Fortescue deal sparks Aussie equity-linked return

Hunan Valin brought an end to a three-and-a-half year drought in Australian equity-linked issuance with a $355 million bond exchangeable into the iron ore producer.

Chinese state-owned enterprise Hunan Valin Iron & Steel sold $354.8 million of bonds exchangeable into shares of Australian iron ore producer Fortescue Metals Group on Tuesday, ending a three-and-a-half-year drought for equity-linked issuance in Australia.

The five year deal, puttable after three years, marks the first ever cross-border exchangeable bond in Australia and the first equity-linked transaction since Linc Energy’s $200 million convertible bond issued in March 2013.

Similar to other China-incorporated companies, Hunan Valin issued the bonds through an offshore branch, Valin Mining Investments (Singapore), and provided a keepwell agreement for credit enhancement. Hunan Valin is an unlisted entity owned by the Hunan provincial government.

Deutsche Bank, the sole bookrunner of the exchangeable bond, approached investors with an exchange premium of 25% to 35% over Fortescue’s Monday closing price. The put price was touted at being between 104.58% and 107.73%, with a redemption price of 107.76% to 113.22%. That implied a yield to put and maturity of 1.5% to 2.5% every year.

The final terms were largely settled at the mid-point of the guidance. The exchange premium was fixed at 30%, implying an exchange price of A$7.124. The bond yields 2% a year based on the final put price of 106.15% and redemption price of 110.46%.

The US dollar-denominated bond was launched with an indicative size of $341 million to $369 million, depending on the size of the demand. The bond is exchangeable into 65 million Fortescue shares.

Timing of the deal appeared to be ideal for the issuer because the bond was priced after a strong rally in Fortescue’s shares, which more than tripled from A$1.45 in January amid a rebound in iron ore prices.

The strong share price performance was backed by a sharp increase in Fortescue’s net profit for the year ended June 30, surging to the equivalent of $985 million from $316 million a year earlier.

According to a source familiar with the situation, the leads had already put together a shadow book that was nearly sufficient to cover the entire deal before launching. That allowed the issuer to launch the trade on Melbourne Cup Day, which is a public holiday in Melbourne and the state of Victoria.

These anchor orders also provided momentum for the issuer to get incremental demand and to eventually price off the bottom of the guidance.

Allocation was evenly split between hedge funds and outright accounts, according to the source. There was no geographical split available, but the deal was entirely sold to investors outside Australia.

There were uncertainties over credit assumptions at launch since Hunan Valin was an unrated and unknown issuer in the international markets. Assumptions were also made difficult because Hunan Valin has supported its Singapore branch — the issuing entity — with a keepwell deed instead of a full guarantee.

Unlike a full guarantee, a deed provider has no contractual obligation to pay off the issuer’s outstanding debt in case of bankruptcy.

The only benchmark for the new exchangeable bond was Hunan Valin’s onshore, renminbi-denominated vanilla bond which yields 6.2% until 2019, according to a bond trader.

As such, bond traders have used a fairly wide credit assumption between 375bp and 450bp for the new issue. Fortescue shares are very liquid and trade $58 million on average every day, meaning that stock borrow was easily available at general collateral level.

According to the source, the new bond has a bond floor of around 90% and an implied volatility of about 27% to 28% at the final price. That is based on a 450bp credit spread and a 3% stock slippage.

Technically, the exchangeable bond allows Hunan Valin to offload about 15% of its 444 million shares in Fortescue, the world’s fourth largest iron ore producer, if all of the bondholders exercise the exchange option.

The Chinese state-owned enterprise bought a 16.5% stake in Fortescue for A$1.2 billion in 2009, a time when Chinese companies were actively seeking Australian resources companies which struggled to repay their debt following the global financial crisis.

At that time it bought Fortescue shares at $2.48 per share, implying that it has more than doubled the value of the investment based on Fortescue’s current market price.

Hunan Valin’s shareholding in Fortescue could fall to 12.1% from 14.2% currently if the bonds are fully exchanged into shares. Still, it will remain as the second largest shareholder behind Andrew Forrest, Fortescue’s founder and chief executive, who owns 33.3% of the company.

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