The Asia Pacific-region remains a modest centre for exchange-traded funds (ETFs) in global terms, but its rate of increase in recent years has been almost peerless. The size of the industry in Asia has increased almost fivefold from US$10.5 billion in 2005 to $48.2 billion in 2010 today, bringing its representation in the global ETF universe from about 2.5% to 4.5%. While the overall volumes are dramatically higher elsewhere in the world – US$715.7 billion in the US alone – only Europe can really compare with Asia in terms of the pace of growth in the last five years.

All of the larger Asia Pacific markets have begun to embrace ETFs over this period, with Korea – with 55 ETFs as of April this year – leading the way. Yet there is also very clear room for growth, both in terms of total products – there are, for example, just three each in Malaysia and one in Indonesia – and in assets under management.

This review will focus on two quite different markets to give a sense of evolution and direction: Australia and China.

Australia for many years was served by a handful of long-running products based on local stock market indices from State Street Global Advisors, chiefly for the S&P/ASX200, and subsequently for the ASX50 and a listed property index. Next iShares, now owned by Blackrock, began launching international ETFs, and at the time of writing offers 19 in Australia, from global equity and emerging market indices to single-country funds based on indices in China, Korea and Taiwan. iShares says financial advisors (who are exceptionally powerful in Australia) use them as building blocks to create global equity portfolios and implement long term strategic asset allocations for clients.

Others have begun to enter the market. Australian Index Investments joined the fray this year with six sector-based ETFs, for resources, metals and mining, energy, industrials, financials, and financials ex-property trusts. ETF Securities has launched exchange-traded commodities, based on gold, silver, platinum, palladium, and a basket of precious metals; each are backed by real, physical metals. And Vanguard, long champions of passive managed funds, has created three ETF versions of its index funds, both domestic and international, listed in Australia. The 33 listed ETFs in Australia by September 2010 had a combined market capitalization of A$3.94 billion, up almost 40% on the previous year, which in turn was up 158.1% on the A$1.095 billion in September 2008.

But what’s particularly interesting is what has come next. In May this year Russell Investment launched the Russell High Dividend Australian Shares ETF, which was subtly different to previous offerings because it was based not on a widely known index but a customized one built by Russell itself, skewed toward companies expected to pay above average dividends – which is, in some respects, an active decision. It has since been followed by a similar product from State Street, which also is based on an index invented (by MSCI in this case) to focus on high dividend yield companies that are likely to be sustainable in that approach.

These new issues bring ETFs in Australia into unfamiliar territory: involving active portfolio construction in what has typically been a purely passive part of the market. And in this respect, it may mark a first stage of ETFs maturing towards the range of product found in Europe, the US and UK: leveraged ETFs, swap-backed ETFs with only synthetic exposure to the assets they give exposure to (as is common with oil ETFs for example), and even inverse ETFs.

Since sentiment about these structures is mixed – the Bank of England warned about them this year – there are correspondingly ambivalent feelings about what sort of reception these might get in Australia. But there’s no question ETFs as an investment class are growing. This is partly because until recently most financial planners charged through trail fees, which naturally disadvantaged ETFs since they don’t pay them. Regulatory change has prompted more planners to charge on a fee for service arrangement, in which trail fees aren’t relevant and so ETFs compete on a more level playing field. And even if more esoteric structures take a while to arrive in Australia, it would be a surprise if the market does not soon see ETFs based around other asset classes such as bonds and more commodities.

China is an interesting market to watch for other reasons, as it shows what sort of traction ETFs can achieve when they appear at the early stages of a market’s development. In the first four months of 2010, China had by far the greatest net new inflows in the region into ETFs: US$2.89 billion, more than 10 times greater than a more mature market like Singapore.

China is the sort of market where people follow trends, and until recently those trends have very much suited ETFs: a heavy momentum market (both upwards and downwards over the last few years) where the perception is that active management will not make much of a difference to returns. Correspondingly many of the largest fund managers in the business have been busy with launches: China Asset management and E Fund Management have two each, while others have been launched by managers including Bosera, Bank of Communications Schroders, Hua An, Fortune SGAN, ICBC Credit Suisse, China Southern, AIG-Huatai and – with two in September alone, though one a related feeder fund – HFT Investment Management. First mover advantage has proven tremendously important here: China AMC (which launched the first ETF in 2004) and E Fund management (whose SSE 100 ETF in March 2006 was something of an industry landmark) account for 73.5% of the market, according to Blackrock.

While many managers are still getting started with ETF launches, there is already a degree of specialism. Some, such as one from China AMC, have a focus on small to medium enterprises; E Fund has a fund focusing on mid-caps, Bosera on large caps. The new HFT product in September was called the Shanghai Cyclical Industry 50 ETF, bringing something of a sector theme to the industry. And CCB Principal has launched one based around socially responsible investment. So far, though, all are equity-related, and there is enormous scope for further industry development.

China is also interesting because of a structural quirk. In China, ETFs are packaged and sold just like any open-ended mutual fund, rather than the share-style exchange-traded purchase and sale that is commonplace elsewhere in the world. One knock-on effect of this is that, unlike most of the world, the bank channel is a major method of distribution for ETFs in China; and, correspondingly, they tend to have large front end fees, typically over 1%, attached to them, which again is unheard of in most ETF markets. Indeed, most would consider this to defeat the point of ETFs, since they sell so strongly on their low-fee, exchange-traded simplicity. But it hasn’t, yet, dented popularity in China, it would appear.

Broadly, Asian ETF markets are still at a fairly mainstream phase of development. The vast majority of products are related to equities, although one can find fixed income vehicles in Hong Kong, Korea and Singapore, and commodities ETFs in Korea, Singapore and Australia. They are, too, overwhelmingly single-country in their focus: 93.7% of Asia Pacific ETFs fit this description, according to Blackrock.

In terms of product innovation, the most exciting market is probably Korea. Consider some of the product launches in 2010: there has been an inverse ETF, launched by Woori; leveraged ETFs, from Mirae, Kodex and KB KStar; sector-specific launches, such as Hyundai’s based on insurance equities; one based on West Texas Intermediate oil futures, from Mirae; and a money market ETF from KOSEF. But of those, only the Kodex leveraged fund and the money market product raised significant funds and has over US$100 million in assets under management; the rest are mainly interesting but somewhat underused so far. In Hong Kong, too, there are signs of growing maturity, with a host of sector-specific A-shares funds launched by iShares in November 2009, for example. But largely, the enthusiasm in the region appears to be for straightforward, index-based, country-specific product.

One interesting question, being discussed widely in China right now but relevant across the region, is whether the more volatile markets typical of 2010 favour active management, and whether that in turn diminishes the appeal of ETFs. Fund managers tend to see a use for both, while financial planners like the flexibility of ETFs to put a portfolio together with a combination of passive and active components.

In sum, it makes sense to expect rapid expansion in ETFs in Asia, in terms of overall assets, number of products, and variety of underlying asset classes. Fees may not be great outside China, but the momentum suggests they will be lucrative for managers who design and market their products carefully.

Asia’s largest state pension funds are swiftly evolving into sophisticated institutions willing to allocate to new markets and asset classes. It’s a transition that is creating opportunities for external fund managers in the region and worldwide.

A look at four of the largest state pension funds in Asia illustrates the changing nature of this sector of asset management. Korea’s National Pension Service, China’s National Social Security Fund, Malaysia’s Employee Provident Fund and Taiwan’s Public Service Pension Fund all to varying degrees show increasing innovation in investment approach, diversification, and willingness to use international external managers.

The biggest of the four is Korea’s National Pension Service, previously known as the National Pension Corporation. As of March 2010, when last disclosed, it had W289.5 trillion (US$245.8 billion) under management and its management has spoken of hoping to reach US$400 billion. These figures dwarf the Korea Investment Corporation sovereign wealth fund, which has tended to attract more headlines; in fact, it’s the state pension fund that has by far the most money and hence probably the greatest opportunities for international fund managers. Since all Korean workers, including foreign employees, are covered by the NPS, it is only going to keep growing: it already covers 18 million people.

One reason the NPS has not attracted quite the same attention as sovereign funds is that most of its assets are deployed domestically and conservatively. By the end of 2008, for example, 77.7% of the fund was in domestic fixed income and 12.1% in domestic equity – only 2.4% went into overseas shares, 4% overseas fixed income and 3.8$ alternative investments.

But the NPS also discloses a long-term target for asset allocation, and this speaks of dramatic shifts in assets. By 2014, it hopes to have more than 10% in overseas equity, up to 10% in overseas fixed income, and more than 10% in alternative investments, with the domestic fixed income contribution dropping to a maximum of 60% and domestic equities potentially topping 20%. (These figures add up to more than 100% as some of them are maximum allocations.)

When a $250 billion fund changes its allocations in this way, that means almost US$19 billion of money shifting into overseas shares, for example – a clear opportunity for foreign managers. It’s not yet clear what form the alternative allocations will take, but it’s already evident this part of the portfolio is going to involve a major chunk of direct property: purchases have included 12% of Gatwick Airport, the HSBC headquarters in London’s Canary Wharf, and the Aurora Place office tower in Sydney.

We know that the NPS is a willing outsourcer, as it has previously published a list of international managers it works with, including 20 active and passive international equity managers, six fixed income managers and 23 alternatives, mainly private equity groups. Domestically, NPS outsources about as much of its equities coverage as it handles internally; overseas, though, it’s unlikely to believe it has the expertise to invest successfully through internal staff, suggesting that most of this shift to overseas assets will be done through external mandates.

While what’s happening at the NPS is exciting, the pace of development is arguably greater in China. The National Council for Social Security Fund was only founded in 2001, following a State Council decision the previous August; by the end of 2009 it had RMB116.5 billion, or US$113.7 billion, under management.

As with Korea’s NPS, the story is not really about allocation today, but where it’s going. As of December 31 2009, it had only 6.54% allocated to global stocks; additionally some of the 40.67% allocated to fixed income is likely to be international. However these proportions are considered likely to increase. The law allows NCSSF to invest in quite a range of international securities and assets: bank deposits, foreign treasury bonds, bonds of international financial organizations, bonds of foreign entities, foreign corporate bonds, overseas bonds issued by the Chinese government or Chinese enterprises, money market products such as banking drafts and large CDs, stocks, funds, derivative instruments such as swaps and futures, and “such other investment products or instruments jointly approved by the Ministry of Treasury and the Ministry of Labour and Social Security.” Particularly on the debt side, that really doesn’t exclude much.

Additionally, NCSSF has built a strong roster of international managers for mandates. The first round was announced in 2006, with a further 13 active equity mandates announced in 2009 (see table). The range of top managers suggests to many observers that overseas allocations will increase, particularly to emerging markets (notably, there was no separate mandate for US equities last year).

Nobody is expecting NCSSF to go wild with mandates to hedge funds and exotic asset classes any time soon. As a social security fund, its policy is based around what it can afford to lose as much as what it should gain: in the medium to long-term it is expected to return no less than 3.5% annually, while never losing more than 10% in a year.

But it’s the fund’s potential that really suggests opportunity. NCSSF’s own literature describes its role, with magnificent simplicity, as “to be a solution to the problem of aging.” It gets contributions from the central government, from the lottery public welfare fund, from the transfers or sales of state-owned shares, from other capital raisings approved by the State Council, and even from other funds such as the Industrial Pooling Fund, another pension fund whose assets the NCSSF has also run since April 2004. It is headed by Dai Xianglong, and that’s considered relevant too: he’s one of the most powerful politicians and bankers and China with a CV that includes being mayor of Tianjin and head of the People’s Bank of China, the central bank. Nobody doubts that a great deal more assets are going to be entrusted to this powerful institution.

At more established pension funds, the pace of change is naturally less intense. Taiwan’s Public Service Pension Fund dates from 1943, for example, and is unlikely to reinvent itself dramatically now: its 2009 asset allocation ratios (40/60 fixed income to capital gains assets, 54.9%/45.1% domestic to overseas, 55%/45% external to outsource) has been refined over many years and will not swiftly be changed. One could argue it has already reached some of the destinations that newer funds will later arrive it, in terms of international investment and use of external managers. Outsourcing practices here tend to resemble sophisticated sovereign funds: Cerulli understands PSPF prefers not to give passive mandates, instead preferring value-add active strategies; that no further overseas mandates are expected this year; that ETFs are used; and that multimanager structures are eschewed because of the additional layering of outsourcing involved and the consequent loss of control.

Fundamentally, the challenge for Taiwanese institutions is very different to that in a newer pension market like China: it’s the daunting prospect of not having enough funds to meet the liabilities of those who will soon seek to draw down their pensions. In China, those sorts of issues are decades away.

Between the two extremes falls Malaysia’s Employee Provident Fund – younger, dating from 1991, but clearly well established and serving a society in transition from developing to developed world. The EPF has more than 12 million members and had RM406.55 billion (US$130 billion) under management by June 30 this year; its future is bolstered by mandatory contributions of 20% of employee wages (8% from the wage, 12% from the employer).

The EPF is a conservative institution and its asset allocations are chiefly domestic. As of June 30 23.32% of its funds were in Malaysian government securities, a further 37.28% in loans and bonds and 6.79% in money market instruments; beyond those debt-related securities 32.21% was in equities and just 0.4% in property. Of all that, just US$5.92 billion was invested overseas by the end of 2009, US$2.38 billion of it outsourced to external fund managers.

The EPF has a strategic asset allocation document which calls for a greater expansion into international equities, to 9% of the total portfolio, and this is beginning to happen; $1.28 billion of these investments were made in 2009 alone.

For all these funds, and other Asian state pension funds, the shift towards international diversification and use of new asset classes is just part of the story. Underpinning it all is a population which, while largely youthful today, will one day need to be provided for in old age. Some countries, like Japan, are pretty much at that point already; others, like Taiwan and Korea, are much closer to it than those like China or India. Each of them needs to deal with the prospect of deficit for this segment of population, and their conclusions about the challenge ahead will dictate how they build their pension funds, how they allocate, and what spoils fall to external managers.

For managers chasing mandates, it is helpful to be able to demonstrate long-term track records, to be able to deliver reliable performance without necessarily shooting the lights out, and to become a trusted partner. Unlike in sovereign wealth funds, where the focus is often on innovative new alpha-generating ideas and alternative assets, pension funds for the moment are more likely to reward proven steadiness.

In recent years asset consultants have developed an influential role in the more than A$1 trillion Australian superannuation industry. Among other things, it is consultants who are in large part responsible for the shift towards illiquid assets in Australian super funds in recent years – a move which some feel came close to backfiring in the global financial crisis.

The role of asset consultants has become particularly significant ever since the choice of super regime came into effect in Australia in July 2005. This allowed Australian individuals to choose whichever super fund they wanted to save into, and had a number of knock-on effects. In particular, industry funds – not-for-profit funds that had previously served only a particular area of society such as education employees or a state government  - were opened up to far wider usage, and as a consequence, rapidly started to grow in sophistication.

One of the ways they did so was by retaining asset consultants such as Mercer, Jana Investment and Frontier Consulting, and several of them started to do some new and interesting things to Australian superannuation portfolios. Probably the most striking example was Access Economics (whose super advisory business has since been spun off as Access Capital Advisers). Access took the view that alternative assets, and in particular big chunky assets like infrastructure, were particularly well suited to superannuation funds, since trustees, with little danger of unpredictable outflows from members, were able to take the long term view that these assets required.

A typical Access-advised fund would look like this: about half the fund invested in mainstream asset classes, and the other half in something called a target return portfolio, made up mainly of unlisted assets. These unlisted portfolios looked most unlike the Australian share-heavy portfolios that local investors had been used to in their savings vehicles. Consequently, MTAA Super, originally formed by the Motor Trades Association of Australia for employees of Australia’s automotive industry, put members into direct holdings in the UK’s East London Bus Group and a port in Gdansk, Poland, along with numerous domestic airports and other properties and utilities. Another landmark Access client, Westscheme, which was set up to service Western Australian public sector employees, by 2007 had 17.6% of its funds in subordinated debt or infrastructure equity, 8.8% in private equity, 10.3% in direct property and a chunk in timber.

It wasn’t just Access clients who behaved in this way. Sunsuper, a Queensland-based industry fund, took a direct shareholding in the private equity manager Carnegie Wylie in 2005, giving itself the right to be a cornerstone investor, with therefore guaranteed allocation, to any subsequent fund it launched.

Better still, it worked. Throughout the bull market that followed choice of super legislation, industry funds dominated superannuation returns league tables, and Access clients like MTAA and Westscheme typically jousted for the top spot.

But there was a challenge here. How did anyone really know what the performance of one of these super funds was? Who was to say just what a port in Gdansk would be worth on open market from one day to the next? Throughout this period the for-profit funds run by the asset management arms of the big banks would grumble about league tables and performance, questioning whether they really reflected reality.

And then came the global financial crisis, and the whispered grumbling became a much more widely discussed concern. At a time when investors were pulling out of funds the world over, what would happen to these industry funds with half their assets in securities that they couldn’t possibly sell? There was growing alarm that illiquid funds would be unable to meet redemptions.

In fact, while that concern was perfectly valid for many alternative funds, it was actually irrelevant for super funds: Australians can only withdraw from them in specific circumstances (such as reaching the minimum age to do so) and Australian employers are required to put an amount equivalent to 9% of employees’ salary into super funds. The wall of money flowing into superannuation is unstoppable, mandated by law: you couldn’t turn the tide if you wanted to. It’s true that, under choice of super, you can take your funds and put them into another super fund, but people tend to show a stodgy inertia about the effort involved in doing so; no runs on major super funds transpired.

Nevertheless, super fund trustees have tended to take a closer look at their risk profile ever since. In April 2009 the Australian Prudential Regulation Authority wrote to all super trustees to clarify its expectations on the valuation of unlisted assets. “By nature, unlisted investments are more complex than listed investments,” APRA said; it stressed the need for a robust, documented policy framework and made specific mention of external advisers such as asset consultants. APRA’s note was more about accuracy of valuation than any suggestion that funds stay out of unlisted assets, or break with their advisers, but it showed a growing recognition of the issue.

While super trustees have not been encouraged to ditch alternative assets – since there is a strong argument they can provide better long term returns and keep costs low – they have been encouraged to consider whether the liquidity they offer members is consistent with the liquidity of their assets.

Consultants today say that the main impact of the global financial crisis was a renewed understanding of liquidity, and the dangers of a liquidity mismatch. Some report more diversification – or a recognition that what they thought was diversification was actually just a range of correlated asset classes. (As one consultant puts it: “There were funds out there which thought they were diversified but then saw everything go to custard at the same time.”) Some report that, far from a suspicion of illiquid assets, use of alternatives has actually gone up, although scrutiny of how those alternative assets behave has increased too. Others report that suspicion has grown of hedge funds, particularly those that did not add value when traditional asset classes ran into trouble in the financial crisis (and also because fund of fund structures sometimes contributed to a liquidity mismatch).

It’s certainly true to say that those super funds that nailed their colours to the alternative mast have stuck with their convictions. MTAA Super’s balanced option had 59.5% of its money in the target return portfolio as of June 30 2010, compared to a target allocation of 45%. 51.8% of that portfolio was in infrastructure, 26.9% in property and 16.3% in private equity. But it no longer tops the league tables: according to industry research group SuperRatings, it ranked 48^th out of 49 balanced option funds in the year to June 30, and 49^th over three years, though it looks a much healthier 13^th out of 34 over 10 years. As for Westscheme, it has reduced the proportion of the fund taken up by its target return portfolio from 44% to 36.7% between June 30 2009 and June 30 2010 – partly a consequence of decent market performance in that time – but has not been suffering from its unlisted holdings, with revaluations of assets including Brisbane Airport, DCT Gdansk and Etihard Stadium increasing the target return portfolio performance by 2.28%.

One trend that has emerged from all of this is that many super funds have added chief investment officers, taking more direct responsibility for investment rather than outsourcing as much to consultants. Consultants are still employed, but under a slightly different supervisory approach than before. Two funds who have recently added CIOs are Australian Super and the Local Government Superannuation Scheme.

Some feel that the power of the consultant diminished with the financial crisis: that it will be a while before trustees will think it appropriate to outsource so completely their allocation decisions. Others remark that Australia remains one of the most intermediated markets in the world for asset management, with advisers employed at every turn from the individual to the billion-dollar fund; in such an environment, the consultant with smart ideas and an ability to demonstrate they work will still be amply busy.

Across the Asia Pacific region, sovereign wealth funds are shifting more and more towards alternative asset classes. They differ in the pace and degree, but almost without exception they are making the transition.

Some sovereign funds have been active in alternatives for many years anyway. One of the most sophisticated funds in this respect is the Government of Singapore Investment Corporation (GIC), which has separate divisions for real estate and special investments – by which it means private equity and infrastructure – alongside its mainstream asset management arm. As of March 31 2009, when GIC’s asset allocation mix was last disclosed, 30% of the portfolio was allocated to what it calls alternatives: 12% in real estate, 11% in private equity, venture capital and infrastructure, 3% in absolute return strategies, and 4% in natural resources.  Even within its public market GIC Asset Management division, it has a separate department for natural resources.

At GIC, it’s not just the allocation figure that stands out but the degree of understanding and specialisation. GIC Special Investments isn’t just a vague private equity division, but looks individually at buyouts, venture capital, special situations such as mezzanine debt, growth capital, and secondary fund investments. In infrastructure it has developed a model of going directly into mature operating assets with a high degree of cashflow visibility in regulated environments; in private equity, it picks funds and partners to invest in and grow with over the long term. It is believed to have over 100 active fund manager relationships and has partnered with most of the biggest names in the business: Texas Pacific Group, Carlyle, KKR, Blackstone, Bain, CVC and Sequoia to name but a few, as well as younger managers such as Ironbridge Capital in Australia, for which it was a cornerstone investor in the first fund in 2004.

As for GIC Real Estate, it has been running as a GIC department for nearly 30 years and is one of the largest global real estate investment firms in the world in its own right, with over 150 dedicated staff and 300 investments in 30 countries.

This level of sophistication is actually problematic for external managers as it is exceptionally difficult to come to them with a new idea they haven’t already thought of, and probably implemented, themselves. Private equity and hedge funds have a far greater chance of new investment from GIC than a long-only powerhouse fund manager. The main relationship in the external managers department, Adeline Li, hails from an alternative background and managers say that has affected the sort of mandates that are likely to be awarded.

The same problem of over-sophistication is true of Temasek, arguably the most evolved of all sovereign wealth funds in that it does almost everything itself, and has its own fund management arm, Fullerton, as a subsidiary (with another, the as-yet opaque Seatown Holdings, to follow). Fullerton has partnered with many institutions over the years, among them Alliance Capital Asset Management, Mizuho Asset Management, Kookmin Bank, Nomura Asset Management, Eurizon Capital, and Bosera Asset Management. But increasingly it’s a direct investor in its own right. Similarly, rather than outsourcing property investments, it does so itself through another subsidiary, Mapletree.

For external managers, then, an easier area of focus is on sovereign funds that are newer, or at least newer to the idea of alternatives.

One sovereign institution fund managers are talking about is the Korea Investment Corporation, only launched in 2005 but getting noticed for its vibrant approach and its willingness to outsource. It is also closely watched because of comments by its chief investment officer, Scott Kalb, that he hopes to deploy 20% of the fund’s assets into alternatives, arguing that illiquid alternatives have become more attractively valued relative to liquid public markets. Kalb believes distressed real estate, credit and private equity are in the early stages of a four or five year positive cycle.

That will represent quite a shift: as of December 31 2009, traditional assets accounted for 93.2% of the overall portfolio. Then, private equity, hedge funds and strategic investments accounted for 4.8% combined, and real estate and commodities a further 2%.

This progression reflects a gradual approach of moving into new asset classes, becoming comfortable with them, and only then looking to be more daring: KIC entered global bonds in November 2006, global equities in April 2007, strategic investments in February 2008 and alternatives in August 2009. It was only in 2009 that the scope of investment was expanded to include, for example, commodities indices, private equity, hedge funds and real estate.

The good news for external managers is that whenever entering a new asset class, KIC has tended to begin by outsourcing, then bring the funds back in-house once the expertise has been developed. So at this stage, most alternative allocations are being outsourced. A core portfolio of hedge funds was put together in 2009, bringing together external managers with expertise in global macro, equity long-short, credit investing, and fund of funds. In strategic investments, KIC has said it is seeking M&A opportunities in line with green growth – a government policy – and natural resources.

The China Investment Corporation has also been increasing its allocation to alternatives. CIC operates a benchmark portfolio structure that has a separate allocation towards alternative investments, although it has not disclosed what that benchmark allocation is. CIC’s four investment departments include one, private markets, dedicated to private equity investment through external managers, co-investment vehicles, partnerships and separate accounts; another, tactical investment, which outsources liquid absolute return portfolios, among other things;  and a third called special investments. Its recently-released 2009 annual report showed an increase in alternative assets from US$0.4 billion to US$7.4 billion, and at the end of December 2009 alternatives accounted for 6% of the total international portfolio. Incidentally, if CIC does turn out to be a potential buyer of Liverpool Football Club, as was rumoured at the time of writing, that would be considered an alternative investment too since Liverpool is unlisted.

Elsewhere, institutions that have previously stayed clear of alternatives have also been active. The Hong Kong Monetary Authority has part of its wealth, called the Investment Portfolio, in a vehicle that has sovereign wealth fund characteristics. This has stayed steadily invested in bonds and equities, but in April this year reports began to circulate that it was considering putting some of the portfolio into hedge funds and private equity.

And a little further afield, Australia’s Future Fund has been dedicated to alternatives since the outset. Its long term strategic allocation includes a 15% commitment to alternative assets – already relatively high – but the fact is, by most people’s definitions of alternatives, the actual figure is much higher. The Future Fund also has a 30% benchmark allocation to what it calls tangible assets, which include real estate, infrastructure, utilities and timber, in a listed or unlisted form. (The bit that the Future Fund calls alternatives refers mainly to hedge funds and other absolute return investments). In theory, as much as half of the fund can be in areas outside mainstream debt and equity.

Since the Future Fund outsources everything except its direct investments in areas like timber, this is also good news for alternative managers. And the theme that comes through across Asia Pacific is that, for managers seeking to get new mandates from sovereign funds, there is simply no better place to be than alternatives. Naturally managers need a good and reasonably long-term track record, and a demonstrable ability to help diversify a portfolio; it helps, too, to be on the radar screen of the big consultants engaged by sovereign funds to help with manager selection (typically including Mercer, Cambridge and Watson Wyatt.)

Managers should expect, too, to be pressed hard by skilled and knowledgeable internal manager selection teams wanting to know exactly how and why a strategy is different to the herd. Sovereign funds expect frequent and detailed reporting and can be demanding clients, particularly on fees. But for those who tick the right boxes, expertise in an alternative asset class is one of the only ways to get noticed by these exceptionally powerful institutions.

Australia is, as some of its natives say, a quarry and a breadbasket. Mining and farming have been two of the main drivers of its economy for decades and will only grow in importance as Asian industrialisation and wealth brings greater demand for resources and crops.

Both also represent natural asset classes for investment. But, while Australia’s mining industry is within easy reach of investors through the dozens of listed resource companies, getting exposure to the agricultural and pastoral theme has been harder. AWB Limited, which is active in grain trading, rural businesses and financial services, is a rare example of a large-cap listed stock in the agribusiness sector.

Instead, two very different themes have emerged around Australian agriculture as an investment class: the tax-effective managed investment scheme, and institutional products.

The first class has a very mixed reputation in Australia. The Australian Taxation Office, among the more draconian of the world’s tax bodies, has long granted a tax deduction on interest when investors borrow to invest in, among other things, agriculture. This fact has led to a wealth of managed investment schemes being developed – collective investment products which put money into a dazzling range of livestock and horticultural possibilities, including vineyards, ostrich farming, truffles, timber, cricket bat willow and macadamia nut plantations.

The form with these schemes has typically been that the investor participates in a lease of some land that is used for a crop or plant (or, in the case of livestock, animals themselves). A fee is then paid to a manager who would, in the case of a horticultural scheme for example, be responsible for planting, maintaining and harvesting the crop, and for finding a buyer. To make the best of the tax benefit, the structure is usually that the sponsor (or an affiliated bank) lends the buyer the money to make the investment, charging interest, which then becomes a tax deduction.

Even in the best of times many of these products have had a very bad name. Fundamentally, financial planners have felt that too many investors have got so caught up in the tax exemption (natural in a place where many people lose half their income to tax) and completely lost sight of the question of whether the underlying investment is actually any good. While there are reputable players involved – Macquarie has become a major player in this area – the ground is fertile for disreputable players, and when that happens, there can be a double hit: investors can not only lose their money if the scheme fails, but might also find the tax exemption revoked if the ATO decides there was never any realistic chance of it making viable income in the first place. One experienced financial planner tells Cerulli he only knows of one investor who has ever held one of these investments to maturity and received a return on their capital.

Through the 2000s the sector did appear to raise its game and improve transparency, performance and professionalism. For investors who could live with the fact that the schemes, even if successful, would take between five and 20 years to generate income, and that in almost all cases they didn’t own but leased the land, they might even have made sense. But things turned really sour in the financial crisis. 

Then, the two largest managed investment schemes in the country, the forestry schemes Great Southern and Timbercorp, collapsed, affecting 61,000 investors who had put $3 billion into them. These were supposed to be profitable and environmentally sound schemes which would help reduce reliance on old growth forests and support the plantation of millions of hectares of plantation timber. It’s hard to see an obvious way back into the mainstream for managed investment schemes.

There is, however, another field: institutional funds. Macquarie, for example, has a business arm called Macquarie Agricultural Funds Management which manages assets from beef cattle and dairy to grains, oil seeds, wheat, canola, sorghum, barley, almonds and wine grapes for institutional clients. The most visible expression of this is the Macquarie Pastoral Fund, which has raised A$800 million in investments and commitments and invested over A$500 million of it, mainly for institutions. All told Macquarie manages more than three million hectares of agricultural assets in Australia, and manages about A$1 billion in the sector, making it one of the largest agribusiness groups in the country.

For groups like Macquarie land ownership is only part of a broader range of businesses: another line would be agricultural risk products, if for example Cadbury wanted to hedge its cocoa exposure. Shipping finance and advisory services to agribusiness companies, and agricultural commodities research, are part of the same overall business.

But the ownership of land, cattle and crop is the most visible part of it, and it rests on a straightforward macro theme: giving investors exposure to the increasing protein consumption in emerging markets, particularly Asia, and more particularly China. Australia is ideally placed for export to these markets; it is acknowledged worldwide as a green, clean, disease free provider; and it is among the world leaders by volume in terms of exports of things like beef and grain.

Customers for this exposure tend to be institutional, partly because any product that gives exposure to farm production tends to be long-term by necessity, often a closed-end, lock-up fund with a five to eight year maturity. Superannuation funds are among the potential buyers: in July three super funds, the Catholic Superannuation Retirement Fund, AustralianSuper, and Auscoal, alongside AMP Capital Investors, raised about $200 million to invest in Australian farms through the Sustainable Agriculture Fund. The premise here was a sustainable, diversified farming product rather than any kind of tax minimisation scheme, and was developed with Melbourne University’s Land and Environment Faculty. The fund will invest in wheat, cattle, dairy and crops. Elsewhere, First Super announced it would invest in agriculture and would look at purchasing distressed Timbercorp assets; others that have either engaged institutional funds or invested directly in agriculture include Telstra Super, AMP Future Directions and Victoria Super. AMP as an overall entity was long considered one of the largest pastoral landowners in Australia, although it’s difficult to quantify.

It is not, though, anything like as much as some think it should be, which suggests room for greater engagement of the A$1 trillion superannuation industry with this asset class. Australian Agribusiness Group put out a report in November saying that less than 0.01 per cent of superannuation funds went into Australian agriculture, yet that international pension funds had put in more than $1.5 billion, or three times the local total. AAG argued that doing so would have protected Australian super funds from the global financial crisis. AAG also claims that the top 25% of Australian agriculture provided 11.2 per cent annual returns over the last 12 years with one third of volatility of the All Ordinaries index.

Some feel that the Australian agricultural sector has not helped itself by failing to promote the fact that it is at the cutting edge of agricultural technology, and indeed has had to be in order to thrive without the government protection afforded to farmers in other countries. Australian farmers have had to improve efficiency to compete and today export five times more food than Australia could consume, Macquarie says.

While Macquarie is the biggest name in the industry, some boutiques have sprung up too and more are likely to follow. Rural Funds Management, for example, is an agricultural fund and farm manager with $300 million under management, and manages a portfolio of large-scale farming and agricultural enterprises in land, water, infrastructure, poultry, viticulture, cotton, almonds and cut flowers. Established in 1997, it is the responsible entity to seven managed investment schemes, one tax-deductible scheme, and is the manager of an unlisted public company and two unit trusts. It was acquired by Great Southern in 2007 and briefly changed its name, but for obvious reasons has since changed it back again.

For the future, there is certain to be evolution of commodities as an investment class, and soft commodities – those you can eat – will inevitably be part of that even if the trend is initially driven by metals. This is partly because there’s a strong case to be made for their merits as a diversifier in a portfolio, and partly because it is such a clear area of strength in Australia. Whether this comes through mutual funds, structured products or exchange-traded funds, or a combination, remains to be seen.

December 2009

If Asia came through the global financial crisis in better shape than it did the Asian financial crisis a decade earlier, one of the most crucial differences was the strength of local currency bond markets. In 1997, borrowers were over-exposed to the dollar, so when their currencies declined in value, their ability to service debt or to borrow again was badly damaged, often fatally. This time, the closure of G3 funding sources barely made a difference to southeast Asian borrowers: they just went local.

Jan Wipplinger, co-head of risk syndicate at Deutsche Bank, thinks the point was proven in the week when Lehman Brothers defaulted and Merrill Lynch was taken over by Bank of America. That same week, Deutsche, Aseambankers and HSBC led a deal for Maybank, a M$1.1 billion issue of tier one debt. “During the height of the crisis internationally, for a bank borrower to be able to go ahead with a tier one transaction shows how resilient the local markets were,” says Wipplinger. “They were somehow isolated from the crisis in the international markets, while local investors at the same time turned to the local borrowers they understood.”

It’s a sentiment echoed widely by international and local bankers. “A lot of countries benefited hugely by having their local currency markets ticking over through the crisis,” says Sean Henderson, head of debt syndicate, Asia Pacific, at HSBC. “When you’ve seen countries that are heavily reliant on offshore borrowing going through a state of volatility, that volatility is significantly enhanced when you’re having to apply to an offshore investor base that is typically the first to pull back its horns.”

ThomsonReuters data shows that local currency debt in southeast Asia had hit US$32.3 billion by November 19 this year, certain to beat the US$32.5 billion for all of 2008 and quite likely to top the boom-time figure of US$35.9 billion from 2007. Thomas Meow, head of debt capital markets at CIMB, estimates that local currency markets provided 85% of necessary funding through the crisis, and G3 markets 15%. “Governments in the region have focused on developing local currency markets” since the Asian financial crisis, he says. “This time around we can see there was not so much of a currency mismatch risk. There was a liquidity risk, when G3 currency markets shut down, but markets like Malaysia and Thailand stayed open.”

In this respect Asia stood apart from many Eastern European jurisdictions whose borrowings in euros became problematic. “If we’d had a very broad exposure to needing to borrow G3 from the Asian region in the depths of the crisis, we would have seen more questions being asked of some of these countries,” Henderson says. “But actually you got almost none: Malaysia, the Philippines, Singapore and Hong Kong were all seen to be relative safe havens through the depths of the crisis, and to a large degree borrowers kept the ability to turn over their refinancing in the domestic currency markets.”

One can argue that, in addition to proving their worth, some southeast Asian local debt markets actually took the chance to develop while other markets were shut. The most obvious example is probably the Philippines, where 2009 issuance was already up more than 50% on the whole of 2008 by mid-November. The record-breaking P38.8 billion San Miguel deal there, discussed in more detail in the Philippines chapter, was arguably the region’s standout deal in demonstrating an untested ability to provide significant funds in a dark global climate. “In the Philippines we’ve seen jumbo issues getting done domestically,” says Terence Chia, vice president, Asia debt syndicate, capital markets origination at Citi. “Local banks were doing subordinated debt there at a time when the dollar markets were shut” to sub debt paper.

Local capital markets were also well supported by the fact that in uncertain times local money wanted to stay invested in credits it was familiar with in its home markets. “Local investors are very comfortable with local credits,” says Chia. “Given what’s happened globally investors are more open to buying local credits than a more highly rated international name. We do see some interesting investor behaviour, and it really results from investors here viewing global credits as something they cannot control: they can’t see it, they can’t feel it.” That said, the Asian bid has returned to G3 issues now, and is an increasingly vital source of liquidity.

Prior to the financial crisis, some markets – notably Malaysia – were succeeding in attracting foreign issuers into their local markets. Singapore continues to do so, with strong interest from the supranational community (see story), but in Malaysia the influx of Korean names into ringgit has faded in 2009, a successful and opportunistic deal for Hana Bank notwithstanding. The basic reason is, as Wipplinger puts it, “the local markets became more local.” So instead of being driven by the offshore bid taking advantage of liquidity, the markets remained active with both local borrowers and local investors.

The growth of importance in local currency debt is such that it is attracting new foreign banks to seek underwriting mandates. “It’s one of the key factors underpinning our regional strategy,” says Reuben Tucker, head of debt capital markets for Asia at ANZ. “We have seen emerge out of the disruption of the last two years a far more resilient set of currency markets in Asia.” In southeast Asia, ANZ is active in Singapore and Vietnam in local currency debt, and plans to move into Indonesia and the Philippines too.

Certain funding structures seem to lend themselves particularly well to local markets. For example, raising lower tier two debt in G3 currencies is challenging for even large and respected Asian banks: OCBC raised US$500 million in November but widened 20 basis points in secondary trading the day after pricing. But lower tier two can be raised at competitive rates in Philippine pesos and Malaysian ringgit, for example.

Structurally, most issuance has naturally been quite straightforward, but there has been room for innovation even in these difficult conditions. For example, in February, as credit markets blew out in the west, Indonesia had its first ever launch of residential mortgage-backed securities, backed by Bank Tabungan Negara. Led by Standard Chartered Securities Indonesia as lead manager and underwriter with Sarana Multigriya Finansial (a government-owned agency mandated to promote Indonesian home ownership) as global coordinator, standby buyer and credit enhancer, it was a modest deal – Rp100 billion – but still a standout for bringing a new structure to a market in the middle of unprecedented global market turmoil (albeit at a coupon of 13%). A second deal, with the same originator, closed later in the year raising Rp391 billion, again led by Standard Chartered as arranger. Stanchart was also involved in a landmark securitization in the Philippines this year, the first to be done in local currency, for the Philippine National Housing Mortgage Finance Corp.

Interestingly the investor base varies quite widely among the six countries covered in this report. Bookrunners say that in Singapore dollars, an institutional base of banks, domestic insurers and pension funds typically create an order book of 20 to 25 investors, while retail can be tapped for tier one capital; Malaysia is chiefly institutional, made of asset managers, insurers, pension funds and some government related entities, often targeting different parts of the curve; Thailand is the market with by far the greatest contribution from retail; the Philippines is diverse, with a large contribution from private banking as well as institutional money.

“Retail is a very interesting angle for Asia generally and will continue to develop,” says Henderson. “We’ve seen a broadening of retail interest from equities into debt. There’s still some way to develop but it will become more important in the next 12 to 24 months.” In 2009 retail has represented the majority of the bid for bond issues in Thailand in 2009, and there is some appetite in the Philippines – where a recent Ayala deal caught strong retail demand, for example – and, previously, Singapore for tier one bank deals, although there have been few recent issues.

“The two countries with a very strong retail bid are Thailand and the Philippines,” says Terence Chia at Citi. “In both, retail investors are very used to buying bonds as part of their investments. When you compare that with what they can get from bank deposits or government securities, corporate bonds certainly do give them a pretty decent yield pick-up over other investment products.” Ling at Standard Chartered, a bookrunner on some of the bigger Thai deals, also highlights the retail phenomenon in Thailand and the Philippines, where the simple approach of going out to local distributing banks to reach as many retail investors as possible has proved very effective.

On the institutional side, Jan Wipplinger notes, “compared to the international markets what you don’t have is the more fast money: you don’t see the hedge fund community, and if you do, it’s on the government bond side rather than corporate bonds. You see a much more buy and hold investor base in local currencies than you see in US dollars.”

One question is whether, now G3 markets are back open again, the status of local currency markets has in any way changed or if borrowing behaviour will return to the way it was before the crisis. Many major Asian borrowers – most recently Hutchison Whampoa – are borrowing opportunistically in dollars, despite not really needing the money. Nevertheless, “local currency markets will still be extremely important,” says Henderson. “The majority of flows still happen in local currencies away from G3.”

Rod Sykes, head of debt capital markets, Asia Pacific at HSBC, points out that “this year you’ve had people doing five or six quarters of funding in one year because the market was shut for a significant portion of last year,” but nevertheless thinks the local currency pipeline is good for next year because of the number of expected redemptions coming up.

Although it’s easy to think of the importance of these markets of having diminished now the financial crisis has passed, that is short-sighted. “It’s easy with the current liquidity of G3 markets to say that local currency is not important, or is less important – that it was just a phase,” says Henderson. “But liquidity in G3 is a volatile beast. The quality of local currency markets is high: it is real economy driven, private wealth, with growing funds under management, insurance and pension funds. It is a real money economy. It’s nice to be able to tap G3 but doing it completely leaves you beholden to global forces. Local currency gives you that escape valve that keeps you out of the worst of the crisis.”

December 2009

If you had to pick one local currency bond market in the region that really stepped during the global financial crisis, it would probably be the Philippines. It’s not that the volumes raised in it are particularly great: less than a quarter as much was raised here as in Malaysia, and less too than Singapore or Thailand. But it’s the magnitude of improvement on previous years, delivered in a hopeless international environment, that stands out.

“One of the markets in the region that has developed most in my opinion is the Philippines,” says Sean Henderson at HSBC. “Historically it’s been a quite predictable, smallish-size kind of market.” But a look at issuance volumes demonstrates how it has stepped up. In 2008, according to ThomsonReuters, P86 billion was raised in peso debt; by November 19, the 2009 figure already stood more than 50% higher at P133.58 billion with several weeks of the year still to go.

Jose Pacifico Marcelo, head of investment banking at First Metro Investment Corporation, says the peso debt market has been more active this year than in any of his previous 10 at the bank. “It’s surprising, as only a year ago investment banking worldwide was thought to be in its death throes,” he says. “The local economy and financial sector has proven to be in better shape than counterparts in developed countries. As a result, the peso debt market became the haven of local borrowers and issuers who, fearful of the negative impact of the global financial crisis, advanced their funding requirements.” His own data puts total volume for the first 10 months of 2009 at P472 billion including government debt – a figure that has trebled year-on-year.

This bounty of new funding was vitally important for companies and banks in the Philippines. “Corporates’ ability to fund themselves without having to go offshore was vital in the depths of the crisis,” says Henderson. “If any one of them had had to come to the offshore high yield markets, they would have had to pay up massively.”

“So it’s done a few things,” says Henderson. “It’s kept a lot of borrowers out of G3 markets through the worst of the volatility; question marks over foreign borrowings haven’t been there; and it’s kept cost of funds lower than they might otherwise have been.”

Arguably the most significant local currency deal anywhere in southeast Asia in 2009 took place here: the P38.8 deal for San Miguel Brewery (see box). But that wasn’t all that happened. “San Miguel was an enormous benchmark for what people could get done,” says Henderson. “But on top of that you saw Robinson Land with two P5 billion issues, JG Summit – as corporate deals these were significantly larger than anything we saw in 2007-2008.”

In fact, a look at the bigger peso deals of 2009 shows a diverse roster of issuers. In the midst of the crisis, in February, Globe Telecom raised P5 billion in a deal led by BPI Capital, BDO Capital and First Metro. Then came the San Miguel Brewery landmark in March, followed by Petron, which raised P10 billion in May; Land Bank of the Philippines, which raised just under P7 in June, and then SM Investments (P10 billion) and Robinsons Land (P5 billion) the same month. Robinsons was back with another deal of the same size in August, by which time Energy Development Corp had raised P7.2 billion; since then Aboitiz Power Corp and Megaworld have raised P5 billion apiece. In short, funds have been raised for banks – including lower tier two capital – real estate, consumer goods and energy.

They’re also, mainly, household names. The brand recognition point reflects a powerful retail bid, expressed through the private banks. In fact, the investor base is quite diversified in the Philippines: banks, trust companies, insurance companies and mutual funds are all powerful. It adds up to a very liquid market for the right names. “When you look at San Miguel in Philippine pesos, that’s a deal size in local markets that’s been unheard of before now for corporate issuers,” says Jan Wipplinger at Deutsche Bank. “It shows the depth of the bid of the local investor base for local names.”

Notably, there is a strong onshore dollar bid in the Philippines too. “You saw with the SM Investment dollar deal, the largest ever corporate dollar deal, that there’s an enormous dollar bid onshore as well as a developing peso market,” says Rod Sykes at HSBC. “If you look at any Philippine dollar deal, in almost all cases there is significant onshore participation.” Wipplinger agrees. “When the Philippines launches in US dollars there is always a strong domestic bid. For SMIC and the banks there is a very tight domestic bid through international dollar curves.”

Peng-Meng Ling at Standard Chartered highlights the appetite for lower-tier bank capital in the Philippines, noting that investors show more interest in subordinated debt or preference shares than in other markets. Lower tier two sub-debt issuers have included Metrobank and RCBC since the collapse of Lehman – among the first places anywhere to reopen sub-debt issuance, he points out.

Still, things are not perfect, and in particular secondary market liquidity is weak. “Overall liquidity in the primary market is high,” says Marcelo. “For the secondary market, the only liquid issues are those by the government. For private issues, investors are primarily buy-and-hold.” He says tenor is lengthening, with retail bond issues showing some demand as long as seven years, and project financing up to 12 years. “Sophistication is still limited, as investors stick to simple products and top-tier issuers,” he says. “New products like securitization and REITs are expected to be more active in the next two years.”

Marcelo says the pipeline looks less impressive than 2009 has turned out. “With the May 2010 presidential elections, issuers will try to complete transactions by the first quarter,” he says. “The second quarter will likely be slow, and then volume will pick up by the second half.” In aggregate, he expects much lower overall peso debt volumes than in 2009, but hope springs eternal: “If the election results are credible, 2011 may be as good as this year.”

BOX: Deal profile: San Miguel Brewery.

If the Philippine debt markets proved their worth in 2009, San Miguel Brewery’s P38.8 billion (US$800 million) raising in March was the deal that did most to create that impression. “San Miguel was the standout in redefining in people’s minds what was achievable,” says Sean Henderson at HSBC, which was a bookrunner on the deal alongside Development Bank of the Philippines.

This was a fourfold increase on the previous record biggest Philippine peso bond issue, achieved in the middle of a global financial crisis, for a first-time issuer. Originally, the issuer had looked at going to offshore markets, or an onshore/offshore combination, before the global markets locked up. Rather than downsize, the deal proved there was no need to go overseas.

The deal did underline the point that brand name is vital in Philippine debt as well as equity. The prompt for the issue was San Miguel Corp’s spin-off of its brewery business, the largest brewery in the Philippines – a 95% market share – and a world-recognised beer brand.

The deal came in three tranches, a three-year at 8.25%, five years at 8.875% and 10 years at 10.5%. All priced at the tight end of guidance. Appetite came from institutional banks, pension funds, insurers and retail, with a wide range of domestic underwriters brought in order to increase to the greatest possible degree the reach of the deal. BDO Capital, BPI Capital, China Bank, First Metro Investment Corp, ING, Land Bank of the Philippines, Philippine Commercial Capital, Rizal Commercial Banking Corp, and Standard Chartered Bank, all ended up with joint underwriting credit alongside the bookrunners.

Other corporate bonds are covered in the main texts, but government issuance has been notable too. Marcelo considers the most significant deal for 2009 to be tranche 11 of the Retail Treasury Bonds, which raised P114.4 billion in September: the biggest retail bond issue for the Philippines since the government first started offering the bonds in 2001. Marcelo also highlights a project finance deal, Cebu Energy Development Corp – the first of its kind to raise all its debt requirements from the peso debt market, raising P16 billion.

December 2009

Singapore wants its local currency debt capital market to be one of its many foundations as a regional financial centre. It’s doing fine, but it might be a surprise to learn that it’s not even southeast Asia’s most prolific corporate bond market – more was raised in ringgit in 2009 than in Singapore dollars, according to ThomsonReuters data.

“The primary market got off to a rocky start at the beginning of the year, mainly driven by a lot of caution,” says Clifford Lee, managing director and head of fixed income at DBS. “Funding was done for refinancing rather than added leverage and the general tone has been more defensive than anything else.”

Although full-year totals are likely to be down from their highs – S$15.235 billion was raised in 2008, whereas just S$9.87 billion had been raised in 2009 by November 19, according to ThomsonReuters – the signs are good for a broadening of the issuer base.

Lee believes in recent years the Sing dollar market has answered its critics. “Previously there were three criticisms of the Singapore dollar market,” he says. “First and foremost was that this market can’t absorb large size. We’ve proven that to be untrue,” he says, referring to a self-led S$1.5 billion hybrid tier one deal for DBS Bank in May, the country’s largest ever Singapore dollar bond deal. Other big deals last year – including a S$600 million hybrid tier one deal for Maybank – support his view. “That belief of constraint has been emphatically debunked.”

The second traditional complaint was that longer tenors could not be achieved. “The market has matured and 10 years is now commonplace,” says Lee. Shortly after speaking, DBS completed an inaugural S$660 million bond issue for Temasek in 20 and 30 year maturities, and has done other deals with 15 and 20 year maturities. “In fact there’s more demand there than for below 10 years,” Lee says. “We are cracking the maximum tenor glass ceiling: for government-linked names and high grade names in Singapore, that’s not an issue anymore.”

The third is the number of investors. Here, too, Lee has seen change. “DBS has been in the Singapore dollar bond market for many years, and previously when we did a transaction we would have maybe 10 to 15 investors within a transaction, maximum. Of them, five or six would be the anchors for every transaction.” Today, things have changed. “The last few public transactions we’ve done saw 60, 70, 100 coming in. It’s taken away from the situation where it was dominated by a handful of investors. It’s given price tension some development, and the secondary market trading is starting to pick up nicely, though it’s still not where it should be yet.”

A key theme in 2009 was the arrival of supranational issuers in Singapore dollars. KfW came twice, for just under S$300 million and S$200 million respectively; the African Development Bank raised S$310 million, and the World Bank S$230 million, all four deals coming within two weeks in August and September. Attracting multinationals does test the limits of the swaps market, but interest so far has been strong.

“The supranational issuance was probably 90% triggered by two things,” says Jan Wipplinger at Deutsche Bank. “Local treasuries of banks being long liquidity; and the MAS [Monetary Authority of Singapore], in regards to allowing AAA-rated supranational issuers and their bonds to be used in the same way as SGS local government bonds for minimum liquid asset requirements [see MAS interview, box]. All of a sudden, investors could switch out of government bonds into supranationals, and use that for the same purposes as government bonds before.” That, Wipplinger says, explains why all the supranational bonds this year have been three years in duration: “That’s where the best pick-up is offered: 50 to 75 basis points over government bonds.”

In previous years retail has played a role, particularly in tier one bank issues, although that has been less widespread in 2009. “In Singapore, the tier one space will come back again,” says Terence Chia at Citi. “In 2010 we should expect to see more such tier one issues either from the local banks or very strong, internationally-recognised names tapping the Singapore dollar market.”

Peng-Meng Ling at Standard Chartered notes there is clear appeal for retail in a low-interest, high-wealth market like Singapore. If a deposit account is paying 1% or less, then a recognizable name offering 5% for two or three years – a bank, perhaps – is going to find an audience. Ling highlights the strength of high net worth individuals as a key part of the Singapore investor base, active in deals for issuers like Hyflux, HPL, CDL and Korea Development Bank in 2009.

Still, retail here is not really the same force as in Thailand, in which buyers drop into their branch to buy a bond. “99%, if not more, of the bond offerings in Singapore have traditionally been offered into the QIB market, for qualified institutional buyers. It hasn’t been meant for mass retail as yet,” says Lee. “So-called retail participation comes in the form of private banks: priority banking-type customers, and they are governed by a minimum size of $250,000 per investment. From an arranger’s standpoint we still don’t sell directly into retail: we sell to private banks, and they sell to retail.”

Still, despite improvements, the Singapore dollar bond market is not all that it could be: lower rated names struggle to access capital. “Rating is still a constraint in the Singapore dollar market,” concedes Lee. Regulation in Singapore doesn’t require bonds to be rated to access the market, but going down the credit curve is nevertheless a challenge.

“We feel we’ve reached a point in the market where domestic investors are keen to see a return of a wider range of international issues,” says Reuben Tucker at ANZ. “But the Singapore dollar market has been exceptionally well balanced in terms of the types of deals seen here: well-known corporate, property transactions, and international issuers.”

Box: The MAS

The Monetary Authority of Singapore oversees the development of Singapore’s local currency bond market. The institution shares it views with IFR Asia on how it’s doing.

“Compared to five years ago, the Singapore bond market has steadily grown by more than 50%, with healthy activity seen from both the corporate and public sector,” says an MAS spokesperson. The authority says it expects healthy new corporate debt issuance in the coming year, in light of expectations of rising global interest rates. “Anecdotally, investment banks have also indicated healthy deal pipelines going into 2010.”

The MAS highlights its high turnover – one of the highest in Asia – and increasing liquidity, with tenors available from one to 20 years, and structured instruments increasingly commonplace. In 2009 it has also attracted increasing numbers of foreign issuers, particularly supranationals. “Foreign issuers make up approximately 30% of S$ debt issuance,” the authority says.

One of its more recent initiatives was to build an Islamic market. In January it announced its first sukuk facility. “It is unique in two aspects,” says the spokesperson. “First, issuance is on a reverse inquiry basis, which means we will issue sukuk according to the needs of banks in Singapore conducting Islamic finance. Second, the sukuk is priced against the Singapore government securities market to provide a transparent price discovery mechanism for these instruments.” The theory is that as the sukuk market grows in Singapore dollars over time, it will then develop its own pricing benchmarks.

“The design of our sukuk facility reflects our effort to tap the strengths of conventional finance, while adhering carefully to Shariah principles,” says the authority. The MAS says the facility has received “strong response”, and has issued tranches to the Islamic Bank of Asia (part-owned by DBS), OCBC and CIMB Bank. “We remain committed to the programme size of S$200 million.”

Additionally, the MAS says the private sukuk market has developed substantially since the facility was launched. City Developments Ltd set up a S$1 billion medium term note programme in January, with S$100 million issued to date, while the Islamic Development Bank issued S$200 million of sukuk via a private placement in September.

One of the biggest impacts the MAS has had on the market this year was the enhancement to its treatment of high quality collateral, allowing AAA-rated Singapore dollar debt securities from supranationals, sovereigns and sovereign-guaranteed companies to be used as collateral to access central bank liquidity. Banks are also permitted to treat these securities as tier two liquid assets with the same (zero) weighting as Singapore government securities.  “These measures, and the issuance that followed, helped banks to diversify their holdings of liquid assets, in the process strengthening financial stability in the banking sector by growing available high quality assets in the banking system,” says the MAS. Since the implementation of the framework, the market has gained about S$2 billion of new issues from triple A rated issuers.

December 2009

Regional bankers tend to express more disappointment about the Indonesian rupiah bond market than any other in southeast Asia in 2009. It didn’t do badly, exactly, but it probably did less than other markets to emphasize its role as a liquid alternative funding source to dollar debt.

ThomsonReuters data says Rp16.8 trillion was raised in 2009 by November 19, already ahead of the Rp16.01 trillion for all of 2008 but well short of Rp24.85 trillion in 2009. That said, many in the industry, interviewed in November, believed there was plenty more to come in 2009, with some still expecting a Rp30 trillion total for the year that would put it in a wholly different light. In particular, an expected Rp3 trillion or larger sub debt raising from Bank Mandiri, due to be settled in December, was being closely watched.

Dhanny Cahyadi, president director of PT ING Securities Indonesia, says the rupiah bond market was “volatile but performed relatively well” during the global financial crisis. It started weakly, before Astra Sedaya Finance became the first private sector corporate bond deal in rupiah in April, raising Rp900 billion in an upsized, multi-tranche issue led by HSBC, Indopremier Securities, ING and Mandiri Sekuritas. With Astra having launched successfully, other blue chips flowed, among them Indofood, which raised Rp1.61 trillion, the largest non-financial corporate bond in 2009; Medco Energy; Bank Ekspor Indonesia, whose four-tranche deal raised Rp2.5 trillion; Panin Bank; Bank BTPN; and state-owned pawnship chain owner Perum Pedagaian. There were no real surprises in the list of issuers. “The type of issues remains relatively the same as previous years,” says Cahyadi. “The frequent issuers are typically from the financial institutions sector, including banks and consumer finance companies.”

Perhaps the most significant rupiah bond in Indonesia this year was much smaller than those – a Rp100 billion deal backed by Bank Tabungan Negara, the first mortgage-backed securitization in Indonesia. “Before this, all bonds were basically straight bonds,” says Iwan Wisaksanai in corporate finance at Kresna Securities. “This was the first securitization.” Regulation permitting securitization actually dates from 1997, but it has taken this long for sufficient interest to develop on both the originator and investor side. “It took more than 10 years to launch one transaction,” Wisaksanai says. A second transaction followed in the fourth quarter, bringing the total issuance between the two to almost Rp500 billion; Standard Chartered was lead arranger on both.

But international bankers have been disappointed with what they’ve seen. One points out that the government bond market is 35-40% held offshore – the highest percentage in the region – and that bigger borrowers still tend to go offshore because liquidity is not abundant at home. “Indonesia is probably a little bit more a hostage to the G3 markets.”

Terence Chia at Citi adds: “Companies in Indonesia are pretty open to issuing in dollars and can get decent sizes done, but issuing in the local currency market is generally not as deep as some other markets.”

Locals seem to view the market differently to foreigners. “We are quite busy, especially in the first half of this year when interest rates were quite low,” says Wisaksanai. Speaking in mid-November he expected a number of non-financial institutions to issue bonds in the fourth quarter, and hoped full year issuance would be between Rp20 and 25 trillion, followed by a drop back to Rp10-15 trillion for 2010.

Similarly, asked if 2009 has been busy in local debt markets, Dini Wijayanti, vice president in the investment banking division of PT Indo Premier Securities, says: “Of course. It’s been very active.” She, too, considers the pipeline so strong, with about Rp12 trillion on its way, that a full year issuance of Rp30 trillion could still be achieved. She is watching closely Mandiri’s forthcoming deal, which she says could raise as much as Rp5 trillion in tenors of up to seven years. “Looking at the current pipeline the most important is Mandiri,” says Wijayanti. “It’s a good company, a massive issue, and the pricing is quite generous, so that one I think will be the benchmark for other issuers in Indonesian bonds.”

It is tough for lower rated names to access rupiah bonds, the more so since a new regulation came into place requiring pension funds to invest only in bonds rated single A or above. “There are not many companies that have a rating of A, so in terms of debt issuance, it has fluctuated a lot in the last 10 years,” says Wisaksanai. Wijayanti adds: “The pool of investors has become a bit smaller for bond issuers below single A.”

Higher rated companies tend to congregate in three to five year maturities, though some have gone as long as seven or 10. “We are bound to see more sub debt issuance and securitization deals so we would not be surprised to see a lengthening of the tenor,” says Cahyadi, although all local participants add that the corporate bond market lacks liquidity. “We hope that over the years the IDR bond market becomes more mature and developed as the other domestic bond markets,” Cahyadi says. “A lot needs to be done by the regulator to create a more conducive environment but we are moving in the right direction.”

Generally, though, the world seems quite optimistic about Indonesia, one of the standout emerging market economies through the financial crisis, and now blessed with political stability after president Susilo Bambang Yudhoyono was returned for another five year term. “After the general election we heard a lot more good things about Indonesia, from both Indonesians and foreigners,” says Thomas Meow at CIMB, which is heavily represented in Indonesia through its ownership of Bank Niaga. “We are very positive and believe investors will be putting more money to work in the bond markets there.”

BOX: Interview with Rahmat Waluyanto, director general of debt management at the Ministry of Finance.

Rahmat Waluyanto oversees the debt capital markets activities of Indonesia. He’s best known on the world stage for his involvement in landmarks like Indonesia’s dollar issue at the start of the year, and the landmark sukuk; however he also has responsibility for development of the rupiah debt capital markets.

From the point of view of government issuance, he says the impact of the global financial crisis was clearly present in increasing yields and a lower volume and frequency of secondary market trades, but was not drastic. “Last year we only issued bonds until October, and then we started again in January,” he says. “The rising yields in the domestic market meant that we couldn’t award the bids in our auctions, but only for two of three months. After that, and especially after our US$3 billion global bond issue, the markets calmed down, as investors perceived that the government had been able to secure its financing for that year.” Contingent financing from the ADB and other multilaterals also helped to calm the markets, and brought down yields on rupiah government bonds considerably.

“Everything has changed drastically,” he says now. “The yield of rupiah bonds [more recently] was 400 basis points lower than in October 2008.” This drop, in turn, helped Indonesia to secure the budget; it conducted its final auction of the year in November and will offer no more until 2010.

Waluyanto notes that something striking happened in October. The net buying of rupiah bonds by foreign investors that month was Rp8 trillion. “It is much, much bigger than the net buying of foreigners in the stock market.” He is encouraged to see foreign ownership of rupiah bonds is increasing, and notes: “There is no tendency that it is going to be lower.” He puts foreign ownership at about 18% of total tradable government bonds outstanding (a total market of about Rp580 trillion), compared to 16% as recently as December. He credits this rise to the strengthening rupiah, the spread between Indonesian government bonds and US treasuries, and growing confidence in Indonesia generally. He also notes that almost 80% of the bonds held by foreigners have a longer tenor, of five years and beyond.

And what of the corporate bond market? Waluyanto denies that issuance in this market has flagged, and makes a bold-sounding estimate echoed in other parts of the market that full-year issuance could hit Rp30 trillion despite the fact it was barely half that by mid-November. He notes, though, that companies have been able to raise funds in the booming equity market this year, which may have removed the appeal of the debt markets.

There is a sense that Indonesian issuers are much more likely to go for dollars than rupiah given the choice. Waluyanto says: “If everything goes well, with no market volatility, we prefer to have rupiah bonds. Basically, it is going to be more stable if we have a widened investor base in the domestic market. There are some advantages of issuing overseas because it can support the reserves, the balance of payments, and create a benchmark for international issuance for corporate. But our policy is still prioritising domestic bond issuance.”

He adds: “The global market cannot last forever in terms of its stability. At any time something can happen: the market dynamics can be destabilized by a bank collapse. We are better prepared by having an investor base in the domestic market.”

So how can the corporate bond market be boosted? “Well, I think we must give them space,” he says, by which he means not crowding corporate issuers out with government paper. “The government has been the largest single bond issuer in the domestic markets, so our main concern is to avoid carving out the domestic markets.” He says that by issuing globally in dollars, samurai, global sukuk, and other offshore measures, “that is one of the ways we gave some space for corporate bond issuance in the domestic market.” Also, he says the government has tried to lengthen the duration of its issues. “This is also to give space to the corporate sector who only issue in the medium term. Five years, three years – we try to do our best to avoid issuing bonds in that tenor.”

Waluyanto has been instrumental in the development of a sukuk market in Indonesia, going right back to the legislation that had to be passed in order to allow the government to issue in the first place. The global dollar sukuk caught the headlines, but it has also issued domestically in rupiah, using the ijara structure, using government assets as the underlying. “Going forward we need to diversify our sukuk instruments by trying to introduce a project-based sukuk next year, hopefully,” he says. “We will select one or two projects that can be financed through sukuk issuance as a pilot.” These deals are in preparation but Waluyanto says they will be in rupiah.  He also argues that there is no additional cost in sukuk issuance. “Any time we issue sukuk, we never give any extra premium.”

December 2009

Vietnam is much the youngest local currency debt capital market covered in this report, and the most vulnerable to external shocks. After a promising 2007 in which D10.5 trillion was raised, issuance almost completely dried up in 2008, totalling less than a tenth of that, according to ThomsonReuters.

In that context, 2009 was something of a return to form. By November 19 D7.3 trillion had been raised by local issuers, including the country’s biggest corporate bond to date, an important, market-reopening D3.5 trillion issue for electricity utility EVN.

Still, both locally and internationally, bankers vary on their opinions about the market’s development and prospects. “I think the market has huge potential,” says Terence Chia, vice president, Asia debt syndicate, capital markets origination at Citi. “It is still at the developing stage but the sorts of sizes we have been seeing getting done are pretty amazing for a market that is so new.”

Since the EVN deal, these have included D1.5 trillion of issuance for Vinacomin, the coal and minerals mining conglomerate; D2 trillion for Sacombank; D1.362 trillion for another bank, BIDV; and most recently D2.1 trillion for a third, Techcombank, in October.

Citi led the Vinacomin and (with ANZ and Sacombank Securities) Sacombank deals; Chia says Vinacomin could have gone well over D2 trillion had it wanted to. “Vietnam certainly has the potential to develop a pretty robust local currency market,” he says. “I think issuance will remain sporadic for the time being because of the interest rate environment, which has been volatile this year. But if we see the rate environment stabilise we should see more deals getting done in the local market.”

Certainly, many of these deals have been impressive in any context, and not just EVN, discussed in the box in this article. Sean Henderson at HSBC points to BIDV, the first lower tier two deal in Vietnam for three years, which HSBC jointly led with BIDV itself. “That was a great print in terms of being able to execute a lower tier two deal through the crisis,” he says. Doing it internationally would have been “exceptionally difficult if not impossible for most names – you’ve only just seen OCBC do it. So it was a great success being able to get them capital out of their domestic market.” HSBC also joint-led the Techcombank deal, with Standard Chartered, the largest single tranche by a financial institution this year. Peng-Meng Ling at Stanchart thinks there’s more where that came from, and reports a number of local currency deals in the pipeline.

There’s certainly no shortage of a need for funds. Vietnam’s vice minister of planning and investment, Dang Huy Dong, tells IFR Asia he hopes the local bond market can be one of many sources for the country’s vital infrastructure funding. “We need a substantial amount of capital to finance our ambitious and huge demand for infrastructure developments,” he says. “So far we have been relying on the conventional sources, such as the national budget, grants and loans. Now we have to look to the commercial bond markets, domestically and internationally.”

He accepts there is more to do. “The domestic bond market is developing,” he says. “It’s still in its initial stages, but we are learning by doing, and as people become more confident it will expand. I’m optimistic about it.”

And it’s not just the projects that need funds. Companies need to expand and are keen to do so with rates low. “Corporates want to raise medium to long term funding for two reasons,” says Nguyen Quang Minh, deputy director of the treasury department at Vietcombank. “Firstly there are real needs to finance their projects. Secondly, they expect that next year interest rates will increase, so if they raise funds now it will be cheaper than in the next two years.”

But Nguyen is typical of local bankers in seeing harder times ahead, and his tone is more cautious than the international players. He says despite the successful issues this year – he calls it “the year of the corporate bond” – things may get tougher. “Now I think it is very difficult for corporations to issue,” because the State Bank of Vietnam is not adding liquidity to the market. Similarly at BIDV, Trinh Quynh Thanh, deputy manager of the dealing room, also bemoans the lack of liquidity and calls 2009 “a tough year” for that reason. “In 2007 you could see a strong amount of capital coming to Vietnam and a lot of government bond investment, but after 2008 and the financial crisis it ran out. There was also a sell-off of government bonds in Vietnam and after that liquidity fell to a low over 2009.”

And the future? “We think 2010 will also not be really good for liquidity for bonds. We need the recovery not only of Vietnam but the whole world.”

Indeed, one of the striking things about the bond issuance in 2009 is that it has been done almost entirely with only a single slice of the potential investor base – domestic banks. Local funds play a limited role, but international capital, once so active, has all but gone. “Last year they [foreign investors] got very big losses because of fluctuations in the exchange markets,” says Nguyen. “I don’t see them coming back yet – the main players are the domestic commercial banks.”

Getting this international capital back into these markets requires changes to happen both inside and outside Vietnam. Minister Dang Huy Dong says that dispersed FDI in the first 10 months of 2009, at US$8 billion, is not significantly down on the $9 billion figure for 2008, but the committed FDI is dramatically down – $18.9 billion for 2009 to date when we spoke to him compared to $69 billion in 2008. And portfolio flows have been even more flighty. “I don’t think they are ready to come back because of their home country; they don’t have the confidence elsewhere in the world,” he says. “But quite a few foreign funds are still active in the stock markets.”

Some are no doubt deterred by the macro position, particularly inflation. “Just like any other country inflation is always an issue and any government has to take a close look at it; Vietnam is no different from that,” he says. “As we are rolling out the stimulus package, we install the mechanisms with a number of different indicators to keep a close watch on inflation.” And what are those indicators telling him? “At the moment they are saying we are still on the safe side. The moment we feel it is shaky, we have mechanisms.”

If foreign flows do return to dong bonds, they ought to support growth in the market. “In 2010 the picture may be a little brighter, but it should be taken step by step and there will not be a big change in the market,” says Trinh. “If you look at the macro, Vietnam is quite an attractive place to invest: we have positive GDP growth rates in 2009, a little bit higher in 2010; we are recovering quite well. By the second quarter of 2010 we may have some cashflow coming back into Vietnam.”

Deal profile: EVN

EVN’s D3.5 trillion bond re-opened a market that had been flattened for more than a year. “The market had really been closed since the fourth quarter of 2007, given the disruption to local fixed income markets with rapidly accelerating inflation,” says Reuben Tucker, head of debt capital markets for Asia at ANZ. “The bond markets had been shut for five quarters.”

ANZ had been close to EVN for years, having handled its inaugural transaction in dong. “We saw them as an ideal candidate to reopen the market with an appropriately sized benchmark deal, to signal to domestic investors that the market was open.” Early in the first quarter of 2009 the bank began sounding out accounts who said they had a lot of dong liquidity to deploy, given the dearth of trading available in the secondary markets at that time. Finding appetite from large domestic players, the bank went back to EVN with that feedback in late February, and the issuer set out for a D1.5 trillion transaction. “We felt that would be large enough to represent a true benchmark in the market, and also an adequate size to reopen the market with.”

Documentation took around four weeks, which Tucker suspects is a record in the local market. “But more important than the timing was the fact that we used the deal not only to reopen the market, but create a benchmark of international style documentation in the local market. It closely resembled a traditional Regulation S offering circular in international markets.”

The bookbuild took three days and closed at over D5 trillion, allowing the deal to increase to D3.5 trillion, the largest ever Vietnamese dong corporate bond. It succeeded in reopening the door, as many other issues followed.

Tucker says he is “very optimistic about this market, which is why we continue to commit more resources to it. It is in early stages of development but there is good diversity in terms of issuers: we have had large SOEs, joint stock banks, and a listed company in the tech space this year. The market is showing its capability to absorb credit across the entire spectrum of issuer types, and that’s occurring at a very early stage in the market’s development.”

He says he is seeing the level of sophistication in bank and asset manager portfolios lifting dramatically. He hasn’t yet seen international funds returning to the market, though he feels it will come back. “The encouraging thing to note is that many transactions have been successful based on almost 100% onshore distribution. While the return of international investors will be an encouraging signal, the fact that the market has seen the volumes it has without them is a strong sign.”