[A-List] Froeign demand for US corporate debt

[Henry C.K. Liu]

This is part of a summary report I put together for my own file:


Foreign demand for US corporate debt has been strong since 1997, as 
healthy corporate earnings and attractive yield levels continue to 
stimulate foreign demand. Demand has been strong worldwide with 
particularly heavy buying activity reported by Asia- and Europe-based 
investors. Foreign purchases of U.S. corporate debt totaled $41.6 
billion in the first half of 1997, exceed the record levels experienced 
in both 1995 and 1996, when foreign investors acquired $57.9 billion and 
$79.2 billion in debt, respectively for the year. The data include 
domestically issued corporate debt securities, U.S. corporate debt 
placed directly abroad, asset-backed securities and issues of U.S. 
states and municipalities.

Europe-based investors were the dominant buyers of US corporate bonds in 
1997, with $28.0 billion in net purchases, accounting for only 67.2% of 
all foreign purchases in 1997.

Purchases by Latin America- and Caribbean-based investors surged sharply 
in 1997, with net purchases totaling $7.5 billion in the period. The 
sharp increase was primarily a result of strong demand by investors in 
the British West Indies and Bermuda where the true identities are unknown.

Net purchases by Asia-based investors totaled $2.6 billion in first half 
of 1997, before the Asian Financial Crisis which began on July 2, with a 
48.0% decline from the $5.1 billion purchased in the same period in 
1996. Most countries reported declines from year-earlier purchases, with 
the exception being Singapore, where investors acquired $971.0 million 
in the 1997 period, a 30.1% increase over the $746.0 million purchased 
in the comparable period in 1996. Investors based in Japan and Hong Kong 
scaled back their purchases of US corporate bonds in the period, 
totaling $941.0 million and $825.0 million, respectively. This compares 
to the $2.6 billion in purchases by Japan-based investors and $1.6 
billion in purchases by Hong Kong-based investors in the first half of 
1996. It should be noted, however, that although investors in Japan and 
Hong Kong decreased their U.S. corporate debt purchases in the first 
half of 1997, they significantly increased their purchases of U.S. 
Treasury securities with $32.6 billion and $10.8 billion of acquisitions 
in the period, respectively.

A new product called retail notes allows brokers to access investment 
grade corporate debt for their clients in $1,000 increments. All the 
different pieces that go into retail notes add up to an excellent 
product for income-desiring individuals. Top of the heap credit quality, 
small increments, comparatively higher yields and even a death call make 
it easy, for the first time, for the average investor to buy individual 
corporate bonds. And they can only buy them through brokers. They're 
simple, and they often offer better rates than other income-producing 
investments. Recently the average yield on 10-year corporate bonds was 
at 4.67 percent, according to Bloomberg. A similarly timed retail note 
for DaimlerChrysler had a coupon of 5.90 percent. An even more enticing 
spread is the 15-year PHH bond (Pioneer High Income Trust) , callable in 
three years with a coupon of 7.95 percent, as compared to the five-year 
government note whose coupon is 3.98 percent.

Introduced in the late 1990s, retail notes have reached critical mass, 
with $71 billion worth of bonds issued. In November 2003, Boeing and GE 
Capital launched retail note issues, bringing almost all the top 10 
issuers of corporate bonds into the retail arena. Now investors have 
dozens of bonds to choose from every week. Retail notes have practically 
become an asset class in their own right; their popularity is exploding 
among individuals and brokers.

The first retail notes were issued by GMAC, the credit arm of car giant 
General Motors, in 1996. The financial press hailed the issue as a 
revolution in bonds. Finally, the individual bond investor had an option 
that was simple, straightforward and useful. Individuals now had a 
chance to buy bonds at par price with guaranteed redemption options. 
While not as safe as investing in a treasury instrument, these bonds are 
as close to ironclad as a corporate bond can get.  Standard & Poor's 
rate GE Capital retail notes issued by Incapital as AAA.  Another 
feature that makes retail notes more amenable to the individual investor 
is their simplified pricing scheme and liquidity. The most unique 
feature of retail notes is the "death call." Every note is callable at 
par by the issuer on the event of the owner's death. No other bond in 
the world has a similar feature.

Foreign investors held $1.61 trillion, or 24.3 percent, of the $6.63 
trillion of outstanding corporate bonds at the end of the first quarter 
2004, according to recent Federal Reserve data, up from 22.1 percent in 
the first quarter of 2003. U.S. life insurance companies held a slim 
lead as the largest owners of corporate debt, with $1.62 trillion, or 
24.4 percent of the market.

A combination of stronger corporate balance sheets and attractive yields 
have drawn foreign investors to corporate debt, making it easier for 
U.S. companies to raise money at cheap rates. Foreign investors held 
13.5 percent of the U.S. corporate bond market on average throughout the 
1990s and 11.9 percent in the 1980s, according to Moody's. The rising US 
trade deficits increase foreign ownership of all types of U.S. 
securities. The dollar-denominated trade surplue is invested in U.S. 
government securities and corporate stocks and bonds. The jump in the US 
trade deficit to a record high of $55.8 billion for June has once again 
thrown the spotlight on the rising external indebtedness of the American 
economy.

The widening of the trade gap, which occurred despite the fall in the 
value of the US dollar against major currencies, represented a 0.9 
percent increase on the $42.7 billion deficit registered in December. It 
came in the wake of figures showing that the current account deficit, 
which measures the rate at which the US is going into debt, continues to 
grow. According to the Commerce Department, the payments gap was $542 
billion last year, easily eclipsing the previous high of $481 billion 
recorded in 2002.

Federal Reserve Board chairman Alan Greenspan has expressed the view 
that the weaker US dollar should eventually help narrow the trade 
deficit, with a warning that "creeping protectionism" could endanger the 
"flexibility" of the global economy. Greenspan feels that global 
financial markets will be able to finance the US payments gap with a 
daily capital inflow of between $1.5 and $2 billion, provided trade and 
other restrictions are not imposed.  There are worries that for any 
reason,when  money starts to move out of the US, a major crisis could 
erupt. Flow of Funds data released by the Federal Reserve showed that US 
financial markets are becoming ever more dependent on inflows of foreign 
capital.

During the fourth quarter of 2003, foreign creditors loaned US borrowers 
an unprecedented $848 billion annualised, an amount equal to one-third 
of all credit market lending. For 2003 as a whole, foreign investors 
accounted for 22.6 percent of net new lending in US markets and raised 
their share of outstanding credit market debt by a percentage point to 
10.9 percent. Between 2000 and 2003, the volume of credit market 
instruments (including items such as US government securities, corporate 
bonds and loans to US businesses) owned by foreign investors expanded by 
more than half. Mainly as a result of purchases of corporate and US 
Treasury debt, foreign acquisitions of US credit market instruments 
"soared to a record $611.2 billion in 2003, more than acquisitions in 
the previous two years combined. Between October and December of 2003, 
foreign investors bought 89 percent of net new securities issues issued 
by the US Treasury and 40 percent of bonds issued by US corporations. In 
a bid to stable their own currencies against the US dollar, Asian 
central banks have been purchasing US dollars, which have then been used 
to buy government debt. Largely as a result of this process, central 
banks and other public agencies accounted for two thirds of the 
acquisitions of US Treasury securities during the fourth quarter of 2003.

The rising US external debt, coupled with the record federal budget 
deficit of more than $500 billion, has prompted concerns that, at some 
point, investors are going to lose confidence and begin withdrawing 
funds. There was also the risk ever growing current account deficits 
would lead to US protectionism and a questioning of the role of the 
dollar as a reserve currency.

World economic growth as a whole continues to depend on expansion of the 
US economy, but this expansion generates ever-increasing levels of debt. 
The US is suking the world's surplus capital, derpraving other economies 
that need capital for domestic development.

Interest rates, at least short term rates as related to the Fed  Funds 
Rate are unpredictable by observing market trends since it is determined 
not by market fundamentals but by Federal Reserve ideology (sound money 
as defined by inflation) and judgement (economic data on growth and 
inflation).  The only way to predict FFR is to get into the mind of 
Greenspan, or whoever happens to be Chairman of the Fed.  But low 
interest rates doe not stop foreigners from investing in the US, it only 
pushes foreigners into higher yield coporate bond markets.  If 
foreigners stop investing in the US, the Fed can make up the slack ogf 
funds by printing more dollars, killing the two birds of oil inflation 
and massive old debts.  The dollars that foreigners accumulate come from 
trade surpluses with the US, which foreign exporters cannot convert back 
into their own currencies without causing their own currencies to 
appreciate against the dollar, thus reducing the foreign exporters' 
trade surplus in dollars. This phenomenon is called dollar hegemony.  
Also foreign exporters selling the dollars they accumulate from trade 
will only cause the dollar to fall further, causing these foreigners to 
lose more than they gain as their remaining dollar holdings will lose 
foreign exchange value against their own currencies.  Thus if China 
which now holds $450 billion, sells $10 billion for yuan or euro or yen, 
the remaining $440 billion will be worth less than the gain (or stop 
loss) from the $10 billion sale. Thus foreign-owned dollars are trapped 
with nowhere to go except to stay in the dollar economy.  It does not 
mean however, that these dollars will return to the US geographically, 
but they will remain euro-dollars (which has nothing to do with euros, 
but is a term meaning offshore dollars).   The expansion of 
euro-dollars, mostly in Asia, will mean that the dollar economy is 
swallowing up Asia, turning it into a financial colony of the dollar 
which the Fed can print at will.  Those who still have jobs or income in 
the US will earn more dollars than their counterparts outside of the US, 
at least until the wage disparity makes wage arbitrage profitable and 
they will become unemployed in order to support multinational corporate 
profit.   First textile, than manufacturing, then high tech  and next 
will be financial services , beyond back office outsourcing but hungry 
25-year-old investment bankers and traders overseaas who will settle 
happily from $1 million s year instead of $5 million demanded by bankers 
and traders in NY.   US interest rates will stay below market for the 
foresseeable future, until dollar hegemony ends.  Whether dollar 
hegemony ends depends on whether China has enough guts to start a new 
ball game.  So far, there is no sign that China, under the currrent 
leadership has the wit to do much, except counting the dollars they own 
while not realizing they more dollars they own, the more they lose by 
exporting wealth from the yuan economy to the dollar economy, as Japan 
has done since the end of the Cold War.  The US is getting to be like 
Saudi Arabia, which has been ruined by its oil riches denominated in 
dollars, leaving the country with a whole population of no marketable 
skills.  Dollar hegemony is reducing the US to a country whose workers 
are overpaid while Greenspan calls it a rise in productivity.  
Productivity cannot be increased by not working. Its that simple.  The 
only jobs that will not be outsourced will be those that are location 
tied, such as housework and cleaning toilets and picking strawberries.  
For those jobs, the US imports illegal immigrants. That is the reason 
Greenspan warns about US trade protectionism.

It is interesting to note that foreigners are buying US corporate debt 
but not equities. Net portfolio inflows into the US of $83.4bn in 
February, 2004 although
slightly lower than $92.3bn in January, were almost double the $45bn a 
month required to fund the US current account deficit and reinforces Fed 
Chairman Greenspan's assertion that the US has no trouble funding its 
external deficit.  The U.S. economy continues to rely almost exclusively 
on sustained foreign investment in public debt and robust demand for 
corporate bonds to fund its deficit. Foreigners purchased net public 
debt of $61.33bn and $21.3bn of corporate bonds, but practically no 
equities, US$0.1bn, in February 2004. Even then, private investors 
purchases of public debt halved to US$10bn in February 2004.

A smaller increase in the Fed's custodial holdings for March, relative 
to February, suggest that net portfolio inflows into the US in March 
were even lower than US$83.4bn seen in February.  As the interest rate 
market's expectation of the timing of the first Fed funds rate hike 
continues to be brought forward, to potentially as
early as the June 30 meeting, the risk is that net foreign portfolio 
inflow into Treasuries will wane. Unless, this is offset by an 
increasing stake in US equities by foreign investors, the US dollar will 
struggle to extend its gains in the midst of a Treasury bear-market.
More hawkish Fed rhetoric and increasing odds of an imminent rate hike 
in the US will be bullish for the US dollar over the next month or so, 
but the US dollar may struggle to extend its gains once the Fed actually 
starts to normalise interest rates.
Foreign purchases of securities are down in February.  Foreign investors 
purchased net US$85.0bn of US securities, $15bn less than in January, as 
appetite for all asset classes waned. Foreigners bought net $37.0bn of 
Treasuries; $24.3bn of Agencies; $21.3bn of corporate bonds;
and $2.4bn of equities.

April 15, 2004 US Treasury International Capital Flows
Three key observations about public debt flows into the U.S:
1. Foreign demand for Treasuries came largely from officials. Of the net 
$37.0bn of Treasuries bought by foreign investors in February, $27bn net 
was bought by central banks & other official agencies. This implies that 
private investors bought net US$10bn of Treasuries in February, only 
half of the $20.0bn bought in January.
2. The proportion of foreign-owned Treasuries (totaling US$1,629bn) held 
by official investors ($947.8bn) fell slightly to 44.4% in February, from
44.9% in January. U.S. marketable securities held in the Federal 
Reserve's custody for foreign official and international accounts rose 
by only
US$16.5bn in March - just over half of the US$30.3bn increase in 
February- which suggests that net foreign official purchases of 
Treasuries in March
were even lower in March. This should be confirmed in the March TIC data 
that will be released on May 17.
3. Foreign investors purchase of public debt (Treasuries and Agencies) 
of $61.3bn in February was markedly lower than the US$74.6bn bought in
January, due to European net sales of US$8.2bn; and lower 
non-Japan/China Asian purchases (US$7.3bn, compared to US$8.5bn in
January). These were partly offset by a sustained rise in UK demand (of 
$14.7bn) and to a lesser extent, a modest increase in purchases by
Japanese investors (of US$32.8bn) (see chart below left).

Foreign investors got cold feet about US equities in February and bought 
net only $2.4bn, after average monthly purchases of US$11bn over November to
January. The large divergence between the S&P500 and net foreign 
purchases of US equities reinforces the picture that the recovery in the 
US equity market
continues to be driven primarily by domestic equity bulls.
European investors, who bought US$3.2bn of equities in February, roughly 
comparable to the monthly average between December and January, are the only
investors sustained interest in US equities. These cross-border flows 
are one factors that will limit upside in EUR/USD. By contrast, UK and 
non-Japan/China Asian
investors had nearly zero interest in US stocks and Japanese and Chinese 
investors remained net sellers of US stock as they have been for the 
previous several
months.

By contrast, foreign investors appetite for U.S. corporate bonds remains 
extremely strong across all regions, rising by US$21.3bn, nearing the 
record high of
US$29.6bn in last November. A number of factors have contributed to the 
rebound.  The economic recovery and improved corporate earnings have 
made buyers more confident about pursuing acquisitions.  Expanded debt 
multiples and better availability of senior debt and high-yield 
financing have also encouraged deal flow.  And while both equity 
sponsors and strategic buyers have returned to the market, large, 
strategic acquisitions have re-emerged in a big way. 

In general, increased amounts of available financing in the absence of a 
robust M&A market has created greater competition among lenders.  Over 
the last year, pricing has come down in the asset-based, cash flow and 
junior secured debt markets because of the supply/demand 
imbalance.  Since the second half of 2003, pricing for well-structured 
asset-based loans has dropped 25 to 50 basis points.  Current pricing 
for M&A transaction revolvers is in the range of LIBOR plus 225 to 250 
basis points, while term loans are at LIBOR plus 275 to 300 basis points.

Leverage multiples have also increased.  Total debt, which was as low as 
3.5 times EBITDA (earnings before interest, taxes, depreciation and 
amortization), has climbed to 4 times, and while it could expand 
somewhat, it's not expected to reach the levels seen in the 1990s.  As a 
consequence, the portion of the asset-based lending (ABL) market 
represented by M&A (LBO and strategic) financing is expected to increase 
from 2003, which was dominated by refinancing and restructuring 
lending.  According to a recent survey conducted by Loan Pricing 
Corporation, respondents estimate that 32 percent of ABL deal flow will 
come from M&A and LBO financing this year, 23 percent and 20 percent for 
restructurings and refinancing respectively, 11 percent for bankruptcies 
and 14 percent for capital expenditures.  Asset-based structures are a 
natural fit for M&A financing because, unlike cash flow facilities that 
emphasize leverage, asset-based loans rely on collateral coverage.

Since 1997, more than $20 billion of mezzanine funds have been 
raised.  It was anticipated that a portion of this financing would fill 
the gap created by the contraction in senior debt lending multiples and 
the retrenchment of the high-yield market.   The high-yield debt market 
has seen a significant resurgence, enabling smaller, lower-rated issuers 
(including first-time issuers) to access the market.  In addition, there 
has been an increased use of junior secured debt.  The original idea of 
junior secured debt was to lend against a company's current and/or fixed 
assets beyond what an asset-based loan would provide.  However, junior 
secured debt has evolved to more of an enterprise value loan with junior 
secured debt players lending on cash flow.

Like the last recovery a decade ago, the rebound of current M&A activity 
is being driven largely by corporate divestitures.


Henry C.K. Liu
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