Chinese convertible bonds: treat with care

CBs are increasingly popular in China, but some say they are simply another way of abusing minority shareholders.

In the first quarter of this year, for the first time in Chinese capital markets, more cash was raised by convertible bonds (CBs) than from initial public offerings: Rmb5.6 billion ($602 million), compared to Rmb5 billion. Last year, there was just Rmb4 billion issued for the whole 12 months.

"What has changed this year, and attracted investor interest, are highly advantageous terms, such as the resetting clauses and low conversion premiums. The CBs coming out this year provide big benefits for the investor - but less so for minority shareholders holding the publicly traded shares," says one Shanghai Stock Exchange researcher.

Take China's largest CB offering to date. In February, China's only private bank, Minsheng, successfully issued a five year Rmb4 billion convertible bond, with a coupon of 1.5% to reduce debt and boost capital adequacy ratios on the back of rapid asset growth. The success of its issue means that it could set a pattern of other companies, say bankers.

In line with most Chinese companies, Minsheng would ideally have done a rights offering - after all, debt has to be repaid - but there is a long queue to issue, and CBs are more straightforward to get regulatory approval for. In the eyes of mainland companies, equity and CBs are free money, since they don't need to be repaid, especially when sweeteners make conversion unusually attractive.

For example, one of the sweeteners is a clause in the bond that stipulates the conversion ratio can go down in tandem with the stock price - the 'resetting clause'.

In Minsheng's case, if for 20 trading days out of the past 30 trading days, the closing quote is lower than 80% of the conversion price, the management has the right to decrease the conversion price by 20%.

CB offerings last year did not have the resetting clauses and therefore did not perform well, leading to their introduction this year.

For Minsheng, the conversion price was Rmb 10.11, but the stock price at the time of the CB issuance was just under 10.01.At a premium of just 1%, "the owners clearly want the bond converted," comments one Western banker.

CB holders are all the more likely to convert since the coupon price is low compared to 5-year bank deposits at 2.8% and the share price has risen strongly since the issue.

Minsheng's stock price surged almost 40% to Rmb 4.1 in early April, before dropping to Rmb 11.4 on SARS-induced panic just ahead of the May holiday.

While the CB is a new vehicle, the underlying problem of majority owners using the stock market as an ATM hasn't changed. Indeed, say critics, the different share classes and the overly concentrated nature of ownership in Chinese companies create distorted incentives for management to use CBs with overly generous terms.

Minsheng has a relatively fragmented share ownership with the top ten shareholders owning 60% of the company.

But often as much as two thirds of the shares of a typical listed company are held by the government or other large, entities , and are only tradable under special circumstances. The value of the non-tradable shares are based on net-asset value, and are far cheaper than the shares in the over-priced public market. (Price-earnings ratios on the two Chinese bourses average 40x due to insufficient investment opportunities being chased by high liquidity money.)

Thus, although ownership has been diluted through a rights offereing or a CB, the non-tradable shareholder is in the paradoxical position of seeing the value of the non-tradable shares goes up, since the extra capital boosts net asset values.

Fraser Howie, co-author of a recent book on the stock market, agrees that the high concentration of ownership amongst the majority shareholders encourages a 'capital is free' mentality amongst shareholders.

"In a typical company, the majority owner might have a whopping 45%, the next two biggest might have 8% and 3% respectively. The A-share holder represents only 30% of the shares, that is distributed across tens of thousands of investors. That means the company can dilute its equity through rights issues or CB issues for a long time before its effective ownership diminishes," he points out.

"Listed companies are theoretically created to make companies responsible to shareholders. That's not been the case with most of Chinese listed companies, " he concludes.

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