IN BONDS WE TRUST
A new insurance product that reduces political risk on bond offerings is coming to Asia.
By Nikos Valance

In the 1980s and '90s, Asian companies looking to launch a bond offering were hamstrung by their inability to protect institutional investors - and their own financial future - from the kind of political shocks that had become all too familiar. Today, although the capital markets are returning to health and investor appetite is growing, the problem persists. Following the lead of two multilateral agencies, insurance companies have begun offering political risk insurance (PRI) to issuers of corporate bonds in Eastern Europe and Latin America. Now Zurich Insurance, the Swiss underwriter, plans to introduce the coverage in Asia.

The product is designed to provide a hedge for multinational corporations issuing bonds within countries that, like many in Asia, may undergo a huge currency slide or impose currency controls. The number of bond offerings by MNCs, which had tapered off after the currency crisis, is now coming back, but mostly in stable markets like Singapore. In the first half of 1999, for example, corporate issuers raised close to US$6.3 billion in bond offerings in Singapore. That's compared with US$4.8 billion for all of 1998. The issuers included sizeable multinational corporations such as United Parcel Service and investment bank J.P. Morgan. The PRI coverage will encourage other issuers to venture into markets that take a greater appetite for risk, and it's the ultimate goal of the insurers to extend the product to local companies seeking the same type of hedge.

"What we are providing is peace of mind for CFOs," says Dan Riordan, a senior vice-president and managing director for Zurich in the US. Riordan lists among countries with particular potential Malaysia, Thailand and the Philippines. He says that for CFOs, "the advantage of PRI is you get as much financing off the balance sheet as possible." Also, "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."

Shutting the Currency Window

The risk that companies take by issuing bonds in markets like Malaysia, which imposed currency controls in 1998, is enormous. When a local government restricts the conversion of its currency into dollars (or is unable to convert the currency), or refuses to let dollars leave the country, a firm that has sold its bonds (in that currency) 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 partner with Morrison & Foerster, a US-based law firm that specializes in PRI. "It's all about the supply and demand for hard currency."

While PRI has existed for a long time, it was available mainly to 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 US-based Overseas Private Investment Corp. (OPIC), an independent agency of the federal government that sells investment services to US businesses around the world. OPIC "came up with a tool that surgically removes the risk from these investments," says OPIC president George Mu-oz. Others have taken notice, and several private insurers and two other US public agencies are now offering PRI, to good reviews.

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 Mu-oz. 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.

What OPIC did 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, notes Mu-oz, 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."

In the private sector, Zurich, AIG and Lloyds are the three largest insurers now offering PRI lines. The public agencies joining the field are the Multilateral Investment Guarantee Agency, an organization of the World Bank; and the Inter-American Development Bank, 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 - Ford Otosan, a joint venture between Ford Motor and the Koc Group, and by the local Coca-Cola bottling affiliate - and has another US$1 billion worth of deals in its pipeline. Zurich Insurance has covered two bond offerings totaling US$190 million for Femsa Cerveza, a brewery based in Monterrey, Mexico. And it recently issued a policy including PRI for US$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.

Above the Sovereign

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 emerging-market corporate 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 US 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 US$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 say those savings will likely make the product a winner in markets where CFOs are seeking lower cost ways to woo skittish international capital.

Nikos Valance is a freelance writer based in New York