The burgeoning growth of Asia’s private banking (PB) sector – with assets under management reaching new highs on the back of regional high-net-worth (HNW) and ultra-high-net-worth (UHNW) growth – has made this investor class an irresistible source of liquidity for primary bond-market deals. DCM bankers are fully aware of this. They have created a practice to incentivise private bankers to push new deals to their HNW and UHNW clients through offering private bank rebates: a 25-30bp discount on bonds they help to place.
Coupled with yield-hungry PB clients, the system seems to work. Recent property and financial-company bond deals have seen private banking participation of up to 75 per cent of the total deal size. Hybrid/perpetual bonds (a PB client-base favourite because of seemingly attractive yields) have seen massive PB participation, sometimes reaching 80 per cent. The question of whether PB rebates work is no contest, but whether they are really the right thing for PB clients (and for the greater development of Asia’s bond markets in the long run) is debatable.
Ideally, the yield offered by a bond should be driven by the point at which investors are prepared to buy the security (based on underlying credit due diligence and where comparable credits are trading in the secondary market) and where issuers are prepared to sell. Essentially, basic demand and supply. But throw in a 30bp PB rebate, and what is usually sold to your typical fund manager at 100 is now sold to PB investors at 99.70.
This interrupts the natural course of supply and demand, resulting in bonds priced at lower yields, which do not accurately reward investors for the underlying credit risk. This is further fuelled by the ability of many PB clients to take on leverage, further inflating their order size and the price distortion. The result? Bonds are subject to tanking in the secondary market as prices recalibrate to reflect true underlying credit risk. This is a misalignment of expectations across the board that has the potential to upset many people: issuer, investors and PB clients.
Misalignment of incentives
Who actually benefits from the 30bp rebate? Private banks can pass on the savings to their clients by selling the bond to them at 99.70 instead of 100, resulting in a higher effective yield to the client. This results in an above-price distortion, or a scenario where you have private bank accounts immediately flipping the bond on the arbitrage opportunity, also resulting in heavy price distortion.
Alternatively, private bankers can pocket the 30bps themselves and sell the bond to their end client as originally intended at 100. That’s a quick $30k in revenue, clean, for every $10m of a bond placed to their client. This creates a misalignment of incentives between the private banker and their client. There is the dangerous temptation to slacken on credit due diligence on the appeal of making a quick buck. Just take a look at recent unrated deals that offered PB rebates – many were anchored by PB accounts.
Coincidence? Perhaps, but what is essentially a commission to the private banker from the DCM banks and issuer undoubtedly creates a moral hazard. This is particularly true for many first-time issuers with no international credit rating and with limited disclosure (eg many mainland companies issuing offshore RMB bonds), who managed to get deals off with the help of PB participation.
Deal makers or breakers
The inclusion of PB rebates in a deal’s marketing has almost become a ubiquitous feature of a bond, as though it were a covenant in a bond’s structure, assisting sell-side bankers to determine the overall marketability of a deal. This is the case particularly for high-yield, first-time issuers, or hybrid/perpetual deals, which offer attractive headline yields but may be unappealing to highly sophisticated funds for many reasons.
Whether this practice is right or wrong is open to debate, but the fact is that DCM bankers are increasingly deviating away from looking at the merits of a deal’s credit worthiness and placing greater emphasis on the inclusion of rebates to determine a deal’s overall chances for success.
The 2008 financial crisis stemmed from the fact that investors were buying into complex financial instruments that they did not fully understand. While it’s still a far cry from crisis mode, PB rebates are fuelling this very same spirit by incentivising private bankers to sell bonds, many of which are unrated, to their clients based on headline yield and credit-name familiarity, in the absence of thorough disclosure and understanding of the underlying credit risks.
It is a classic case of bankers enjoying healthy fees and revenues in the near term at the expense of a potentially damaging unwinding in the long run. With hope, financial regulators will have the foresight to see this sooner rather than later.
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