For other Asian credits, they don’t tend to issue in large volume and don’t need a significant amount of senior funding, if any at all.

“That’s why we’re seeing things develop in the Australian and New Zealand markets first: they’re going to benefit the most from accessing new investor bases, creating new depth in markets, and gaining access to bank balance sheet and central bank investors. It’s about gaining diversity, which obviously makes their funding task easier and less prone to volatility.”

BOX: Elsewhere in Asia?

Outside of Australia and New Zealand, the only place in ex-Japan Asia to have shown any interest in the development of a covered bond market is Korea. In May 2009, Kookmin launched a US$1 billion five-year covered bond issue. Then in July 2010, Korea Housing Finance Corp raised US$500 million in 5.5 year covered bonds through BNP Paribas and Standard Chartered.

For backing, KHFC used a pool of trust registered assets (25 to 30 year residential mortgages) held by the bank through statute. This differed from Kookmin’s earlier deal, which had used bankruptcy-remote vehicles, making it something of a halfway house between asset-backed deals and covered bonds in the European sense. When Kookmin issued, there was no legislation equivalent to European standards of covered bonds; since then, the KHFC Act has been passed, giving investors a priority claim on cover pool assets.

“When KHFC came out with the first statutory covered bond out of Korea it was five times oversubscribed, which shows investors want it,” says Warren Lee, global head of structured finance solutions at Standard Chartered. But while it attracted a solid book, in pricing terms it seems to have been a tougher sell. Although the deal sold around the world, 49% of it going to the US, KHFC priced at 235bp over Treasuries and 197 bp over mid-swaps for a five-year deal – not a sufficient improvement on the institution’s usual cost of funding to warrant many copycat issues. “Some investors felt that first time issuers with a legal structure that has never been seen before require a significant premium over an unsecured issue,” says Lee. “There’s some validity in that: Korea has gone through two big crises and has never tested a default scenario. But others thought it should price near the sovereign or as a quasi-sovereign, and if you look at the secondary spread today it is pricing inside where a quasi-sovereign is.”

Asian banks, though, have less of an obvious need for covered bonds than others in the world because there is so much liquidity for them already. KHFC did it in the name of opening a new source of financing, not just for itself but other Korean banks and mortgage institutions (KHFC is a state-owned entity with a public policy function). “The key reason it hasn’t developed before now is liquidity in the market,” says Lee. “In the bank sector the loan to deposit ratio averages around 70%: there’s no need to tap funding. Very few Asian banks have senior unsecured bonds outstanding because they can easily fund through bank deposits. Korea is the only exception, which is why it was the first to push out covered bonds.”

Still, he’s hopeful of more issuance. “KHFC has a program and will hope to tap two deals a year,” he says. “Once KHFC approves other Korean banks to issue, they will do the same.”

While the KHFC deal was closer to European standards than the Kookmin one, there is still a sense that the stringency in the Pfandbriefe market in particular is greater than anything that has been produced from Asia Pacific thus far.

“The investor reaction to the Korean deals shows not only that having the legislation is really helpful, but also that the investor base is looking for some sense of how the bonds fit within the overall covered bond market,” says Ted Lord at Barclays Capital. “What are the rules, what happens if there is a default, how easy is it to take control of the covered pool? They are all questions investors continually ask.”

And even if Korea builds a market, where else? Malaysia and Thailand set up task forces to look at covered bond markets two years ago but were hit by the financial crisis. Singapore could be a candidate but there is little market discussion about it. Hong Kong would be the best fit, but no issuer immediately needs it. “In Hong Kong it’s up to the banks and private sector to push this through,” says Lee. “Right now nobody has any funding needs: in Hong Kong the only worry is how you lend more money. But their local currency is rated AAA by Moodys, so they would be ideal to issue covered bonds.”

In the end, it’s usual about critical mass: one good deal leads to others. “Nothing succeeds like success,” says Lord. “It’s just a matter of time until you see more countries getting involved in this.”

Euromoney, April 2011

Chief investment officers of sovereign wealth funds are, by definition, a rare breed. Despite the $3-4 billion of global capital they manage between them, there are only about 40 such funds in the world. Scott Kalb is rarer still: a foreign CIO.

Kalb works at one of the newest sovereign funds, the Korea Investment Corporation, which was founded in July 2005 and really only started putting money to work in November 2006. Kalb was not there at the start – he replaced Guan Ong, another non-Korean, as CIO in April 2009 – but he is nevertheless instrumental in shaping one of the sovereign funds that is most animatedly discussed by the fund managers who pitch them for business.

KIC is one of a cluster of sovereign funds that comes with a somewhat nebulous mandate. Unlike the sovereign funds of Abu Dhabi, Kuwait, Qatar or Norway, it does not have to invest the proceeds of a depleting single commodity asset like oil and gas. Unlike the Government of Singapore Investment Corporation, it does not have overall responsibility for a country’s foreign exchange assets. Unlike Australia’s Future Fund, it does not set out to meet a clearly defined need like an unfunded pension liability. Instead, like fellow newcomer the China Investment Corporation, it has no liabilities, and no obvious mandate bar protecting and generating a return on sovereign wealth for some as yet unspecified future need. “We don’t have a liability stream, so our job is to protect and grow this capital for the benefit of future generations in Korea,” Kalb says on a snowy January day in Seoul. “They haven’t yet defined how this money is going to be spent – we hope it will be spent on positive social infrastructure, or other things that will benefit the people – but in the meantime our job is to protect it and grow it.”

Trying to compare sovereign wealth funds, with their myriad mandates and attitudes, is “like a blind man trying to describe an elephant by touching it,” Kalb says, and the constituency of sovereign funds without liabilities is a small subset of the sovereign wealth world. The lack of that liability stream ought to mean a greater freedom in investment approach, and since his arrival Kalb has been trying to develop an investment policy that takes advantage of that. “When I first came here we were 100% in publicly traded fixed income and equity – 70% of it in fixed income,” he says. He and his team then moved that to 50-50, then in June of 2009 introduced an alternative investment program, which really meant investing as an LP in private equity, hedge funds and real estate. Next came commodities and inflation-linked bonds, and then strategic investment.

“The first thing you’ve got to do if you want to create a bulletproof portfolio is you’ve got to diversify,” he says. “You want uncorrelated return streams. And if you are a sovereign wealth fund without a liability stream, one of your biggest advantages is a long-term investment horizon.”

But that doesn’t fix all your problems. “Being a long term investor is no magic bullet,” he continues. “Just because you can invest for the long term doesn’t mean you are always going to make money: if you invested in the top of the market in 2007, even though you are a long term investor you may never get your money back. Being a long term investor doesn’t mean you can be a blind investor, but it is a great tool to have in the toolbox and it can help free an asset allocator to look for and collect attractive risk premiums.”

Carrying this out has meant a steadily increasing exposure to alternative assets, and this is the reason the KIC is being so excitedly talked about in asset management despite total assets (around US$37 billion at the end of 2010) that are relatively modest by sovereign wealth fund standards. When last disclosed in the 2009 annual report, alternatives occupied just under 7% of the portfolio; today, in terms of committed capital, it is a little over 10% (though the precise figure won’t be disclosed until the 2010 annual report comes out shortly). And Kalb isn’t finished there: he thinks 20% is a logical ceiling. “Attractive risk premiums arise in areas that are beaten up, where there is mispricing, or a lack of investors or liquidity, and often they are things that may take some time to work,” he says.

Similarly, KIC launched a strategic investment program in June, allowing it to take direct stakes in companies, notably Chesapeake Energy. Again, full year returns won’t be clear for another month or so, but Kalb is clearly pleased so far. “Normally when you do alternative and strategic investment there’s a J-curve effect: it takes a while to see your performance, and your costs are front-loaded. But we’re ahead in all of our alternative and strategic programs, and it’s all making money even on a short-term basis. That helps in expanding those businesses.”

It’s useful to be able to demonstrate good news, because although Kalb has the benefit of working without the hindrance of liabilities, he does face some distinct challenges.

One is the fact that the KIC is funded by two separate sponsors: The Bank of Korea, which is Korea’s central bank, and the Ministry of Strategy and Finance. Most of the initial funding came from Bank of Korea; the finance ministry has provided most of the subsequent funds in blocks of $2 or 3 billion apiece in the meantime; and this coming year, there will probably be about $8 billion more contributions, this time split between the two sponsors.

This would be fine if the two sponsors brought the same attitude to risk and investment, but they don’t. The central bank is naturally conservative, the ministry more inclined to take risk for returns. Some say the discussions over how these interests should be represented in the portfolio can get heated.

For his part, Kalb says: “As you’d expect, the money you manage for the central bank is more conservatively managed because that’s their job. We try, within their frame of reference, to be a little creative and to deliver returns for them. The ministry is a bit more flexible in their capital and a bit more risk-oriented which makes sense: it can afford to be more strategic and have a longer vision, which gives us much more flexibility.” He says, though, that positive returns so far have led the central bank to gain comfort in KIC’s approaches; “we’re an important conduit for them to invest capital in areas other than treasuries and fixed income. They can take the money they don’t need for policy purposes and are comfortable allocating and placing it with us.” In this context the likely commitment of Bank of Korea funds this year – the first new allocation since the original US$17 billion funding – is significant.

Asked if it’s possible to keep both consistently happy, he says: “Nobody’s happy all the time. In a variation of what President Lincoln said, you can keep some people happy some of the time but you can’t keep all people happy all of the time.” He says KIC reports to its sponsors on a segregated basis and “in terms of managing these disparate interest, that’s our job.” The big areas of overlap in the portfolio are managed collectively or on a pari passu basis.

Another, related, challenge is that Kalb works in one of the few big sovereign wealth funds that exists in a vibrant democracy with a lively parliament. If we accept that Singapore, which is nominally a democracy but could hardly be called a vibrant one, is a separate case, then out of the biggest funds only Norway and Kuwait (with a vigour of parliamentary debate that surprises outsiders) are really structured for direct public scrutiny of their behavior. Norway’s vast sovereign fund is a case in point: after almost flawless returns for decades, the fund had one bad year and faced a parliamentary inquiry. Similarly KIC has undergone investigations and public fury over its $2 billion investment (before Kalb’s time) in Merrill Lynch, still heavily underwater today.

“From my point of view, this is a very important part of the democratic process,” says Kalb. “People have a right to know how their money is being invested, what it’s doing and what the thought process is behind it. I believe in it, the institution believes in it and we want to support it: it’s good for transparency.” He says the only disadvantage is getting caught in “the political winds that may be blowing,” not in terms of specific investments – which nobody has the legal right to force KIC to make – but in things like new hires and salary ranges. “That’s part of my job, to help the organization to move forward to become much more like a global private asset management company, even though it is 100% government owned.” On the Merrill investment, he says it “remains a thorny issue… but it’s history. I came here to manage the portfolio on a forward-looking basis. You can’t manage money from a position of regret.”

Kalb was an interesting selection in a country which tends to be hands-on with its state vehicles, especially given this level of public scrutiny. Quite apart from being an American, Kalb’s background is steeped in hedge funds: he was principal and CEO of Black Arrow Capital Management and a senior equity portfolio manager at Tudor Investment, as well as having worked at places including Citigroup and Drexel Burnham Lambert.

In fact it’s not quite as out-there as it seems: Kalb spent much of the 80s in Korea, and three years working for the Economic Planning Board within the government, subsequently merged into the finance ministry. He speaks Korean and considers the country “a second home”. But nevertheless it was a bold appointment. “I think it’s to their credit that they are willing to bring in an outsider to this kind of key position,” he says. “There are many foreigners working in lots of the sovereign wealth funds but I don’t know any that are in this kind of position and I think that speaks volumes about Korea’s intentions to put best practices in place, to adhere to global standards, and to be willing to tolerate some potential discomfort to achieve those objectives.”

Foreign fund managers talk effusively about the KIC, far more so than the country’s National Pension Service, despite the fact that the NPS has a vastly greater pool of assets to target. “KIC are ones to watch,” says one. (Fund managers hate being quoted directly about sovereign clients so all have been kept on background in this piece.) “When they were first announced, they were the institution everybody had to work with, even though in the grand scheme of things they are still pretty small,” says another.

There is a lot of chat about the relationship between the two sponsors and the impact it has on the overall mandate; “we think Scott’s view is that they will use the BOK money as beta exposure, and offset that with high alpha using the MOF money,” says another. And there is just as much chat about the manager being particularly tight on fees. But people want to be involved with it. “Scott says he wants managers to visit him only if they have a true sustainable alpha capability,” says one manager. “He is not willing to pay for beta generation.” Another echoes the point. “When you approach them they are very clear: they will not set an appointment unless you have a clear alpha generating capability.”

And they’re right. Kalb hates paying for beta, and so the sophistication he has brought to the place comes with disadvantages for external fund managers. Between 2008 and 2009 the proportion of funds that were outsourced to external managers fell from 60% to 35%, although Kalb says it’s likely to stay around that level.

Kalb is a believer in what he calls “beta architecture”. When you manage a portfolio with a 5% real return target, he says, 3.5 to 4 points of the return are likely to come from beta, just 1 to 1.5 from alpha. “Alpha is very elusive and it’s a zero sum game; beta is what you get in the market,” he says. Initially, a lot of that passive beta exposure was outsourced, but as the KIC has built ability in different asset classes it has increasingly brought that exposure back in-house. “There is no reason to pay for enhanced or passive fund management if we we can do that ourselves, and we can,” he says. “When you give a passive mandate out, you’re throwing in the towel on any kind of alpha. You’re saying: I give up, I just want the beta, and you wind up getting the beta minus cost.”

“So the idea for externals is that we want guys that can really deliver,” he says. “I want to focus my risk budget on guys who can give me alpha, not just market returns.”

Other changes are underway at KIC: an increased benchmark emphasis on emerging markets, so as to better reflect their contribution to the world economy rather than world capital markets, is an example. “If you don’t make that adjustment you will constantly be behind the trend, trying to catch up.” Another is increased exposure to credit. But in particular Kalb is seeking to change the way allocation is thought of, to a discussion that starts with risk tolerance. “Benchmarks are very useful in terms of monitoring performance and controlling your direction,” he says. “They are very poor in terms of risk control. The assumption is that your risk free position is to be neutral to the benchmark. In real terms that’s not risk free at all, it means you have 100% benchmark risk, and we all learned in 2008 what can happen when you do that.”

“It’s risk adjusted returns, that’s the name of the game, and the object is to sit down and have that risk discussion first. Then we can design a portfolio that makes sense.”

Asked if he feels that’s where KIC is up to today, he speaks of dialogue and progress, but his emphasis is on a work in progress – for everyone in the enterprise, from sponsors to management to himself. “We’re continuously adjusting as we go along,” he says. “It’s all a growing experience.”

South Korea’s National Assembly has blocked a proposed new law that would have smoothed the way for a sovereign sukuk issue. Local reports suggest that lawmakers objected to the bill – a piece of tax equalisation common in any countries seeking to streamline sukuk issues – on religious grounds.

Under Korean tax laws, companies have to pay between 1.5 and 3.5 percentage points more in tax for an Islamic issue than a mainstream one, an imbalance that the government has been pledging to correct since 2009. The new sukuk law would have provided new tax breaks to create a level playing field with mainstream issuance.

While it is not uncommon for tax laws to take time to clear parliament, Islamic practitioners may be concerned to find that religious objection appeared to be the main reason for blocking the new legislation. In particular, Lee Hye-hoon, who is a congresswoman within the Grand National Party and a committed Christian, has been quoted in local media saying: “It is possible that 2.5% of the proceeds from the bond issuance are given to Islamic missionaries,” and “acknowledging the religious restrictions on charging interest is against the Korean constitution that stands for capitalism.”

The government had hoped that the new law would help it to diversify sources of income and attract capital from the Middle East. While the sovereign itself had been expected to issue a sukuk, many other South Korean companies had also expressed interest, including oil refiners, airlines and construction companies. Despite objection, they had been confident about getting the tax change through: as recently as December, the ruling Grand National Party had said it expected the bill to pass within a week. It was recommended by the legislature’s taxation sub-committee, but then blocked at the overall level. Minister of Strategy and Finance Yoon Jeung-hyun is among those who had hoped the bill would go through: he has spoken of a need to “diversify the sources of foreign borrowing. When economic cooperation with the Middle East is important, there is no reason to discriminate against Islamic bonds.”

The news was greeted with some alarm in the Middle East, where Arab News devoted a 1,300-word editorial to it, calling it “a wake-up call for the global Islamic finance industry” and bemoaning “Islamophobic lobbying from powerful Christian evangelical groups”.

It is not clear if Korea will attempt to pass the bill once again, since there is little that can be done in terms of technical modification that would get it past the religious objections that have stymied it so far. In its absence, it is highly unlikely Korean issuers will bother to launch sukuk issues.

An investigation into a market plunge on the Korea Exchange in November has put Deutsche Securities under the spotlight and triggered a raft of changes to Korean derivatives market practice. Deutsche will probably find out by March what, if anything, it’s been found guilty of and what the outcome will be.

On November 11, the Seoul market fell steeply in the last half hour of trade on the back of heavy foreign selling, much of it in program trading, and specifically an arbitrage trade on an expiry date for options. Deutsche’s local securities unit made W1.6 trillion won of sales, bringing the Kospi index down 2.7%.

A market fall of less than 3% is not the end of the world, but it caused a great deal more scrutiny than might otherwise have been the case, for two reasons. One, the market movement was bad enough to bring one Korean asset manager, Wise Asset Management, unstuck; it has since folded. And two, it happened just as Seoul was hosting the G20 meeting, where world leaders – and financial top brass including Deutsche’s own CEO, Josef Ackermann – were gathering to discuss, among other things, greater financial stability.

Embarrassed and puzzled, Korea’s regulators, the Financial Supervisory Service and Financial Services Commission, set about an investigation on two fronts. They dispatched a team to Hong Kong, since the trading involved Deutsche’s Hong Kong office; and they set about revising market rules.

The Deutsche investigation is interesting. While Deutsche clearly moved the market by unwinding the trade, there’s nothing illegal in that. So what’s the regulator looking for? Those close to the investigation say Deutsche may have been late – by about a minute – in its disclosure of its intention to do the trade, but that’s something to be told off for, not banned. Instead, the focus appears to have been on whether any related trades took place at the same time. The regulators themselves say the Hong Kong investigation is “working to determine if an act of violating the Capital Market and Financial Investment Business Act, including market manipulation, was involved.” Soomi Kim, a spokesperson at the FSS, says the investigation has “made considerable progress and is under legal review.”

Regulators are also looking into what happened to Wise Asset Management, since there is clearly a deep underlying problem if a fund manager can go under on the back of such a modest fall. There was obviously a major leverage issue here, but regulators so far think the problem is isolated rather than endemic. “We found that with arbitrage trading, some asset management companies were exceeding their clients’ daily investment limits, which led to some exposures and losses,” says Yoonkon Choi, head of the securities market team in the Financial Investment Department of the FSS in Seoul. “But we believe it is not an industry-wide issue. We have found only a couple of AMCs and some securities companies are vulnerable in these areas,” and he believes Wise was the only one with a serious problem.

On the market side, revisions were announced in December and clarified in January, with some due to be in place by the end of the month. They include changes to margin rules, requiring pre-trade margin deposits for many institutional investors rather than post-trade as is the case today; the imposition of daily order limits; revisions to so-called random end rules, which allow for an extension to the deadline for submitting quotations when there is a big movement in the market in the last five minutes of the day; and a prohibition of new program trading after 2.45pm on option expiry dates. There are also caps on unsettled positions and new reporting requirements on futures and options positions.

“We did not realize a large volume of trading could impact the stability of the market, so that was an issue we focused on,” says Choi. “We believe once these measures are implemented it will be difficult for market to see such large-scale trading and may lessen the impact on the market itself.”

On the ground in Seoul, opinion seems to be somewhat fragmented. Much of the frustration voiced is about the nature of arbitrage and program trading rather than specifically about Deutsche.

But there’s also one other key piece of information that needs to come out of the Deutsche investigation that may shift opinion. Several reports, apparently all stemming from the same briefing, have quoted Ackermann as saying that the trade took place for a client. Some in Korea see this as somewhat diluting Deutsche’s responsibility, in that banks have to do what their clients want them to.

But there’s a problem with this. Euromoney believes the trade was not for a client, but proprietary. An arbitrage trade on this scale, with its numerous moving parts, is unlikely to have been for a third party client, and many in the market believe it looks like a bank trade and that Ackermann’s comment was either erroneously understood or wrong.

If this is true, it will be interesting what impact it has on the regulator’s conclusions and Deutsche’s standing in Korea. If nothing else, making a market-moving proprietary trade, at the precise moment one’s own chief executive is in town with world leaders talking about how to make the markets more stable, is unfortunate timing on a truly epic scale.

The exchange of fire between the North and South Korean military yesterday has made market bears especially nervous. It’s easy to see why: the Korean situation could very easily escalate, and it’s natural that markets would underperform in the shadow of that uncomfortable prospect. Both world markets and certainly Korea’s own bourse, you would think, should suffer.

Strangely, though, history tells a different story. When flashpoints have happened in Korea over the last five years, the local market hasn’t been impacted at all, either in terms of outright performance or in the behaviour of foreign portfolio investors.

Korea Exchange has compiled some data on this theme to illustrate exactly what happens to the market when North Korea tries sabre-rattling. Generally, in the day or so after an event, things are choppy, but they return to normal with surprising rapidity.

The three most uncomfortable moments in North-South Korean relations prior to yesterday’s artillery strike were the two nuclear missile tests in October 2006 and May 2009, and the sinking of the South Korean warship Cheonan in March this year.

With both missile tests, they were known to be happening in advance, and foreigners had ample opportunity to take flight if they wanted to. But that didn’t happen. During the Daepodong missile test in 2006, foreign investment was net positive by US$496 million on the day of the test. On the day of the second test, in 2009, it was also positive, by US$170 million. In terms of local market performance, the KOSPI index was back above the level before the test within three trading days.

The Cheonan sinking is perhaps a more accurate comparison since nobody knew it was coming, like yesterday’s strike. But here, too, the market behaviour is surprising. On the first trading day after the sinking (which took place at 9.30pm the previous night, well outside trading hours) foreign investment was net positive by US$289 million. And KOSPI was back above its pre-Cheonan levels within a day of the sinking being publicly known.

Today, the KOSPI index opened about 2.5% down on the previous close (news of the strikes came very late in the Korean trading day yesterday) but if you take a look at the index performance through the day, it describes a steady upwards path: at the time of writing it looked likely to close flat on yesterday’s close having recouped its losses in the space of a few hours. Traders in Korea say net foreign portfolio investment has, once again, been positive.

Why? There are two interpretations. One is that since nobody appears to want a war, the assumption is that one will be averted. The presence of the US and China as allies to the various sides is geopolitically imposing, and so formidable that it may well stop outright conflict. The other interpretation is that even if fighting does commence, it is not expected to be particularly damaging to the South Korean economy.

If anything, the impact appears to be bigger on world markets, just because Korean uncertainty is something to be added to the debit side of the ledger on risk. There is a whole raft of ingredients in the mix here: Ireland; European sovereign debt generally; tightening of Chinese bank lending policy; worries about quantitative easing. Korean tension gives another reason for risk appetite to leave the market. Those who were already uncertain see in it a deciding factor, a pivotal moment in shaping their decisions to be in or out of the markets.

ANZ noted yesterday: “The North Korean situation has overtaken everything.” With the odd exception, it seems, of the Korean markets themselves.