Cathay Financial Holdings launched its highly anticipated convertible yesterday (Monday) as SinoPac Financial Holdings joined the queue of finance issuers with a prospective $350 million deal via UBS Warburg. The Swiss bank has been awarded sole books over long standing favourite Merrill Lynch, which had been expected to win the transaction after holding a mandate for a GDR issue where UBSW had been joint-lead.
In the meantime, Cathay's smaller than anticipated issue of $700 million has divided convertible specialists. For lead manager Goldman Sachs, which has sole control of the deal with no other syndicate, execution requires a delicate balancing act between a large deal size and aggressive terms on the one side with weaker market conditions and a stock which lacks borrow on the other.
Pricing is scheduled for Wednesday following a two-day bookbuild and pending successful completion, the deal will set an important new benchmark and record for the Taiwanese market, where Fubon Financial Holding's $430 million offering currently ranks as the largest to date. In its favour, Cathay is regarded as one of the premier credits in the Asian equity-linked universe and its deal should bring investors their long hoped for liquid benchmark out of a country where deal sizes average less than $200 million.
It is also the case that after discounting the two exchangeables where the underlying credit is European - Cable & Wireless and Vodafone - there are just two other transactions in Asia with a BBB+ or Baa1 rating - Korea Telecom and PCCW-HKT. Yet as telcos, neither credit automatically sits at the top of an investor's wish list, whilst a Taiwanese banking credit coming from a sector that rarely taps the international market, almost certainly does.
Furthermore, because insurance contributes just over 90% of Cathay Financial's revenues, the holding company has been assigned the highest rating in the Taiwanese holding company universe. In applying a BBB+ rating Standard & Poor's has placed the company four notches below the AA - level of Cathay Life. By contrast, Fubon Financial Holdings was assigned a BBB- rating six notches below the AA- level of Fubon Life. This is because its overall revenues have a more even mix and the credit profile is dragged down by the weaker credits of Fubon Securities and Fubon Commercial Bank.
The lead is consequently believed to have been very aggressive in pricing the credit component of the transaction, with investors reporting a credit spread assumption of 120bp over Libor, against the 145bp level expected by the market. At these levels, Cathay Financial is being priced on top of the credit default market where it is being quoted at a 120bp level rather than the asset swap market where it is being quoted at 140bp.
Terms for the five-year deal include a zero coupon, 20% to 25% conversion premium and yield-to-maturity of 2.25% to 2.75%. With a premium redemption structure at 111.8% to 114.6%, the deal also has hard no-call for three-years, thereafter subject to a 130% hurdle and a three-year put at 106.9% to 108.5%. There is also a $150 million greenshoe, which could bump proceeds up to $850 million, bringing the deal in slightly below initial expectations of a $1 billion issue size.
According to investors, the lead is working on underlying assumptions, which comprise a bond floor of 90.4% to 92%, fair value of 100.1% to 102.9% and implied volatility of 24.9% to 30.2%. This is based on a credit spread of 120bp over Libor, zero dividend yield and 4% stock borrow cost. Historic 260-day volatility has been calculated at 42%.
For most participants, a key point of debate is whether investors will be willing to accept a 10-point equity option. Most conclude that since there is virtually no borrow on the stock, the bond floor is too low and particularly given that the company is trying to push out such a large amount of paper onto the market.
As a result, a number of banks' proprietary desks were seen to be shorting the bond aggressively in the grey market yesterday, pushing the bid/offer spread below par. As one banker explains, "Hedge funds cannot short the stock, but prop desks can short the bond and some houses appear to be taking the view that they are unlikely to get squeezed because the deal wont be suddenly massively bid above par as the deal is too large to attract massive oversubscription. This often happens with large deals and stocks with no borrow."
However, some investors are said to be setting up hedges against futures contracts such as the MSCI Taiwan, which is traded out of Singapore and the domestic banking index, which is traded out of Taiwan. In both cases, the cost of setting up the hedge is only about 1%. Where the MSCI Taiwan is concerned, there is said to be a 60% correlation and with the Taiwan Banking Index, an 80% correlation.
Convertible specialists agree that some investors are likely to take this route, although a number query whether there will be enough demand from this source to support such a large issue size. And as one argues, " Although there is a correlation for an index heavyweight like Cathay, it is not a perfect one and most people regard the MSCI Taiwan as a tech proxy. Many investors will not be willing to accept the correlation risk and for investors with QFII status in Taiwan, they would also need to run large cash positions to be able to set up a trade against a domestic futures contract."
But convertible analysts do agree that on deeper analysis, Cathay's terms do not appear quite as aggressive as they do on first reading. This is particularly the case where the volatility is concerned, since Cathay trades at a much higher historic volatility than Fubon, some of whose constituent stocks were more illiquid prior to their incorporation in the holding company.
Fubon, which benefited from stronger market conditions and first mover advantage, was able to price its deal in early April almost right on top of historic volatility levels. With a 2.25-year maturity, the deal had a bond floor of 93.5%, fair value of 100.92% and implied volatility of 27.8%. This was based on credit spread of 190bp over Libor, dividend yield of 1.6%, 4% stock borrow cost and 30% volatility assumption. Also with premium redemption at 107.52%, the deal had a zero coupon, 21.2% conversion premium and yield-to-maturity of 3.25%.
The deal is currently above par at 103% - 104% on a yield of 1.55% and implied volatility of 29.7%. Bankers conclude that although most of the recent string of convertibles dropped from the heady valuations of two weeks ago, they are still well bid and this should support Cathay's bid to follow suit.