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Convertible bonds

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Taiwan’s convertible bond (CB) market has arguably been one of the most compelling stories of the year in Asia. While equity-linked deals have been few and far between elsewhere in the region, Taiwan has led the way with over $2.2 billion in issuance so far this year. And this surge in CB issuance has attracted the attention of hedge funds, eager to exploit arbitrage opportunities by stripping out the embedded equity option and in the process, earning an often enticing return. In turn, this has led to a boom in the asset swap market in Taiwan, and some players even claim it could eventually lead to emergence of one of the first Asian currency credit derivatives markets.

Taiwan’s cash hungry technology sector has led to charge so far. With Taiwan’s equity market among one of the best performing in the region, and with interest rates close to historic lows, a number of tech firms have leapt at the chance to issue through the convertible market. All in all, eight tech companies had tapped the market as of May, with names such as consumer electronics and microchip companies

Siliconware Precision, Macronix International, and UMC raising a combined $550 million within the first few months of 2002. “Around 57% of all new equity capital raised outside of Japan and Australia has been by Taiwan issuers,” remarks William Bowmer, managing director and head of Asian equity capital markets at Lehman Brothers based in Tokyo.

This hive of activity has attracted the attention of CB arbitrage funds, which specialise in stripping out mispriced equity options embedded within the convertible bond, either through purchasing credit protection in the credit derivatives market or by entering into an asset swap. However, while credit default swaps are frequently used by hedge funds in the US and European markets to buy protection on the underlying bond, there are no credit default swaps on Taiwanese names trading in the interbank market, predominantly because there is no outstanding US dollar denominated debt from Taiwanese companies. “In Taiwan, it will generally be asset swaps rather than credit derivatives,” says Daniel Steeds, Hong Kong-based vice-president of trading, Asian credit markets, at JP Morgan Chase. “It’s not a market that we have seen any evolution, although I personally think it will develop.”

Consequently, convertible asset swaps have been thriving in Taiwan, with market participants estimating that anything between 25% to 75% of deals this year have been asset swapped – that adds up to anywhere between $500 million to $1.5 billion in asset swap business. For onshore banks, taking the fixed-rate side of the asset swap is an attractive proposition because they can realise higher spreads for domestic names than would be achievable onshore. “The demand for asset swaps from the offshore banking units of domestic banks and other corporate and financial institutions is quite high, because they can sometimes get as much 200 basis points more than onshore,” says Morris Li, senior executive vice-president and head of capital markets at China Trust in Taipei.

And now the CB market in Taiwan looks set for a further surge. In March, the Taiwanese regulator, the Securities and Futures Commission (SFC), abolished the requirement for entitlement certificates, which should encourage greater demand from investors. Investors had been required to accept entitlement certificates – which did not pay dividends – until the conversion into new shares had been approved by the regulatory authorities, acting as a brake to market development. “The entitlement certificates are essentially illiquid, so they would trade at discount to the actual stock until they neared the conversion date,” explains Mark Wightman, a company director responsible for business development and support of Asian markets at Monis Software, a supplier of convertible bond analytics software, based in London. The change in legislation should eliminate liquidity risk and push conversion premiums higher, making it more attractive to issue convertibles, Wightman adds.

But more importantly, Taiwan’s newly created financial holding companies (formed following government measures to consolidate the financial sector at the end of last year) are preparing to tap the market, and with it, the amount of issuance should surge dramatically. Already, Fubon Financial Holdings and Cathay Financial Holdings have issued mammoth $430 million (led by Credit Suisse First Boston and Salomon Smith Barney) and $700 million (led by Goldman Sachs) deals respectively in the last few months – the two largest issues to emerge from Taiwan to date. And a horde of other financial holding companies are set to enter the market, including China Development Industrial Bank (a $450 million deal, led by Goldman Sachs, was launched as AsiaRisk went to press), Taishin (expected to be around $250 million), Sinopac Financial Holdings ($350 million), and China Trust (JP Morgan Chase received the mandate for this deal in late May. These newly created holding companies are keen to improve their capital base, and with further consolidation expected in the financial sector, they are also eager to build up acquisition ‘war chests’, say bankers.

However, this sudden gush of activity has prompted some concerns about ability of market to absorb all of the new paper, with doubts that the hedge fund players will be interested in stripping and holding the option out of the financial holding company issues. “The financial holding companies don’t have too much equity, so if you look at the option within the bond itself, the stock movement is not so exciting,” says Eric Chuang, in charge of convertible bonds and asset swaps at Citibank in Taipei. “If you are a hedge fund, you won’t feel it’s very sexy in option terms, so I really doubt whether the market can absorb this sort of size.”

Another factor is that offshore players cannot go short in the domestic equity market. As the new holding companies have little equity issued offshore in the form of American depository receipts (ADRs) or global depository receipts (GDRs), hedge fund managers cannot hedge the option by shorting the stock. Consequently, the tech firm issues may retain the lion’s share of interest from the hedge funds. “There’s a lot to be said for doing a $250 million tech convertible out of Taiwan, which has a lot of volatility,” comments Kenneth Poon, managing director for equity capital markets at Merrill Lynch in Hong Kong. “If you were an investor going into a $1 billion transaction from a financial company, which has low volatility and you are not able to hedge, versus a $250 million deal, which is going to be quite tight in terms of supply and demand, it’s debatable which one you would go for.”

And in fact, it is rumoured that Goldman Sachs had some difficulty getting the colossal $700 million Cathay deal away. Fubon, on the other hand, was covered within 60 minutes, says Julian Hall, director of equity capital markets at CSFB in Hong Kong. “All the issues that have offered a diversity play have gone well,” he states. “Fubon was the first non-technology firm to come out of Taiwan for three years.”

But due to the generally higher credit ratings of the financial holding companies – Standard & Poor’s rated Fubon and Cathay at BBB– and BBB+ respectively – the bonds may be more attractive from the fixed-income perspective, adds Citibank’s Chuang. “Fubon is quite popular because it is the first [financial holding company to issue] and it’s quite a decent name. In terms of credit quality, Cathay is one of the best Taiwan names, so if you just buy it from the fixed-income point of view, it may make sense.”

It is also pointed out that there is often little stock borrow for many of the Taiwanese tech issuers either, meaning that hedge funds have been buying the cheap option and often holding it as an investment rather than selling it on. “Most of the names in Taiwan are not hedgeable,” says Merrill Lynch’s Poon. “Unless the issuer has a liquid ADR programme, even if domestic trading volume is large, the supply of stock borrow is always severely limited. Typically, the funds aim to buy cheap options with a fair degree of under-hedge, hoping that the stock will go up.” Only the most liquid names, such as TSMC and UMC, will have enough stock available to put on a decent hedge, he adds.

Citibank’s Chuang agrees, noting that if there is little borrow on the stock, the option is generally cheaper anyway, providing more value for arbitrage funds. “If the funds enter the Taiwan market, they generally buy and hold from the option point of view, typically because of the difficulty of doing hedging,” he says. “The option is priced relatively cheap compared to G7 mature markets, so they just take a stance as an investment.”

One potential future development, however, is the participation of the domestic institutions in the offshore European convertible bond (ECB) market. Domestic banks such as China Trust are already involved, both on the credit and the option side. “We take the credit risk ourselves, and we also act as a broker, dealing this product to offshore institutions or domestic offshore banking units,” says China Trust’s Li.

But Taiwan’s domestic securities houses also obtained licences to trade asset swaps from the SFC, at the end of last year. While currently prohibited from dealing in the ECB offshore market, some houses are already participating, stripping out the option and selling on the credit risk in the form of credit-linked notes. “The credit-linked notes provide us more flexibility to sell the credit-linked structure to other levels of investors, including private customers,” says one manager at a domestic securities firm in Taipei. “In either market, we always try to be a broker instead of a credit risk holder. For the CLN business, we use the ECB market to cook the deals, while in the asset swap market, we use domestic CBs.”

In most cases, however, the securities firms are at the early stages of convertible asset swaps in the domestic market. Grand Cathay Securities has just completed its first convertible asset swaps on Compeq Manufacturing and VIA Technology totalling around NT$150 million ($4.4 million). The counterparty was insurance company Taiwan Life Insurance, with Grand Cathay offering them fixed rate at 4.65%. Polaris – a securities firm based in Taipei – completed its first deal in January, a NT$30 million deal on Enfield Medical. Meanwhile, Yuanta Core Pacific Securities has been most active, transacting 10 deals with a nominal amount of NT$800 million since its first deal last November.

However, the securities firms are currently not allowed to sell on the stripped out equity option from the local CBs, meaning that they have to hold it themselves as an investment. Market players say that this has hampered activity in the market, although it is hoped this regulation will soon be relaxed. “The regulator has completed the deregulation plan, so I suppose the regulation will be changed very soon,” remarks Vivian Tsai, section chief at the SFC in Taipei. Once this regulation has been changed, market participants reckon that Taiwanese high net worth individuals and corporates will be the primary buyers of the option.

One major impediment, however, is the relatively small size of the market as well as the credit quality of the names that issue. The outstanding volume of domestic CBs was around NT$85.5 billion ($2.49 billion) at the end of 2001, and around NT$71.5 billion ($2.08 billion) as of April. “So far, we are short of paper to do the asset swap,” says Tony Ko, assistant vice-president of fixed-income at Grand Cathay Securities in Taipei. “There is not enough underlying paper.”

Nonetheless, the increasing levels of activity has prompted some bankers to suggest that the domestic convertible bond market could be a driver for one of the first local currency Asian credit derivatives markets. “I think you’ll see the credit derivatives market grow,” says Bryan Yap, co-head of local fixed-income and derivatives trading at Deutsche Bank in Singapore. “There’s greater depth in corporate issuance relative to some of the other Asian markets. That makes it easier to benchmark credit spreads. Onshore credit derivatives markets are one of next year’s potential growth areas.”

Others are not so bullish, however, noting that while the CB boom is boosting interest in credit derivatives products, the Taiwanese regulators are likely to take some time before they approve a framework for these instruments. “So that’s why no one really uses the credit default swaps, even though we have the knowledge,” adds one Taiwan banker.

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