Corporate bond “captive sales” face curbs ... Will corporate funding costs rise? [fn Market Watch]

[Financial News] Securities firms’ so-called “captive sales”—using investment demand from in-house asset management divisions or affiliated financial institutions to artificially lower corporate bond issuance yields—are set to face a curb. This follows KOFIA’s move to amend regulations to prohibit advance agreements between issuers and lead managers or underwriters on yields and volumes, among other practices. With market rates already having risen sharply, some companies could face further increases in corporate bond funding costs if captive demand is also restricted, according to forecasts.
According to KOFIA on the 1st, the annual yield on three-year, AA- rated unsecured corporate bonds stood at 4.407% on October 30 last month, up 0.948 percentage points from 3.459% on January 2, the first trading day of this year. The Bank of Korea raised its benchmark rate in both July and August, and Korean government bond yields have also risen, leaving companies with a greater funding burden than at the start of the year.
Market watchers say that restrictions on captive sales could weaken bookbuilding coverage ratios and bidding intensity for some corporate bonds in the short term. A sense of caution hangs over the corporate bond market.
According to the financial investment industry and KIS Asset Evaluation, the yield spread between three-year AA- rated corporate bonds and government bonds—a gauge of investor sentiment toward corporate bonds—widened from 47 basis points at the start of the year to 68.5 basis points on the 30th of last month.
There are also expectations of positive effects. Over the medium to long term, issuance yields—which had been artificially depressed—are expected to normalize to reflect actual investment demand, increasing incentives for institutional investors such as asset managers and insurers to participate.
KB Securities analyst Park Moon-hyun said, “Restrictions on captive sales may ease bidding intensity in the short term, but they will provide an opportunity to strengthen the corporate bond market’s demand base by normalizing issuance prices and expanding allocations centered on genuine demand.”
There are also expectations that selling pressure in the secondary market could ease. Previously, corporate bond holdings acquired through captive sales were sometimes put up for sale immediately after issuance, contributing to wider credit spreads on those bonds. If these holdings are replaced by purchases from investors with genuine demand, selling pressure immediately after issuance could decline and secondary-market prices could become more stable, according to the explanation.
Earlier, on October 20 last month, KOFIA announced a proposed amendment to the “Regulations on Securities Underwriting Business, etc.” The core of the proposal is to curb the practice of unfairly mobilizing investment demand from lead managers, underwriters, or affiliated financial institutions during corporate bond issuance to artificially lower yields.
The proposed amendment follows management-caution measures issued by the Financial Supervisory Service last April regarding captive sales at major securities firms. At the time, the Financial Supervisory Service cited conflicts of interest and inadequate internal controls in the corporate bond underwriting and asset management operations of six securities firms: Samsung Securities Co., Ltd., Mirae Asset Securities, NH Investment & Securities, Korea Investment & Securities Co., Ltd., KB Securities, and Shinhan Investment & Securities.
The proposal also bans lead managers and underwriters from directly participating in bookbuilding for corporate bonds they are underwriting. Issuers will also be held more accountable.
The lead management agreement must prohibit issuers from requesting participation in bookbuilding at specified yields and volumes, and must set out liability in the event of a violation. Plans are also underway to include related information in securities registration statements. In particular, if investors suffer losses because material information related to captive sales is misstated or omitted from a securities registration statement, lead managers, underwriters, and others could face liability for damages under Article 125 of the Capital Markets Act. “This could go beyond strengthening internal controls and lead to legal liability,” an investment banking industry source said.

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