TheAsset

The Asset: How does 2008 look for Asian fixed income?

 

Ivan Lee, Citi: We are in the doldrums at the moment. No one wants to catch a falling knife. The financial system in the US remains  fragile. There seems to be no shortage of negative headlines, with the latest one being AIG understating their CDS/subprime exposures – by as much as US$5 billion. Now it’s just a guessing game about who is next in line and whether all the skeletons have been brought out of the closet. So I think the market will remain nervous for the next month or so, probably until the next quarter. If the major investment banks show stability in the first quarter results, we will probably see a relief rally by then. But in the near term, we are likely to see relatively weak markets.

Dilip Shahani, HSBC: I have just come back from three weeks in the US and London and most people are more bearish than me. I have been consistently bearish since last year. What clients made me think about more is that whereas everyone knows what the endgame is, how to get to the endgame is the critical issue in that there isn’t a lot of clarity and there are two or three big issues that need to be resolved.

Before I get into those, the positive thing is that the Fed is now changing tack and becoming far more aggressive, targeting negative interest rates because they are trying to target asset inflation. Bernanke (Ben Bernanke, chairman of the US Federal Reserve) is well versed in this particular issue given that he studied the 1929 recession and also the 1907 recession, so he is trying to stop financial asset prices from falling and also property prices from falling, so that’s the first plus. But besides that, from a market perspective, the technicals are really badly broken in the US, and in Europe they are getting worse. People are going to focus on the monolines and how that is going to get resolved. The current discussions are quite weak, in that the banks can’t really save the monolines and it has to be some sort of government effort, which delays the whole process.

The other big issue is that people are really concerned more about the European banks as they are far more opaque. The particular issue that has been bothering the market, and I agree with the market, is that the ECB (European Central Bank) has lent out 450 billion euros to the European banking system through repos, and these banks haven’t been able to fund themselves back into the interbank market and the commercial market via senior debt. Unless they do that, this will remain a big issue, which is really weighing on the European side of the equation.

And the final thing is, coming back to where we started, the Fed is cutting interest rates to stop a recession but we don’t know if there will be a recession, and if there is one, whether it will be mild or severe. The more severe a recession is, the more you can interplay all the factors I’ve talked about and a multitude of other factors that can still happen. I think it’s still early to call a bottoming out. You can get relief rallies along the way, but I still think it’s quite opaque out there right now.

Ben Falloon, Credit Suisse:  I fully concur with what Dilip just said – this market is going to continue to deteriorate. In fact, Asia has got away relatively lightly so far compared to the US and Europe, simply because of the issue of supply – the amount of paper we actually have, and the amount of leverage we have on that paper.  In the US and Europe, it’s a bloodbath particularly in the leveraged finance space – the securitization space. The emerging markets have managed to survive up to now, but even there we are beginning to see some stress and I expect that to continue until the end of the first quarter.

I agree that we need to see what the Q1 results for the investment banks are. Some banks have done relatively well so far this year, through the non-traditional businesses – the balance-sheet-light business.  The old business of using balance sheets to inflate asset prices has pretty much gone, particularly for the broker/dealers when you see they’re funding at 200 basis points over Libor. You really have to look at your core business and work out whether that business actually exists anymore.

Edwin Chan, UBS: We have set out the 2008 strategy in a defensive position. With the bias towards a further slowdown in the US, market volatility could persist for a while. We think it makes sense to continue with the defensive position, at least in the near term. UBS has slashed growth forecasts in the US and is calling for a moderate recession. Assuming a moderate recession, we think the medium-term value case for Asian dollar bonds has strengthened as credit spreads have priced in excessive default risks. We may have also entered a sweet spot where bonds’ attractiveness has improved vis-à-vis equity. We could be looking at Q2 as the first signpost for the possible return of some of the liquidity to the Asian bond market. Hence, it makes sense to stay nimble and selectively identify opportunities. That said, we think that there are still substantial risks on the horizon including the possibility of a deeper recession, further subprime related developments, and supply. This reinforces our defensive bias in the near term.

 

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David Fernandez, JPMorgan: In Asia’s credit markets this year, you can tell a story of two halves. Right now, in this first half of 2008, markets are dominated by US recession concerns while in the second half of the year, we may start to see the bottom and spreads tighten. But I would say that increasingly it feels like the so-called first half could get extended towards the end of the third quarter, and that until then, the overall macro picture is still uncertain and we still see people in defensive positions. So, while everyone holds out for the possibility for a rebound – and I think there will be one – we may have to wait until the end of the third quarter for that rebound to appear.

Damien Wood, Credit Suisse: I agree that the potential for a rebound is there. It’s just that fear is driving the market, and other factors such as the unwinding of leverage into an illiquid market are exacerbating the problem. Another issue that worries me is that there is a huge disconnect between the equity markets and the credit markets at the moment. I still think there’s some downside risk from equity markets falling and dragging credit investors lower down as well. In the near term, it’s not particularly great, but longer term, there are great opportunities. This is a good market for those who can prove their value. Investors cannot just buy and hope for the best. They have to add value to the process. The long-only investors have a bit of a problem with the first quarter results; they don’t have much flexibility with what they can do. The hedge fund guys have more flexibility to show what they are worth.

Dilip Shahani: We visited quite a few long-only funds in the US, and the smart strategy is not to put money in cash, but to put it in cash equivalents. A lot of them have been putting huge positions into treasuries, and reducing positions in corporate and bank debt and making a lot of money. Now that is what the smart money in the long-only world is doing. But I suspect a lot of them are still like rabbits in the headlights and haven’t done anything and those guys are in trouble. But the smart ones have done exactly what they should be doing. So being long doesn’t mean you fall apart.

The Asset: From the trading desk, how does today’s crisis compare with previous sell-offs?

Richard Cohen, Morgan Stanley: It feels worse than 2000/01; it doesn’t feel anything like 1997. In 2000, Asia was still recovering from the crisis and then it was one or two shocks, whereas this is continuous. We are being hit by negative news, after negative news, after negative news and the shocks are very much more global. The speed of spread movements has been increased by the amount of credit derivatives in the market because the hedge funds are much more active. Hedge funds were minor players in 2000/01 – they virtually did not exist in 1998 – and  now they have a huge effect. 

The difference today as compared to previous sell-offs such as in 2003 with Korea is that then the Asian banks were the buyers of last resort because there was a lot of liquidity in the banking system and they were sitting there waiting to buy assets. We have not seen that this time because this problem was led by the financials, not the corporates as in 2003. Although they have taken hits, the Asian banks are in better shape than some of their global peers. But they are taking care of their balance sheets and they are not taking risky assets on board in the way that they have in previous sell-offs. In general, the bank bid has not been there        in size, which is more akin to 1998/99 when the financials were the key       component of the sell-off, along with sovereigns. 
 
Damien Wood: Dilip, when you were in the US, have people moved from asking if we in a recession to accepting that we are already in one now?

Dilip Shahani: If you remember in 1997 and 1998 in Asia, at least 60% of people lived in denial. They were just talking the talk and doing nothing to adjust their positions to what was really going on. And I get the sense that that is what is happening in the US as well. They never thought this could happen and they are praying that the policy makers can get them out of it and hence they haven’t actually made the adjustments. In terms of the macro picture, to be more specific, you don’t yet get that sense in the big cities because this is really associated with the subprime – those are out on the peripheries and in the lower income groupings. I suspect that will come now and filter into the cities in the first and second quarters. It is still a slow motion action that is going through and may intensify as it gets more into the cities. But you don’t even see in the newspapers in the cities that people are seriously concerned as yet.

Damien Wood: David, what insulation can Asia get from this slowdown in the US?

David Fernandez: I’m calling into this conversation from India, and macroeconomically, I feel confident in saying that India will be relatively insulated from the US slowdown. If you wanted to tell a decoupling story in Asia, then I would do so here in India, as well as in China where a strong policy response would hold up the GDP numbers. Even though I’m not a believer in decoupling for the rest of the region in the event of a US recession, I would make the point that what matters for investors deciding what to do right now, it really doesn’t matter what I think about it or even what they think about decoupling. What matters is that the policymakers in Asia seem to believe that their economies are not decoupled from the US. As a result, they are ready to take out insurance against the possibility of a US slowdown and I think that is going to say a lot about how people should make their investment decisions this year.

Damien Wood: Ivan, there’s been a lot of press that high default rates in the US are going to increase even more, do you think it will be same in Asia?

Ivan Lee: Asia should see a much lower default rate than the US. The US base-case scenario is somewhere between 4% and 5% high-yield default rate by the end of this year, from below 1% last year. In Asia, if you look around the high-yield world, you can probably highlight three or four names out of the 70 odd names that are at the risk of default in the next two years. Thus, the default rate in Asia probably will be in the 2% to 3% range and those defaults may not even happen. They might just muddle through. So the default ratio in Asia definitely should be lower, given the fact that Asia is on the periphery of the US economic downturn.
I think a good parallel is to look back at 2001/02 when the US economy went into a recession and the default ratio went all the way to 11% to 12%, and high-yield spreads went to 1,000 over. During that period, Asia’s high-yield spreads held up relatively. What you typically see in the first phase of the crisis is that each market tends to be synchronized in terms of widening, but once you reach a certain stage, different asset classes tend to decouple and behave more according to their underlying   fundamentals. For instance, back in 2001/02, Asian spreads widened all the way to early 2001 and from there onwards, Asian spreads did very well. The Enron and Worldcom defaults only had a short-term impact on Asian high-yield spreads which only widened 100 basis points but fully recovered 12 months later. But if you look at the US, high-yield spreads widened by another 600 basis points, and they didn’t recover until the economy came out of recession.

Ben Falloon: One of the key issues is the private market, which is far bigger than the visible public market. Here you’ve got some pressure points, particularly in China. If the IPO pipeline doesn’t open up, a lot of debt that was done on a pre-IPO basis last year will be in significant difficulty, because it’s dependent on the IPO taking place and pre-payment occurring on that debt. If there is no IPO, we run into a number of scenarios, where we have pre-IPO puts at considerable IRR’s (internal rate of return) and if a business hasn’t been able to launch an IPO, to actually get the money to meet those put obligations, it’s going to become very difficult.
Already, some names have been facing a shortage of capital and are scrambling for money, which is pretty hard to come by. I don’t think we will see an up-tick in public default rates unless the new issue pipeline doesn’t materialize at all in 2008 and people have to focus on real businesses. On the private side, we really have to keep a close eye on what’s going on in the IPO market and at this point I think it’s stacked up with 30-odd names and they will continue to line up week-by-week. If it becomes a real jam, we could see some real stress in our space.

Damien Wood: Do you think any of these China property deals can be done this year?

Ben Falloon: We’re just about to get one deal done for a single-B type issuer – a relatively small deal. There is still money there; the difference is really in the IRRs. We have gone from doing deals with 17% guaranteed IRRs to guaranteed IRRs of between 25% and 30%. There’s a market and the market’s willing to pay. There’s a large differential between that and what you get in the public markets already. If you can price deals and structure them in a way that gives better returns and better security packages then there’s money willing to come in.

 

Ian Krassek, JPMorgan: As far as the public market is concerned, if you are talking about opening up the high-yield market again, the best possibility right now may be to take a company that has an existing issue, and ask five or six investors at what price they would be willing to buy a new issue. Then, go back to the issuer to see if there’s a chance that they would issue at that level. This way, we can go into the public market with a strong conviction and say: “We have half this deal done at this price, are you in or out?”. It is important to come from a point of strength and certainty. When attempting to market a deal now, clearly it’s very, very difficult.

With regard to the private side, some investors have come into our office – specifically London and New York-based hedge funds, as they visit sellside counterparties on their initial 2008 Asia visits, saying: “We still have money to put to work in this illiquid pre IPO/mezz space”. However, they clearly want shorter tenors, cleaner structures, more cash interest, and to be less dependent on the warrant valuation.

Damien Wood: The local bond markets continue to grow, can this and syndicated and bilateral loans alleviate some of the pressure we have on the supply in the market now?

 Dilip Shahani: I think the corporate debt market is not big enough and they need more time to develop to achieve what you are talking about. The syndicated loan market plus the general bank loan market and other forms of that derivative can pick up the slack left by a temporary closure of the US dollar high-yield market. The point I’m trying to make is that I think the high-yield market, when it was created two to three years ago in Asia, really wasn’t a function of the issuers’ demand, but was a function of foreigners searching for high yield and seeing the allure of Asian growth. That was one of the equations that made the market develop. The other equation was that the investment banks and commercial banks were trying to make a fee out of it. Since I have come back from US and London, I find a lot of the clients actually aren’t interested, so the formation of this market has been on weak foundations, but the banks themselves are very liquid in Asia, and can easily take up the slack again, and I think they will continue to take up the slack. Then you are going to get the hedge funds and the private equity guys taking up the slack. But I think the public market in high yield is on shaky ground now from what I have seen.

 

David Fernandez: In terms of interest in local currency government bond markets in Asia, foreign investors in the US and Europe are still very active. The growth of the GBI-EM benchmark represents a sea-change for these investors and it is these real money investors who so far haven’t got hurt as much. They have stayed in the sovereigns generally and have especially been in the local currency space. While clients have exited positions across the board in corporates and banks, they have stayed in the sovereigns and they have done well even in these awful markets.

Damien Wood: Ivan, you mentioned the disconnect back in 2001 between the US and Asia and a big part of that was the Asian bid – that is the private banks and commercial banks in the region. Do you see the Asian bid coming back?

Ivan Lee: It will take a while, but it will eventually come back. Back then, there were two groups of investors that eventually came to the credit market – the private banks, and the equity hedge funds. There are still a lot of investors out there – both equity and private bank clients – who still have hope in the equity markets. But if the equity markets fall another 30% to 40%, then those hopes will be gone. With interest rates expected to be close to zero percent by the middle of the year, high BB credits that are yielding 8% to 9% will look very attractive. If an investor already knows some of the China property companies relatively well, and with the bonds yielding 12% to 15%, they look attractive and I think these investors will come in in the second half of the year. 

Damien Wood: CDS and index trading have dominated volumes of late, do you think this will continue if markets conditions improve later in the year?

Ian Krassek: Yes, because the private side of the market is much larger than the public side. Many of the CDS and indices trades are a reflection of credit investor hedges to their illiquid private deal exposure. These positions are actively managed and are expected to continue.

Ben Falloon: Over the past couple of days alone, we have probably seen a couple of billion dollars worth of enquiry in CDS and the indices. We have not hit on much of it, but we have seen it. It is a very, very active market. I have sales guys dedicated to this product and this product alone because it is that busy. There are at least 60 active institutions that we talk to. The activity changes depending on what people are doing. But there are some who are active pretty much on a daily basis. It’s very understandable in this market where it is so expensive to borrow cash. It’s the only way to trade this market. You have got to use derivatives.

Richard Cohen: The other reason it is so active in CDS is that there are large number of part-time players such as equity accounts who are coming in and out trying to finds ways to hedge their portfolios – people who you would not call credit investors per se are very active. Right now, they are very active.

Damien Wood: The credit markets and equity markets appear to be disconnected, is this technical or do investors have different views? Or is one right and the other wrong?

Ivan Lee: Most investors have this behaviour of ‘seeing is believing’. People in the credit market have seen the meltdown, they have seen how investors in CDOs have lost their shirts and how the market went into meltdown. But equity investors have only felt it through reading newspapers – the actual impact on corporate earnings and what you actually see in your daily life have been relatively moderate. If you use conventional measures, one can argue that the equity market is still not expensive, the p/e ratio (price to earnings) is not demanding, the price-to-book is reasonable and therefore coupled with the stimulation effect of the Fed rate cuts, there is reason for them to be less pessimistic. But as we go deeper into the economic slowdown, there will be more spillover effects into the economy. By then, the two markets will converge and it will be very difficult for the equity markets to sustain where they are now.

Dilip Shahani: I don’t think there is any disconnect, I think both markets are working quite efficiently. The issue is if you look at the credit market, a big subset of that has been financials and the financials got hit and that has had an overpowering effect on the credit indices. If you go back and look at the equity markets, you have to be careful to dissect the market carefully. If you look at the sub sectors that have been hit, they are the same subsectors that were hit from the credit perspective – the banks, the investment banks, the housing-related builders etc. But the equity market has more depth in sub-sectors and those are now holding the market up ie the energy sector, the health space and so on. Similarly, in the credit markets, those haven’t fallen. In the equity market, those sectors are still rising, but will they ultimately connect from an aggregate basis, that’s a macro question. If you believe there is a general recession then they will connect, but I think both markets are working efficiently. You have to drill down a little bit more in the equity market to see the sub sectors but in the credit market the sub sectors are so big they are having an overriding impact on the overall indices.

 

Edwin Chan: We may have entered a sweet spot where bonds attractiveness has improved vis-à-vis equity under the moderate recession scenario. Expected returns for equity are still way ahead of those for dollar bonds. But we ran a sensitivity analysis to show how much cut in equity target prices are required to equalize the return on the two instruments. Our analysis shows that in many cases, you just need a 10% to 30% slash in equity target prices to equalize the expected return. And this is before any assumption on spread compression or any risk-adjustments for equity versus bonds. Both of these will further increase the attractiveness of bonds. That said, we think credit spreads can still ratchet up as equity markets re-price downwards, before snapping back.

Damien Wood: Where do you see Asian credit spreads will be at year end, tighter, wider or flat? And what will be the key catalysts.

Ivan Lee: I think they will be tighter. Where we are now, Asian spreads are now wider than they were in 2001 when Asia was much worse in terms of fundamentals with Indonesia in the middle of restructuring and banks in most parts of Asia in the middle of recapitalization. Today, we don’t see any meaningful weak links in the Asian economies. The fundamentals are simply much better than they were and that should allow the market to see more sanity by year end.

Ben Falloon: I think the market is going to be pretty difficult up until the end of the year. There will be sectors that will have tightened from here – probably the banks, but there will be others that will be much wider. I think we will decouple in sectors that find it more difficult to fund in this market as they will have to either give up equity in the form of CB’s (convertible bonds) or pay up for shorter dated debt. Maybe we will have a decent distressed market by the beginning of 2009.

Dilip Shahani: I agree with Ben. I think it’s a really difficult question because between now and the end of the year, they are going to first get a lot wider, then they will tighten. But the banks will be tighter by the end of the year from wherever they blow out to. But the Chinese property sector – I don’t think it’s coming back – it will be a serious underperformer. And I also think that emerging market (EM) sovereigns will be underperformers in the second half of the year because if this is a US recession, it will have a huge impact on commodity complexes and EM sovereigns will be affected quite significantly.

David Fernandez: I disagree with that. The late second half recovery will be a combination of banks recovering and sovereigns that will continue to be solid performers even through the US recession concerns. I expect the JACI (JPMorgan Asia Credit Index), for example, will be tighter at the end of the year compared to now. In these tough markets, Asian sovereigns should outperform. First, the fundamentals for the bigger Asian sovereign issuers, Indonesia and the Philippines, continue to improve. Debt ratios, servicing costs, growth, balance of payments dynamics – all of these trends remain positive. Second, as investors stay on the sidelines when it comes to many Asian corporate and financial names, Asian sovereigns are getting an extra demand boost. I had one Asia credit investor say to me recently: “The big mistake we made was investing in anything other than sovereigns.” I think that’s a common sentiment out there.

Damien Wood: I believe spreads will be tighter because the credit space is so wide and there will be a minimum amount of defaults. I think the banks will be the leading performers.

Edwin Chan: We expect Asian credit spreads to close the year at tighter levels. If you look at credit spreads from the Asian premium angle, the Asian premium is just too wide. For instance, PCCW’13, HUWHY’11, and HKLAND’14 widened out 96, 82 and 50 bps respectively over the last three months on a Z-spread basis. The Asian premium for these bonds reached highs of 80, 105, and 64 bps respectively. We are talking about blue-chip companies here in Asia. Even in the high-yield space, single name 5-year CDS for Hynix, C&M and STATS ChipPAC have reached 300 to 600 bps, pricing a significant default probability of 20% to 40% in five years. We believe that risk premium has been excessive as the macro and the micro picture in Asia still looks decent despite the potential slowdown. The widening was driven more by market dislocation, less by the fundamentals. If we assume some order returning to the market in the second half of the year, we should see compression of the Asian premium to a more sane level. The UBS house view calls for a moderate recession scenario in the US where we expect some recovery in the second half of 2008. But I agree that we may see wider levels before we end up tighter given the volatility.

 

Richard Cohen: I think spreads will be tighter at the end of the year. The question is how they are going to get there? I am concerned that the overhang of bank paper is so great that we may not see bank bonds performing as well as other people are expecting. Sovereigns have held in reasonably well, so it’s hard to see them significantly tighter. Chinese property is probably stuck where it is; if it goes anywhere I think it’s further south. But given the distressed prices a lot of stuff is trading at, maybe the downside is somewhat limited. Some of the corporates and indices have been shorted just because people need stuff to short. Then people will realize   that the defaults won’t be as dramatic as is currently priced in and we will rally, but I think we go worse before we go better.

What we are going through is basically a giant de-leveraging and this week has been the best example of it. The reason that the CDO market is not dead is because the deals are being unwound. CDO flows are very important, but it’s not printing new deals, it’s just unwinding or rebalancing old ones. Asia is just caught in the crosswinds of what is going on in the rest of the world. TRS (total return swaps) for leveraged loans get unwound in Europe and that causes sellers of LevX, which causes people to short crossover based off recovery values, people then short Asia high yield based on their perception of Asia versus Europe. And it all starts off when a couple of guys need to dump leveraged loans as market triggers are hit in CLOs . And that is this particular round. In previous rounds, there have been other forms of de-leveraging. So as far as I can see the grand deleveraging is still very much underway. People are using whatever they can – CDS and indices – to be short and when that stops, the shorts of choice are going to gap and it’s going to gap dramatically.