What are your thoughts on the issue of liquidity in the secondary loan market in Asia? Observers argue that as long as bankers aggressively price credit to try to win business from corporates, rather than where they believe the credit will trade in the secondary market, loans in Asia will never become liquid.
As one of the major arrangers of transactions in Asia, we don't price deals according to what we believe the secondary market should trade at, although we do price deals based on the credit itself. But the other more important component is the liquidity in the marketplace. If there's a lot of liquidity in the market that one [lender] will decide to chase good deals, and will be prepared to sacrifice a bit on the pricing in order to own the asset because they really want to back this client, and as arrangers there is very little we can do about it. We can say that we believe the credit is going to be priced at a certain level, but if there are enough market participants going for the deal -at a slight discount to the credit pricing vis-a-vis a bond that particular borrower has in the market or credit default swaps - we'd end up not being able to do any deals due to competitive reasons.
The other more important thing, apart from pricing the transactions according to the credit, is to consider the market demand for that particular credit. If you always look at secondary pricing, then we are talking about a bond market and not a loan market. Loan markets have more to them than just a credit side because people back them for relationship reasons, for cross-selling reasons - to sell other products to this particular client. A bond deal it purely transaction-based whereas with a loan deal, the relationship element is also a factor. That is why there's always this discrepancy between loan and bond market pricing. In the bond market you're looking at relative value plays. For instance, on a single A credit, one would examine where it's trading in Asia vis-a-vis the US or Europe. It tends to make the pool of funds move around globally. But if you look at the banking side, it's a bit different. There are a lot of relationship elements in it.
But market demand is being dictated by so many lenders chasing so few borrowers?
This is especially true after the financial crisis. That is why credit pricing or spreads in the loan market are moving down substantially in various countries. It's because liquidity is chasing credits. In the wake of the financial crisis, there are only a limited number of credits that lenders are chasing. It was very different before the crisis. It was a market where lenders were chasing the top-tier credits, but at the same time, there were different credit levels that lenders were comfortable with and with corresponding compensation associated with the risk. After the financial crisis, there has emerged a big discrepancy between the top credits and the second or third-tier names because most investors prefer to stick to the top end of the market.
With the trend we are seeing in Europe, where even loans are now being rated, do you see this happening in Asia? And how would this dictate secondary market trading?
It sets a credit benchmark for investors. The difference between the Asian and the European or US markets, is that there arent many rated credits compared to Europe or the US. This is because most borrowers are not really convinced of to the benefits of a credit rating, unless it is a very large multi-national or corporate that wants to tap a totally different investor base - other than the banks in Asia. If you look back before the financial crisis, there were a lot of corporates in Southeast Asia that started to get a credit rating. This was because their inherent business required longer-term funding compared to what the bank market could offer, or maybe because they had exhausted their financing options. Some of the more capital intensive companies (eg. pulp & paper or textile companies) require huge capital investment on day one but the payback is more than five to 10 years down the road. Most tenors in the bank market before the crisis had a cut-off of five years. This would result in a mismatch of the cash flow profile for corporates in sectors such as pulp & paper and textile companies which relied on the bank market for working capital but would resort to the Yankee market for longer-term financing.
Having said that most Asian borrowers are cognizant of the fact that once they get a rating they have to go through an annual review process. It's great to maintain the rating or improve, but obviously it is not good if ratings start deteriorating for a variety of reasons such as the country outlook, sector outlook, etc. That's a major concern for most Asian corporates. Also the sheer exercise they have to go through every year also gives management a headache. That also deters the urge to get a credit rating. Thirdly, most companies in Asia, with a few exceptions, tend to operate mostly within Asia. They're well satisfied with the banks. Up to the financial crisis, you saw a net inflow of banks into Asia. Once there are more banks coming in, obviously more country limits are available to the area. The new banks are eager to establish a relationship and put in the money to participate in a syndicated loan.
In economic downturns, especially with banks feeling the pinch and trying aggressively to get more business from the limited pool of borrowers, pricing is one of the first things to be affected followed by maturities and covenants. What are your views in that regard?
About a year ago pricing was really competitive, so much so that a deal was won on a difference of one basis point against your competitor. As far as tenor is concerned you can only lengthen based on the investor appetite. Tenors get extended only when participants get more comfortable with a country, have more and longer country limits for a country. As arrangers, we are cognizant of the fact that investors are getting comfortable with a particular country and particular sectors and are comfortable with stretching out the tenors from five to seven years. It's a gradual process though and it doesn't jump from a five-year to a seven-year bullet overnight. It jumps from a five-year bullet to maybe, having one-third of the tranche with a seven-year amortisation. Maturities are lengthening in certain markets, particularly in Hong Kong where liquidity is so abundant. However it is a gradual process and is not open to every one.
Regarding covenants, I must say I'm pleased that there is not a lot of competition on that front. If you look back before the financial crisis, there was less competition on that front. With the onset of the crisis, a lot of lenders looked at what they had in their loan agreements and realized that regardless of what happened there was very little they could do about it because the covenants were quite weak. People have learned their lessons and they realize the importance of covenants. And the presence of covenants in loan agreements sets them apart from bonds. Loan agreements tend to have straighter covenants, more reps and warranties, more financial and non-financial covenants compared to a bond instrument. Bond instruments have very standard, boiler plate-type reps and warranties.
Investors are going back to 'credit101' when they evaluate a credit. That's why there is a differential in pricing between a loan and a bond. For a loan, the covenants, the reps and warranties, the events of default are catered for on a deal-by-deal basis. It can vary from borrower to borrower, purpose of financing and the rest of it, whereas a bond is not as tailor-made as a loan.
But with so many participants competing for so little business and with pricing going down, don't you think we are returning to the pre-crisis days wherein borrowers are getting highly leveraged and lenders are throwing caution to the wind?
I don't think borrowers have as high a gearing these days. A lot of the investors are focusing on 'credit101s' , not only on the covenants, but also ensuring that a deal is being done because there is a specific reason to do the deal, a specific purpose tied to the financing. Our observation is that people these days want to stick to simple credits, simple structures as opposed to before the financial crisis when there was a lot of convoluted structures.
Are we going to be seeing more plain-vanilla deals then?
Yes in a way, but there will also be LBOs, the acquisition-finance deals, project finance deals, export-credit related transactions, etc. Before the crisis, there were a lot of secondary papers that were being sold as a result of specific structures or derivatives. We haven't seen many of that type of transaction recently. Investors are looking for credits without complex structures.
If you are looking at only plain-vanilla deals it can't be very profitable and could lead to consolidation in the market?
I do agree that the market will consolidate and we'll be left with fewer players. What we have seen since after the financial crisis, is that a lot of players have returned to the region with fresh country limits available. There was limited liquidity in the market at that time and these new players realized that rather than being just a participant in a deal with the bigger players, they were looking to lead and underwrite the deals so that they could be seen as the arranging bank or one having close relationship with that corporate. What has happened now is that some of these players are finding it difficult to justify being there because they do not have the product offerings. As a result they cannot cross-subsidise each other in terms of doing a transaction. They find themselves stuck in a position where they have a big syndication team which cannot justify its costs. Some of these players will drop away to a mere participation level while the bigger players will hold the advantage with their wider array of products. So going forward, the tombstone will look like a more orderly Christmas tree than an inverted Christmas tree, which was pretty much the case so far.
Is that why we are seeing the merger of loans and bonds departments at some of the firms?
It comes down to what a firm can really offer to a client - is it a loan, a bond? A lot of times there's an arbitrage between a loan and bond. Can one pitch a three-year or a five-year loan to a borrower and at the same time pitch a five-year bond? It depends on the situation. A five-year bond doesn't necessarily have that kind of appeal to investors. If you are talking about a $100 million transaction, it doesn't offer liquidity for institutional investors to trade in and out. But as far as a loan is concerned, people are happy to hold $10 million to $15 million a piece and do not really need an active kind of secondary market to trade in and out.
It's not so much that you actually put the bond and loans team together. It's more really whether a bank can do an effective cross-selling job. That's the key. If you look at some of the houses that have a common platform for their loan and bond businesses, they still have product heads for both loans and bonds.
What is BNP's view in this regard? Are you merging your loans and bonds together?
We don't have the intention of merging the bonds and loans business. We definitely pitch a lot together, talk to each other a lot in terms of providing a solution to the client rather than going into product silos. It does not matter whether you combine your bonds and loans teams, it matters whether you can communicate better or cross-sell better.
But if you are working together, cross-selling better, how do you distribute the remuneration or the profits from that deal?
It depends on the internal management accounting and is unique to each bank. Some banks have a referral fee mechanism or a selling concession. As long as the internal recognition system is fair to both product lines it works just as well vis-a-vis having a single balance sheet. It's up to a particular firm's culture, the internal management accounting system, the working relationship amongst the different groups, not just loans and bonds departments. There could be a situation where the loans team could be cross-selling a derivatives product, not for speculation but for hedging. We have structured loans where because of the credit itself, certain risks need to be hedged. Obviously, we would bring in our derivatives or swaps colleagues and attempt to cover off the risk, which would make a part of the overall transaction. It is open for bidding to everyone but this is one form of cross-selling for our swaps or derivatives team.
The merger of loans and bonds departments obviously raises questions about people's abilities and expertise?
Absolutely. Loan and bonds are two different products. Structuring and pricing a loan is very different from pricing a bond. A loan sales person doesn't necessarily sell loans like the bond sales person does. For the latter it is only a question of the rating of the credit, the tenor, the levels at which the particular credit is trading at compared to a similar-rated credit. So he is aiming at making it a relative value play. The loan sales person on the other hand, is not just selling a five-year credit, which may not be rated in most cases, but also structuring the loan in terms of the drawdown or repayment schedule to match the cash flows of a particular borrower, tailoring the amortisation schedules bearing in mind the expectations of the company going forward, expansion plans of the company. The loan sales person will also try to include covenants and hedging requirements as 'bells and whistles' so as to prevent certain things from happening.
The bond product and the loan product can be complementary to each other, they can be competitive, but they are very distinct. It's not easy to find good quality people who can sell both bond and loan products. That doesn't necessarily mean a bond sales person cannot be an effective loan sales person, but at the same time a loan sales person could also be quite effective in selling a bond because this is a part of the whole selling process that they go through in selling a loan.
There have been situations where a borrower had asked for bids on both a bond and a loan proposal. Some of the features I mentioned earlier, such as flexibility, catering of the cash flow requirements, the drawdown schedule, amortization etc come into play in terms of what a loan could offer and what a bond could offer.
