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SCMP Reporter

HONG Kong merchant bankers who have been designing innovative financial instruments have been caught off-guard by the rise in US interest rates.

  Their attempts to launch pre-placed debt issues, bristling with new devices to attract clients, are being over-shadowed by investors' concerns over the prospect of volatile interest rate movements.

  The European Bank for Reconstruction and Development's (EBRD) HK$200 million five-year corridor dragon issue, arranged by CS First Boston and launched just before the Chinese New Year, met with only mediocre response.

  The bond offered a much higher yield than the straight bond issue by the EBRD with the same maturity in January - by more than 250 basis points - but investors are fearful of volatility in interest rate movements.

  ''The timing isn't quite right. Investors who are picturing a further interest rate increase are wary of selling the caps and floors of these papers,'' said Andrew Fung, manager of swaps and trading at Wardley.

  This fixed-rate bond from the EBRD, bearing a coupon rate of 8.625 per cent, is structured in a way that if the six-month London Interbank Offered Rate (LIBOR) falls outside the pre-set interest rate bands, investors will receive no interest payment on those days.

  ''Under the prevailing upward path of interest rates, investors are very hesitant to buy instruments with an interest rate cap,'' Mr Fung said.

  The five-year maturity of the bond has also worried investors who are fearful that they may lose out on the floor side.

  ''In five years there can be two economic cycles. Interest rates can go up and down again. The risk is too high,'' he said.

  Long unhappy with low interest rates and low return on traditional debt papers, fund managers have become more ready to take on higher risk to enhance their investment yields.

  Seeing this, merchant bankers thought up innovative products or special redemption formulas.

    Bankers may be compelled to launch their issues even though the environment may not seem appropriate.

  ''Corridor issues have more complicated structures and bankers need time to explain and sell to their customers. They might have pre-sold a portion in advance. So arrangers have to launch the issues,'' Mr Fung said.

   The timing of the EBRD issue is already better than the corridor notes launched by the Mass Transit Railway Corp right before the 0.25 percentage point rise in the US federal funds rate.

  Not only does the EBRD base its interest rate bands on LIBOR, which has lower volatility, it has also taken into consideration the higher US short-term rate in constructing the bands.

  ''The MTRC corridor issue has seen its paper's capital price falling due to the interest rate increase. It is a result of wrong timing,'' Mr Fung said.

  The MTRC launched a HK$250 million two-year FRN priced at 1.25 percentage points above the three-month Hong Kong interbank offered rate (HIBOR) on January 26, with Morgan Stanley International as the lead manager.

  Another issue which dealers think to be ill-timed is the Hang Seng index-linked notes issued by Credit Agricole in London at the beginning of the month.

  Arranged by IBJ, the issue aimed to attract investors with a bullish outlook on local stocks. The three-year notes are zero-coupon but are redeemed at par plus half the percentage increase in the value of the Hang Seng index.

  Due to a copyright issue, these notes, which were privately placed to European and US investors, had to be launched in London.

  ''We were required to apply for a licence from Hang Seng Index Services which will probably take quite some time. So we decided to launch through the London office,'' said Philip Li, director at IBJ.

  Market dealers note the interesting concept of linking the yield to the Hang Seng index. But agreed the issue was mis-timed.

  ''At that time, the analysts were bullish on the index, and their eyes were setting on the 14,000 level,'' said Paul Smith, assistant director in Union Bank of Switzerland.

  Dealers expect these innovative products to subside for a while until a clear direction on interest rate movements emerges.



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Bonds

Instruments may be ill-timed