US$700m? That’ll do nicely for Goldman

IFR Asia 794 - May 4, 2013
6 min read

Jonathan Rogers, IFR Asia Senior Credit Analyst

Jonathan Rogers, IFR Asia Senior Credit Analyst

By this time next week we will know which political grouping won the Malaysian general election. An array of issues have been raised by supporters of the opposition PKR alliance in an effort to unseat the national coalition that has ruled the country since independence in 1957, including the pricing and use of proceeds of investment company 1MDB’s US$3bn private placement from late March.

I wrote about the deal in the April 13 issue of IFR, wondering whether it might become a subject of controversy in Malaysia’s cliffhanger election, which this Sunday’s “GE13” promises to be.

Mention bonds to average voters and their eyes glaze over. Try to talk about pricing and they will probably enter an instant coma. On the other hand, mention billions of dollars and you’ll probably get their attention. Hundreds of millions will probably do the trick, too.

So if you were to tell Malaysian voters that, courtesy of 1MDB, Goldman Sachs, which arranged the private placement, had booked a profit of US$700m, what would their reaction be? Outrage, one assumes, even if your average voter is not exactly familiar with the relationship between bond prices and the direction of yields. It’s even possible that an outraged voter will be more likely to vote for the PKR, which has pledged to dissolve 1MDB should it win power.

WHERE DO I get the US$700m from? Well, at the risk of sending the readers of this column into the aforementioned coma, and assuming they know a little more about the dynamics of fixed income than the average Malaysian voter, I will attempt to explain.

The 1MDB private placement of 10-year bonds was sold to Goldman’s Principal Financing and Investing Group at a price of 90. It carries a 4.4% coupon for a 5.74% yield. Now just where would the US house have been marketing that paper to investors, on the rather safe assumption that it didn’t look to warehouse the paper until maturity? In the absence of a sovereign benchmark at the 10-year point from the Federation of Malaysia, which has provided a letter of support to the private placement, a reasonable proxy for the sovereign would be state-owned Petronas.

The Petronas 2022s were last week quoted at a yield of 2.8%. Chucking in a modest 10bp illiquidity premium for the private placement paper, and assuming that investors would be willing to view the 1MDB paper as Malaysia risk, that means that at 2.9%, the deal could be sold to investors at a cash price of 113.75. Assuming Goldman didn’t hedge the paper and was able to sell it down in total, I make that a US$712m profit for the US powerhouse.

Of course those are big assumptions, but even if Goldman hedged the credit risk by buying Malaysia credit default protection and the interest rate risk by shorting US Treasury futures it still stands to make a fat profit by selling it on at a more appropriate market rate for Malaysian risk.

With Malaysia five-year CDS last week quoted at 81bp, I make that a US$21.8m cost for hedging the credit risk. Assuming Treasuries remain relatively stable, the futures hedge could probably be taken off for minimal cost, running perhaps into the single digit millions.

Alright, the US$700m figure might be on the high side. But when every moving part is taken into consideration it’s likely that Goldman made – or stands to make – hundreds of millions of dollars from the 1MDB trade, and I would guess closer to US$700m than US$600m.

It’s the kind of transaction that exists only in the dreams of most investment bankers and you can’t knock Goldman for pulling it off, since everybody knows that the business of investment banking is all about making money. In the knowledge that there was a 300bp yield gap between where the paper was warehoused and where it could be sold to investors I’m pretty sure that any house with decent distribution would have put balance sheet on the line for that trade.

BUT OF COURSE that yield gap represents an opportunity cost to the Malaysian taxpayers that fund the state-owned 1MDB.

In response to criticism in the media about the private placement, 1MDB’s corporate communications department published this response on the company’s website:”As a prudent government owned entity, 1MDB considered all of its options (pricing, structure, investment bank, and others) in the recent financing and chose the optimal path in light of the various considerations. The company stressed that 1MDB opted for a private placement to ensure the timely completion of this economic initiative.”

The word “timely” is rather lost on me. 1MDB’s mission statement, reiterated in the company’s corporate communications release is to invest in “strategic and important high-impact projects like energy and strategic real estate”. So why the rush? It’s not as if the company was engaged in a takeover bidding war and needed a trump card at the double.

Sunday’s election might well unseat the ruling coalition after 56 years of incumbency. That would probably push the cost of Malaysian credit protection higher and widen the spreads of its offshore bonds, although not by the 300bp that represents Goldman’s cushion on the 1MDB paper.

It might be fully hedged on the position but my guess is that Goldman got out of it weeks ago.

In the meantime, while it’s hard to imagine a bond deal being an electoral game-changer, if ever there was one, this is it.

Jonathan Rogers_ifraweb