November 21, 2010 9:41 am

Convertible bond demand up amid weak global orders

Asia’s primary convertible bond market is powering ahead.

There is little bad news coming out of the region (apart from the prospect of further fiscal tightening in China), with strong economic growth and relatively stable capital
markets.

Demand for convertibles is proving particularly robust in Asia in sharp contrast to global issuance, which remains weak amid a fragile US economy and concerns about European sovereign debt crisis.

According to Dealogic, issuance for Asia Pacific so far this year is $30bn – double last year’s figure. That is one-third of global issuance of $91.7bn, up only marginally on last year’s $84.2bn

Moreover, $13bn of Asia’s issuance was done in the two months of August and September.

Importantly, the investor base for Asia convertible bonds has shifted dramatically from hedge funds to outright investors and as a result these securities are being priced and structured differently.

While this is a global trend it is more pronounced in Asia where long-only funds are definitely dictating the way convertible bonds are being structured, according to Paul Dolan, Nomura’s Hong Kong-based global head of convertible bonds.

What has changed is the way these bonds are promoted.

“Marketing is geared towards outright investors who are focused more on individual company stories rather than punching numbers into a model and checking arbitrage opportunities,” says Mr Dolan.

“They are also demanding more coupon structures, more dividend protection, more takeover protection and lower premiums.”

That is not to say hedge funds have disappeared, he adds, but he is seeing more deals priced for long-only funds.

He cites as an example Singapore’s recent Keppel Land convertible bond issue, which did not feature the characteristics that attract hedge funds: low implied volatility, high liquidity of the underlying equity, and asset swap availability. The issue attracted mainly long-only investors keen to buy growth and earn a steady income stream.

Convertibles have long been a first hold ground for hedge fund arbitrage plays because they combine a bond and a call option in the stock. Since the bond element carries credit risk and the option carries equity risk, hedge funds made money by using hedging strategies to offload either exposure.

Barry Sharkey, director of global capital markets at UBS, says the funding landscape for hedge funds has changed – for some, it has become more costly to employ certain convertible trading strategies. Prime brokerage terms have tightened while at the same time long-only funds have enjoyed continued inflows.

“Outright [long-only] funds often want to participate in primary deals rather than depend on the secondary market, where many existing instruments are out of the money having been issued before the global financial crisis,” he says.

John Borshoff, managing director of Perth-based African uranium miner Paladin Energy is in agreement.

Paladin has just launched an issue of up to $300m in five-year convertible bonds to fund mine expansions. This is Paladin’s third issue in as many years and it brings the company’s total outstanding convertibles notes to $875m as investors seek a cheap entry into one of the world’s few pure uranium plays.

Mr Borshoff can confirm the move on convertibles by long-only investors is gathering pace and the bonds are structured to satisfy them. “About 70 per cent of our subscription was long only and of the hedge funds probably 30 per cent of those are not true hedge funds.”

He thinks the strong demand – the latest issue was four times oversubscribed – is to do with the rarity of Australian resources stocks and currency issues.

Asia Pacific Asset Management’s James Chirnside, who has also noticed the pick up in outright investors in convertibles, believes they prefer being a debt holder as it affords them more control and they are reasonably protected against dilution.

“Outright investors have suffered from the massively discounted equity issuance over the last year or so, so trustees are happier to take convertible bonds on Asia stock.

“Since Asia’s corporate balance sheets are in good shape and interest rates are at decade lows, getting a convertible instrument away at a reasonable cost is easy.”

Currency appreciation is another reason for the growth spurt in convertible bond issuance, and the liberalisation of the Chinese currency renminbi will be a major drawcard.

One way investors can ride that appreciation is through buying renminbi-denominated bonds structured for the international markets listed in Hong Kong.

The region’s biggest-ever convertible bonds issues both took place this year: the $5.9bn offering by Bank of China in June and the $3.7bn offering by Industrial & Commercial Bank of China.

Domestic renminbi bonds are primarily held by domestic China investors, who are unconcerned with renminbi liberalisation. However, renminbi-denominated and settled offshore convertible bonds are expected soon.

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