The hiccups in global credit markets notwithstanding, private debt in Asia is the beneficiary of healthy demand. Bradley Ziff, a director at New York-based consulting firm Oliver Wyman, and his team spent the last few months interviewing 60 of the largest Asia-focused hedge funds that invest in the region’s credit markets.
What he came across, he says, is a “boomlet”.
Four out of five fund managers in Ziff’s study said they invested in privately placed high-yield debt in the region; almost 40% said so-called special situations—another name for debt that isn’t sold in public markets—are “very important” to their business in Asia.
Asian companies like to sell debt privately because they get funds more quickly, and with fewer regulatory hassles, than they would if they were to put together a bond issue. Banks arranging the offers don’t mind the fees, either.
Hedge funds like to invest in them because of the high yields. Sure, they forgo the liquidity of owning publicly traded securities. But that isn’t much of a sacrifice in Asia, where corporate bond markets are small and shallow.
For the first time, companies in Asia outside Japan will raise more money through private placements of high-yield debt than public sales this year, Citigroup Inc. said in May.
Is this a new financial vulnerability in Asia? Not really.
Rather than think of ways to limit the participation of global hedge funds in the private placement market, policymakers in the region ought to make efforts toward improving the state of their bond markets.
Once foreigners are able to buy local currency bonds in the region and hedge their risks in onshore derivatives markets, a penalty for “illiquidity” will automatically emerge. And the systemic risks to Asian nations will ebb. The International Monetary Fund (IMF) in Washington has noticed hedge-fund involvement in high-yield, privately placed debt in emerging markets, and it isn’t very happy about it.
“Many hedge funds are attracted to the high yield offered by some borrowers, as well as the lack of mark-to-market accounting on such loans,” noted the September issue of IMF’s quarterly assessment of risks in the global financial system. “Weaker credits and more first-time issuers—some of which may be inadequately covered by analysts and rating agencies—are becoming involved in the high-yield debt market,” IMF said.
IMF’s caution is directed more toward the emerging markets of Europe, West Asia (Middle East) and Africa, together known as the EMEA region: Private loan placements in Asia, growing slightly from 2006, may amount to about $90 billion (Rs3.5 trillion) this year. At more than $250 billion, EMEA is where there is an issue of excessive speculation.
In a phone interview from Hong Kong, Ziff gave three reasons why one need not get too alarmed about the current state of increased hedge-fund investing in Asia’s private-placement market, especially in Indonesia, India and China, the hot spots.
According to Ziff, hedge funds investing in private corporate debt in Asia aren’t using as much borrowed money to magnify the size of their bets as they are in other markets.
The risks of defaults are, therefore, lower.
Second, funds typically require that the financial institution originating the loans also invest along with them so there is substantial risk sharing on these transactions.
Third, the documentation and the due diligence on these privately placed loans are often of a high quality, allowing a greater degree of scrutiny, Ziff said.
Comfortable with risks
“Among the several lessons investors drew from the subprime-related credit crisis was that they needed to have a sharp eye and not be overly dependent on ratings,” Ziff said.
“A number of hedge funds in Asia are putting their own boots on the ground,” he said. “Rather than wait for arrangers to bring them the deals, the hedge funds are often discovering the opportunities themselves. That also makes them more comfortable with the risks.”
IMF says privately placed loans are risky because “their secondary market liquidity is likely to be very limited in the event of a downturn or when credit difficulties arise.”
That is a challenge. Most hedge funds in Ziff’s survey said they were concerned about not being able to unwind positions. Their strategy, therefore, is to limit participation to only those loans that mature in to two-to-five years.
Developing deep, liquid bond markets is a policy objective in all Asian countries where corporate finance is still dominated by bank loans.
It isn’t going to be an easy task.
Banking systems across the region are flush with funds, thanks to high savings rates. Derivatives for hedging interest rate and currency risks are either absent, or inadequately developed. Weak legal systems dilute creditor rights. China and India have significant capital controls.
All this limits the opportunity for bond investors, especially foreigners. Privately placed debt offers a window through which global hedge funds can satisfy corporate Asia’s need for credit even as it waits for the public markets to grow in size and sophistication. Rather than trying to shut the window, policymakers’ efforts should be to open the doors.