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Wednesday, 18 October 2017

Outside the box

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  • Outside the box

A surprise offering last year opened new funding channels for Japan’s municipalities with implicit government guarantees.

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When Japan Finance Organisation for Municipalities issued US$1bn worth of senior unsecured notes in September, it looked like a win-win for everyone.

Established in 1957 and rejigged 51 years later as a more streamlined operation channelling low-interest capital to the country’s 1,713 municipalities, JFM was keen to mine new funding channels. Last year’s five-year, 1.5% Reg S trade, due September 2017, appeared to be the perfect solution to its needs.

Overnight, the agency had created a brand new asset class, seemingly with no downside. JFM was able to suck in new investors, including central banks, expanding the rarefied world of Japanese quasi-sovereign buyers.

Stable sanctuary

Investors, for their part, were just as keen to get on board. The world last autumn was a gloomy place bedevilled by troubles both existing (the ongoing eurozone debt crisis) and pending (The US’s looming fiscal cliff). In light of the problems affecting much of the rest of the developed world, investors in search of security rightly continue to view Japan, for all of its problems (soaring public indebtness, deflation, slow or no growth) as a stable sanctuary.

“Last year, when you wanted to diversify out of Europe and the US, and if you didn’t want to go to emerging markets, Japan was one of the few remaining options,” said Tetsuya Kodama, vice-chairman of Barclays Japan, one of three issuers along with Bank of America Merrill Lynch and Nomura. “In this context, a lot of investors decided that the JFM deal was a good bet, with a good spread, the perfect deal for everyone.”

Plus, of course, JFM’s September surprise offered that most tasty of carrots in a low-interest world: yield. This, bankers and investors say, was what set the deal apart from the rest of the herd. In this case, JFM simply removed any semblance of “explicit” state backing, removing the usual cast-iron guarantees that accompany such deals.

Of course, an “implicit” guarantee remains: no one was left in any doubt that any debt issued by JFM – or any Japanese agency – would not be fully backstopped. As a joint fundraising organisation which, the agency’s website declares, is run “of local governments, by local governments, and for local governments”, there is only the thinnest of red lines separating agency with its political and economic overlords in Tokyo.

Strong links

Standard & Poor’s, in a note at the time, assigned the issuance an AA– debt rating which, the ratings agency said, reflected the “very strong” links between the Japanese government and its municipalities. “There is a very high likelihood of extraordinary government support in the event of financial distress at JFM,” S&P said.

In the event, everyone proved a winner. JFM dragged in US$2.5bn in orders, with roughly 55% coming from Asian investors and the remainder from central banks, lenders and public institutions in the Middle East and Europe. And the offer even of a relatively slim yield proved tasty enough: the deal was priced with an elevated premium of nearly 40bp surrogates in dollars.

The agency quickly followed up its September surprise with a sequel, completed in late January: another US$1bn sale of five-year senior notes with a coupon of 1.375%, at mid-swaps plus 45bp, issued through Barclays, Deutsche Bank and Mizuho.

Higher yields, of course, do mask the uncertainty that naturally accompanies the lack of an explicit guarantee. This seems unlikely entirely to disappear. JFM’s September issuance started at mid-swaps plus 80bp, tightening as orders piled in to plus 73bp. Now compare this to a similar deal, a mid-July US$2bn, 1.125% sale bearing explicit government backing, issued by the Japan Bank for International Cooperation, which priced at plus 34bp.

Implicit guarantees

Both JFM issuances required an element of hand-holding. The implicit guarantees, a clear departure from the norm, “were new to many investors”, said Koji Omachi, head of public sector at Citigroup global markets Japan. “A lot of education was needed: everyone understands of course how explicit guarantees work, but with implicit guarantees, we had to really get deep into the specifics the deal.”

“The good thing was that investors were happy to do a lot of the leg-work. They really wanted to understand what this new asset class was all about. They realised what a great opportunity [JFM] was, and they wanted to be part of the story”

However, once the guts of the new investment class was revealed, everyone seemed to pile in. “Investors now accept the set-up that JFM has in terms of implicit guarantees,” said Shohei Takahashi, joint head of international debt capital markets at Nomura Securities.

Education – particularly before and during the September issuance – helped drive demand and lower pricing for the January sale, bankers said. “Before the first [September] sale there were a lot of questions,” said Tetsuya Kodama, vice-chairman of Barclays Japan.

“The good thing was that investors were happy to do a lot of the leg-work. They really wanted to understand what this new asset class was all about. They realised what a great opportunity [JFM] was, and they wanted to be part of the story.”

The question now is: what next? To a large extent the answer to this is: “More of the same”. JFM’s reorganisation in 2008, dreamt up by one former premier (Junichiro Koizumi) and rubberstamped by another (Yasuo Fukuda) was designed largely to allow municipalities to “stop hiding behind the sovereign guarantee”, said one Tokyo-based banker, and operate more like their counterparts in Scandinavia.

Spending shift

This also helped Japan’s municipalities to fund and finance their own capital needs, while enabling Tokyo to shift spending (and debt) on to local governments books.

For now few bankers expect anyone else to follow JFM’s lead. “I can’t see this being repeated at other Japanese agencies,” said a Tokyo banker who worked on both deals. “JFM is one of a kind, and other agencies just don’t have the same sort of appetite for diversified foreign funding.”

For JFM, though, the process of issuing implicitly backed bonds to international investors has only just started. After all, both sales, in September and January, were, by any measure, blowouts, with banks surprised not just at the level of turnout, but at the range of investors.

In the 2012 sale, nearly half the book (45.6%) was snapped up by European and Middle Eastern investors including “to our great surprise”, said Barclays’ Kodama, “central banks, particularly the big ones”. Most bankers now expect JFM to issue at least US$2bn in new implicitly backed notes each Japanese fiscal year, most likely in two, separate tranches.

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