Global investors are gobbling up bonds that can be turned into stocks, feeling good about the prospects and return potentials of smaller companies.
In the US, convertible bond issues have been at the highest since 2021, when near-zero interest rates during the pandemic fueled a boom. In Australia, mid-sized Telix Pharmaceuticals Ltd. found enough demand last week to upsize its offering to A$650 million ($422 million), in what would be the largest health-care equity-linked issue in Asia in three years. Meanwhile, the frenzy for artificial intelligence is making Taiwan a hotbed for convertibles.
But the enthusiasm doesn’t seem to extend to Chinese companies. After a brief rush of issues from tech giants in May, which gave investment bankers in Hong Kong some revenue and reprieve, this offshore convertible craze is already running out of steam. In hindsight, Ping An Insurance Group Co.’s $3.5 billion deal in mid-July is looking like the finale to a short-lived dream.
In mainland China, the situation goes far beyond a lack of new issuances. A $129 billion market, which has helped hundreds of smaller companies finance at cheaper costs, is facing an existential threat. About 21% of the 584 bonds outstanding are trading at below face value, the highest since the early pandemic days when businesses were shut down.
Convertibles are a draw for hedge funds that try to capitalize on mispricing between hybrid products and the underlying stocks, as well as longer-term investors who want a bit more than just fixed income. At the same time, issuers are happy to enter the market. The interest rates they have to pay are a lot lower than on conventional debt, since they’re offering buyers the option of turning their debt into a company’s stock.
A typical trader would buy a convertible while shorting the underlying stock in what’s called a convertible arbitrage. If the share price falls, she can profit from the short. If it gains to a certain level, she can convert the bond into equity and sell her shares at market price. It’s a fairly low-risk trade unless there are serious concerns over a company’s credit profile.
This is exactly the problem China’s equity-linked debt market is facing right now. One-fifth of the notes outstanding are trading below face value — it’s enough evidence of investor worries that many of the smaller listed firms are not able or willing to survive.
The default of Sou Yu Te Group Co., a small apparel design company, in March created a bit of jolt, as it was the first in the onshore convertible bond space. But it was China Grand Automotive Services Group Co., one of the country’s biggest car dealers, that really spooked traders.
By mid-July, Grand Auto’s share price had closed below 1 yuan ($0.14) for 20 consecutive trading days, thereby triggering a forced delisting according to China’s securities regulations. After all, what’s the value of a convertible if the underlying stock is no longer publicly traded?
A lot of questions have been swirling around Grand Auto’s corporate governance. Skeptics asked why the company was not using its substantial cash pile to buy back shares and avoid a de-listing, and why it paid 9.8 billion yuan to its controlling shareholder for intangible assets, which by nature are hard to value. The company said about 85% of the cash on its balance sheet could only be used as collateral for bank loans.
In other words, investors were worried Grand Auto may be shifting its most valuable asset — cash, in this case — to its parent and bankers before throwing in the towel in public markets, and that other firms would follow suit.
Even offshore, tech companies’ recent issuances raised uncomfortable questions about their capital management. Why would Alibaba Group Holding Ltd. need to raise $4.5 billion to fund share buybacks if it has more than $100 billion of cash on its balance sheet? Can the e-commerce giant take money out of China if it needs to, given the government’s capital controls?
A convertible is essentially a combination of a straight bond and an equity call option. Everywhere else, investors are focused on the latter, hoping to reap some benefits in a low-risk way if a new drug is discovered, or if big tech continues spending billions of dollars on AI. But in China, where concerns over default risks keep on resurfacing, convertible arbitrage simply doesn’t work.
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