Using an asset-swap strategy can enhance your bond portfolio return
Over the past few years, a number of leading Thai corporations have issued US dollar bonds to secure dollar funding for business expansion. Although these corporations are very well established in Thailand, their international credit ratings are somewhat
This means that the bonds would need to post higher US dollar yields than Thai sovereign bonds to compensate for the company’s credit risk.
Using cross-currency swap agreements, there are some cases in which investors can buy US-dollar bonds and swap the coupon into Thai baht, and have an all-in baht yield that is higher than the baht bond of the same company issued in Thailand. Generally, the process is referred as “asset swap”.
To illustrate how the asset-swap concept works, let’s assume that a 10-year US-dollar bond issued by one of the leading Thai corporations is traded in the international market at the coupon and yield of 5 per cent, while the baht bond of the same corporation is traded at the coupon and yield of 4.8 per cent.
Investors can enter into a cross-currency swap with the bank to hedge the dollar yield into baht yield.
As an initial exchange, investors would pay baht to the bank and receive dollars to purchase the bond. The initial exchange is transacted at the dollar-baht forex-market rate. During the interim period, the investors pay the 5-per-cent dollar coupon earned from the bond to the bank while receiving the baht coupon of 5.5 per cent from the bank.
At the end, when the bond matures, the investors return the dollar principle received from the bond to the bank, and the bank pays back baht to investors. The final exchange rate is at the same rate as the initial exchange, thus eliminating the forex risk from the investor’s standpoint. In this case, investors receive the baht coupon of 5.5 per cent from the asset swap, higher than the baht bond coupon of 4.8 per cent.
Investors might wonder how such opportunity exists in the cross-currency swap market. It is due to two main factors. Firstly, Thai corporations more have a comparative advantage in borrowing in baht, as opposed to US dollars. So, investors can exploit the opportunity to swap their dollar bonds into baht, and receive higher returns.
Secondly, while the bank pays the baht coupon to investors in the above example, there will also be an opposite transaction when the bank needs to pay a US dollar coupon to counter-parties like multinational corporations, which may hedge their US dollar loans into baht.
Thus, the indicative asset swap yield can always change depending on the flow that dominates the market at certain times.
These strategies have become more and more popular for some insurance companies and asset-management firms.
However, the US dollar bond investment and CCS agreement are subject to regulatory approvals, and the investors require the bank’s credit line to execute the transaction.
So, what are the risks associated with this strategy, and who is this strategy suitable for?
The main risk here is that the cross-currency swap is a contract separated from the bond purchase. For some reason, if you need to sell the bond before the maturity, you will also need to terminate the cross-currency swap agreement, which might see you gain or lose money in addition to your initial bond purchase.
Therefore, the strategy is more suitable for investors who have the ability and willingness to hold the bond until the maturity to capture the total return, which is higher than the bond of the same credit quality but issued in baht.
The author, Skul Boondiskulchok is CFA Senior Interest Rates Trader at Bangkok Bank. Email Address: [email protected] [email protected]
