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Defusing Global Bond Risk

A new form of coverage for debt securities is starting to make offerings in Third World hot spots less explosive.

1May

In the 1980s and '90s, companies looking to launch a bond offering in an emerging market were often hamstrung by their inability to protect institutional investors from the kind of political shocks that had become all too familiar. While political risk insurance (PRI) did exist, it was available mainly to the corporations and banks making loans in less-stable countries, and not in the more complex world of corporate bonds.


But lately, a PRI product for corporate debt securities in political hot spots has been catching on, in a form devised by Washington, D.C.-based Overseas Private Investment Corp. (OPIC). Others have taken notice, and PRI is now being offered, to good reviews, by several private insurers and two other U.S. public agencies.


Historically, PRI coverage for lenders has proven quite useful. Over the past 20 years, there have been more than 150 instances of emerging-market countries restructuring their debt, often interrupting loan payments. From mid-1994 to mid-1996, for example, Venezuela imposed foreign currency controls that disrupted numerous deals. And in 1998 came Russia's moratorium on the payment of its private external debt, and Malaysia's restrictions on converting local currency into dollars.


Those last two events triggered the final collapse of confidence in uninsured investments within risky nations, and led to "the drying up of emerging markets for commercial corporate bond issues," says OPIC president George Muñoz. So, "after the Russian and Malaysian interventions," he says, "the bond rating community started asking questions about political risk insurance."


Specifically, bond raters sought a way to reopen those markets to investment by neutralizing the risk created by uncertain government monetary policies. In response, OPIC, an independent agency of the federal government that sells investment services to U.S. businesses around the world, analyzed the situation and "came up with a tool that surgically removes the risk from these investments," says Muñoz.



A Closed FX Window

The surgery was in the form of PRI designed especially for the bond market, and aimed primarily at easing worries about monetary convertibility and transferability--the risk that a local government might restrict the conversion of its currency into dollars (or be unable to convert the currency), or that it might refuse to let dollars leave the country. When either convertibility or transferability is restricted, a firm that has sold its bonds in an emerging-market country suddenly finds itself strapped for dollars and unable to pay the bondholders.


"Inconvertibility and nontransferability are like closing the window for foreign exchange," says Rick Jenney, a former assistant general counsel at OPIC and now a partner with Morrison & Foerster, a Washington, D.C., law firm that specializes in PRI. "It's all about the supply and demand for hard currency." What OPIC did, he says, was to perform "the role of the [emerging nation's] central bank when the central bank wouldn't, or couldn't, do it."


The hedge that PRI creates, though, relates only to deterioration due to political events, he notes, and not market forces. And the insurance protects firms against currency devaluation only if a prior contract exists that calls for payment at a particular exchange rate. "The devaluation risk is with the [borrowing company], not the bondholders," says Jenney. "The coverage is specifically against political risk, not commercial risk."



A CFO's Peace Of Mind

In the private sector, Zurich Insurance, American International Group, and Lloyds of London are the three largest insurers now offering such new PRI lines. The public agencies joining the field are the Multilateral Investment Guarantee Agency (MIGA), an organization of the World Bank; and the Inter- American Development Bank (IDB), a multilateral organization focusing on Latin American projects.


But the undisputed leader is OPIC, an heir to the Marshall Plan, which reconstructed Europe after World War II. OPIC has provided coverage for two deals in Turkey--by Ford Motor Co. and Koc Group's Ford Otosan joint venture there, and by the local Coca-Cola Co. bottling affiliate--and has another $1 billion worth of deals in its pipeline.


Zurich Insurance has covered two bond offerings totaling $190 million for Femsa Cerveza, a brewery based in Monterrey, Mexico. And it recently issued a policy including PRI for $156 million in mortgage- backed securities issued by Argentina's Banco Hipotecario Nacional, a deal that was rated A1 by Moody's and A+ by Fitch IBCA.


"What we are providing is peace of mind for CFOs," says Dan Riordan, a Washington, D.C.-based senior vice president and managing director for Zurich U.S. Previously OPIC vice president for insurance, Riordan joined Zurich to establish a political-risk division in Washington. For a corporate finance department, "the advantage of PRI is you get as much financing off the balance sheet as possible" and "subsidiaries can do their own deals without their parent having to finance them," he says. "Finally, it offers an alternative form of funding a project. Where you might have been considering a combination of equity plus debt, you can now go to the capital markets and issue a bond arranged by an investment bank. By covering the offering with PRI, you can hedge."



Several Notches Higher

What exactly is the value of the hedge? "It takes the country risk out of the equation," says Riordan. "Political risk insurance raises the investment from a below-investment-grade rating to, in some cases, seven notches higher. It saves the borrower money and facilitates financing. Ultimately, it brings the rating of the deal several notches above the sovereign rate, making it investment grade."


And it certainly boosts prospects for insurers offering PRI for overseas bonds. "Even though this is a niche industry," he adds, "we see it as a major area of growth, due to high demand from investors, coupled with a positive response from the market."


The potential value to a U.S. subsidiary abroad is confirmed by David Smith, Ford Otosan's finance chief. "This is a cost issue," he says. "We were looking at the best way to achieve an investment-grade rating, above the Turkish sovereign rate. In the end, we were able to get a BBB rating instead of a B rating. We came in at 384 basis points over Treasury, and 200 basis points under the Turkish sovereign spread. Without the insurance, the best we would have been able to get would have been Turkish sovereign plus 50 basis points. And the premium wasn't particularly high." Ford Otosan's $105 million offering was launched last July.


Generally, the savings from a PRI rider to a bond offering add up to about 50 to 100 basis points, experts in the field say.


Michael Coombs, CFO of Istanbul-based Makasan Manisa, one of Coke's Turkish bottling units, says he knew nothing of OPIC or PRI when he first started putting together an $80 million bond offering last year. The original deal had been planned for August 1998, but then the Russian default occurred. Spreads increased tenfold, jumping well outside Makasan Manisa's reach. The company withdrew its plans, and only as spreads later tightened did it venture back to the market. Still, spreads were higher than the levels before August 1998. That's when one of its U.S. bankers suggested it take a look at OPIC's insurance.


"We started asking around, and it became clear that it was a relatively new instrument on the market," Coombs says. "We also heard that Ford Otosan was looking at doing a similar deal. Then we put things in motion."


The results were positive. "We were effectively being penalized for being in Turkey. We were going to have to pay a higher spread on our debt than if we were in another country," he explains. "With the OPIC product, we had an effective way of overcoming many of the handicaps associated with being in an emerging market. We got a rating well above the Turkish sovereign rating."



Public Or Private?

Corporate interest in emerging- market bonds started creeping back last year after having collapsed in 1998. That year, less than $5 billion of bonds were placed in developing countries in each of the last two quarters (see chart, page 134). But without the availability of PRI, it's doubtful whether there would be any appetite for such bonds now. "The main thing is that investors in bonds, who are paying a premium, have to see value in them," says Zurich's Riordan. "The interest in emerging markets was there, it left, and now it's back. But without PRI, there would be no interest."


Of course, even PRI isn't enough to make some markets appealing. OPIC has had several of its deals canceled or put on indefinite hold. "The market won't take just any bond," says OPIC's Muñoz. An example is a bond offering OPIC was arranging for telephone company Telefonica del Peru, a company in a country with an especially low debt rating. "With the Peruvian deal, we were going to the market, and then the wheels just fell off," explains Muñoz. "This was the only deal that was stopped, though." The others are "just waiting for the rates to come down."


Would companies find an advantage going with one of the public agencies over a private insurer for PRI coverage? Coombs and Smith expressed satisfaction with OPIC, and Smith was so pleased, that on March 10 Ford Otosan placed a second tranche of an additional $25 million through the agency.


"We looked at private insurers, but OPIC was above all very easy," says Smith, even though some complexity is necessarily involved in dealing with a government agency. "You have to meet various requirements on environmental standards, worker health and safety guidelines, and workers' rights issues. But because we had an American parent, we were already in compliance with all that."


While Smith appreciates OPIC's helpfulness getting Ford Otosan through the process, he says, "in the end it was about pricing; OPIC's structure was the lowest cost."


But private-sector insurers move more quickly, Riordan says. "What would take OPIC 6 to 12 months to put together, we can do in two to four weeks. There's a savings on legal costs, and much less paperwork involved," he maintains. "Sure, the premium is higher, but not significantly."



Bright Future

In general, the future for the product appears promising--whether from a private or a public insurer. Zurich is planning deals in Asia; Riordan lists among countries with particular potential Malaysia, Thailand, and the Philippines. Eastern European markets that appear ripe are Hungary and Poland. But don't expect much activity in Indonesia or China for a while--the former because of the extent of its depressed economy, the latter because of the system of a dual currency. The going might be tough in Brazil, too, because of its current sovereign rating below grade B.


Currency devaluations--the one major risk factor that no political risk insurance yet addresses--have soured other deals. A recent example was in Ecuador, where the currency plunged 80 percent in last year's fourth quarter. "While we can insure conversion, converting the currency to dollars, we are unable to insure the rate," comments Muñoz. "Some investors will stay outside until someone comes up with devaluation insurance." Experts believe a product that covers devaluations may well be devised in the future.


But for those bond offerings that PRI makes attractive, says Muñoz, the sooner "CFOs get some experience, the sooner they will reap the rewards."

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