Can Exchangeable Bonds Satisfy Cash-Hungry Shareholders?

Rigid requirements

In the years when the liquidity in financial market had been reduced by the country's tight macro adjustment policy, the relevant enterprises in need of cash funds have encountered great difficulties - the increased threshold of the bank loans, raised bank interest, the gloomy equity financing market, and the delayed cash flow, etc. The emergence of exchangeable bonds does provide a new financing channel, but according to Article 2 of the Trial Provisions shareholders applying for the issuance of exchangeable bonds are required to meet a number of rigid requirements which, amongst others, include:

(1) the applying shareholder shall be a limited liability company or a joint stock limited liability company in compliance with the provisions of The Company Law of the PRC (中华人民共和国公司法) and The Securities Law of the PRC (中华人民共和国证券法);

(2) the applying company's net assets as of the end of the preceding period are no less than RMB300 million;

(3) the annual average distributable profit of the applicant over the last three accounting years is no less than the amount of interest payable on the bonds for one year;

(4) the accumulated outstanding amount of bonds after the issue of the exchangeable bonds does not exceed 40% of the net assets of the applicant at the end of the preceding period;

(5) the amount of bonds to be issued does not exceed 70% of the market value of the shares to be exchanged, calculated in light of their average prices within the 20 trading days prior to the date of the public announcement of the prospectus, and such shares to be exchanged shall be pledged as the guarantee of the bonds issued; and

(6) the bonds are rated as good by credit rating agencies.

The issuers of the exchangeable bonds prescribed hereunder are confined to certain companies satisfying the above requirements regarding their scales and qualifications. These are intended by the state securities watchdog to reduce the risks from some non-standardised small and medium-sized enterprises issuing exchangeable bonds.

As for the shares underlying the issuance of exchangeable bonds, the Trial Provisions also set forth in Article 3 detailed qualifications to safeguard the credit of shares as the collateral:

(1) the net assets of the issuing listed company as of the end of the preceding period are no less than RMB1.5 billion, or its weighted average return on assets over the last three accounting years is no less than 6%, which is calculated in light of the lesser of the net profit after deducting the non-regular profits and losses and the net profit before such deduction;

(2) the shares are freely transferrable as of the date of application; and

(3) the shares are not subject to any proceedings or title dispute.

Based on the current statistics, the number of the companies qualified to issue the exchangeable bonds pursuant to the provisions of the Trial Provisions stated above is 385, which is less than one-third of all listed companies. Most of them are shareholders owning more than 5% shares in a qualified company. Therefore, only a small portion of enterprises in great need of cash can raise funds via issuance of exchangeable bonds under the Trial Provisions. For those shareholders owning less than 5% shares, most of which are bad quality shares or belong to investment firms, generally having little controlling power of or influence upon the company, and mostly having not yet been rated or are rated unfavorably, the exchangeable bond proposal does not apply and the Trial Rules can only exert a slight influence upon them.

Potential reluctance

Pursuant to the Articles 1 and 5 of the Trial Provisions, the holder of exchangeable bonds has the right of option upon the expiration of 12 months of the issuance of the exchangeable bonds under the agreed conditions. The swap price of the exchangeable bonds may not be lower than the average trading price of the subject shares over the 20 trading days prior to the announcement date of the prospectus, or the average trading price of such shares on the previous trading day. The prospectus should stipulate the convertible price and its adjustment principles in advance; if such adjustment results in the shortage of the shares to be exchanged for the exchangeable bonds, the issuer shall make up the difference with its other shares and enter into a pledge with regard to such other shares. Under Article 7, the shares into which the bonds can be exchanged and any yield accrued thereon (including shares reverted from capital reserves, bonus shares, dividends and interest, etc.) shall be the security for the exchangeable bonds. To guarantee the to-be-exchanged shares' security to prevent bonds' default risks and protect investors' interests, it is also stressed that before the issuance of exchangeable bonds, the entrusted manager of corporate bonds shall sign a contract on a pledge of to-be-exchanged shares with a listed company's shareholder, and get a credential on the equity pledge right by handling equity pledge registration at a securities depository and clearing authority. Under the Trial Provisions, as we can see, the interests of the holder of the exchangeable bonds are protected from a legal and a technical perspective.

However, for those companies eligible to issue exchangeable bonds under the Trial Provisions, such “temptation” may not be attractive enough even if they are in need of cash funds. One of the reasons is that in such a flagging stock market, the market value of the stocks they hold is mostly undervalued.

Another concern is cost payout which makes the exchangeable bonds less attractive. The cost payout includes the costs and expenses incurred in applying to the competent authorities and agencies, retaining rating firms and other financial services firms to evaluate and set prices and marketing and promotional activities, and those paid to the holder of exchangeable bonds in terms of interest thereon. For those in urgent need of financing, they may prefer to directly sell the shares they hold to cash out.

Taking time to attract investors

According to a CSRC spokesperson, the exchangeable bonds are special corporate bonds that differ from other bonds used in investments. However, the smooth implementation of the Trial Provisions and the issuance of the exchangeable bonds are definitely reliant upon whether and to what extent the investors can accept such a newly emerged financing tool. For those bond investors seeking higher yields, the exchangeable bonds seem to be of far less of a temptation. The interest rate for exchangeable bonds can be much lower than other corporate bonds and bank loans.

From a theoretical perspective, the exchangeable bonds may be cherished by some institutional investors and those individual investors preferring long-term stable incomes in that the exchangeable bonds lock up the equity swap price in advance and that the investor can simultaneously get interest based on the coupon rate and options of the shares exchanged at the equity swap price, thus acquiring the yields from the rising stock price, or holding them as bonds till expiration if the price falls down. The diversified and smooth risks make the exchangeable bonds suitable for investors who pursue stable incomes, especially securities investment funds, insurance funds, social insurance funds, pension funds and enterprise annuities.

However, as the CSRC said in a statement in August, the country's slumping market reflected a correction from previous highs, rising global financial uncertainty and concerns about the domestic economy – and China's unsound stock market exacerbated the situation. In such a financial market downturn, investors are inclined to doubt any policy, be it favorable to the market or not. It will take time to build up the confidence of investors in the stock market and bond market. Investors will only regain confidence in the Chinese economy and return to the capital market when the policies and measures including the Trial Provisions are taken by the CSRC and relevant governmental authorities with regard to the stock and bond market and the macro administrative agencies well coordinate with each other in fabricating and implementing the fiscal policies, monetary policies and industrial policies However all this will take time.

To ease the pressure of the oversupply of the freed locked-up shares under the Share Segmentation Reform in the A-share market and satisfy those enterprises in urgent need of cash funds, the Trial Provisions can be of limited significance. Under the rigid requirements regarding the qualifications of the issuer of the exchangeable bonds and the shares underlying the issuance thereof, only a small portion of companies are eligible to issue exchangeable bonds to raise funds, part of which, however, show little interest in issuing exchangeable bonds in view of the fairly high issuance costs. For those unqualified enterprises, especially those small to medium-sized enterprises holding shares of low quality, the exchangeable bonds are only hard-to-get vehicles, and they still have a strong will to dump their holdings for cash. As for the buyers of the exchangeable bonds, although their interests are safeguarded under the relevant provisions, most of them are apt to wait and see until the overall Chinese economy boosts to make the investors regain their confidence in Chinese financial markets. To satisfy the hunger for cash, exchangeable bonds are not the first option.