Baosteel seals $500m bond exchangeable into CCB

The Chinese steel heavyweight is potentially offloading its equity stake in China Construction Bank through an exchangeable bond structure in Hong Kong.

Baosteel Group, the world’s fourth-largest steel producer by production volume, completed its second equity-linked issuance in 12 months on Tuesday by printing a $500 million zero-coupon bond exchangeable into the Hong Kong shares of China Construction Bank.

Similar to other China-incorporated companies, Baosteel issued the bond through its offshore subsidiary Baosteel Hong Kong Investment and provided a keepwell and liquidity support deed for credit enhancement purposes.

Pricing was fairly aggressive but equity-linked investors had no difficulty snapping up the new three-year bullet deal after the redemption of China Unicom’s $1.84 billion five-year convertible bond last month created ample liquidity in the market.

The fact investors are familiar with the issuer also facilitated the bond sale, one source close to the situation told FinanceAsia. Baosteel Group has two outstanding five-year dim sum bonds and both are rated A3 by Moody’s, A- by Standard & Poor’s, and A- by Fitch Ratings.

Exchangeable bonds differ from convertible bonds insofar as they can be exchanged at some future date for the stock of a company other than the issuer, usually a subsidiary or, as in this case, a company in which the issuer owns a stake. Unlike straight share sales they also enable the issuer to avoid having to offer a discount. 
When the Baosteel deal launched on Tuesday night it was marketed with a premium range of 38.5% to 45.0% over CCB’s HK$5.48 close, which was fairly aggressive considering that the bond’s double zero – zero coupon and zero yield – structure.

The initial premium range translated to a conversion range of HK$7.59 to HK$7.95 per share. CCB's share price has barely reached those levels in the past five years except for in May this year, when the shares touched HK$7.94 shortly before the market crashed.

In the end, the exchangeable bond was priced at the investor-friendly end of the premium range at 38.5%, translating into a conversion price of HK$7.59.

That is slightly richer than Baosteel Group’s first exchangeable bond into New China Life's A-shares issued in November last year, which is trading at an effective premium of 33.8% and has a fixed coupon of 1.5% per annum.

Even so, the new bond sale was well-covered at the end of the bookbuild with a combination of about 40 lines, including Asia and US accounts, the source familiar with the situation told FinanceAsia.

Despite an absence of stock borrow facility from the leads, the deal was able to attract hedge fund participation because the underlying stock is highly liquid. Also, there was abundant stock borrow available on the street at general collateral level. In the end the book was evenly distributed between long-only equity-linked investors – so-called outrights – and hedge funds.

Underlying assumptions from the leads include a bond floor of 91.3 based on a credit spread of 180 basis points. Implied volatility was 30.3% compared with three-month historical volatility of about 28%.

Even assuming full conversion, dilution was minimal at around 0.2% because of CCBs huge market valuation of $179 billion. The deal size equates to only 13 times CCB’s average three-month daily volume of $38 million.

A second source described the bond as free money because the full dividend pass through ensures that bondholders are eligible for the generous dividends banks normally pay. CCB’s currently dividend yield stands at 6.6%, which means the bond has an effective yield-to-maturity of 19.8% over a term of three years.  

Higher credit risk

Nevertheless, bondholders will be exposed to higher credit risk than a Baosteel straight bond in case of default because the keepwell deed is not a full guarantee, an equity-linked trader in Hong Kong told FinanceAsia. A keepwell deed provides credit enhancement to the issuer but the deed provider has no contractual obligation to bear its outstanding debt in case of bankruptcy.

"Keepwell deeds are not guarantees and are subject to much greater legal and regulatory uncertainty than compared to guarantees. In particular, capital control laws in China heighten the risk that timely payments will not be made, even if keepwell deeds exist," Gary Lau, a managing director for Moody's Corporate Finance Group, wrote in a research note in October.

The Baosteel exchangeable bond deal was executed at a time when sentiment is souring towards Chinese banks due to rising non-performing loans.

China Orient Asset Management, one of China's four biggest bad debt managers, estimates bad loans as a percentage of bank portfolios to rise to 1.94% by the end of 2016 from 1.59% as of the end of September. "Nonperforming loans at China’s banking system will continue to rise in the next four to six quarters," it said in a note on Tuesday.

Despite that, bankers believe the successful Baosteel bond sale will likely provide price guidance for other, upcoming equity-linked deals, including two separate $1 billion convertible bond sales from China Railway Construction Corp and CRRC Corporation. 

Baosteel's new bond was indicated at 99.75 to 100.05 in the grey market and was slightly below par at around 99.75 in secondary trading on Wednesday.

UBS and HSBC are joint global coordinators of the exchangeable bond sale. Citigroup, Barclays, Morgan Stanley, CCB International, BOC International, China Merchants Securities (HK) and CMB International are joint bookrunners.

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