In 2003, China launched the Qualified Foreign Institutional Investors (QFII) system to encourage foreign investment in China's capital market. The QFII system authorizes approved foreign institutions to trade local currency denominated stocks and bonds in China. In addition to their involvement in the local stock ("A-share") market, the QFIIs have also shown great interest in Chinese convertible bonds as a means of achieving attractive returns.

As a result, Chinese convertible bonds have recently become popular among Chinese issuers and foreign investors. They offer unique features such as low conversion premiums, an annual reset of the conversion price, and commercial bank-guaranteed payments. These features reflect the different objectives of Chinese issuers as well as the unique character of China's stock market, making them interesting investment alternatives to Chinese stocks.

Equity Offering Equivalent

It is critical to note that a convertible bond offering in China is essentially a common stock offering. For historical reasons, around one-third of the total shares of China's listed companies trade on the exchange and the rest of the shares are held by one or more state-owned investors whose shares are not tradable. The largest shareholders are not as sensitive to share price and ownership dilution as are smaller stockholders of the listed shares, and they have the ability to vote in bigger blocks to approve convertible-bond offers.[1]

Why do issuers prefer convertible offerings to straight equity or rights offerings? The bond payment obligations create issuer discipline over cash flow management and corporate governance as a whole. As such, in China, convertible bonds are treated like "debt" from a regulatory point of view and approved relatively quickly. Conversely, equity offerings are subject to a complex and time-consuming regulatory approval process. Chinese companies have also reportedly found convertible bonds easier to launch than share-purchase rights or additional share offerings.[2] Additionally, the convertible bond floor (and other features discussed in detail below) attracts investor participation, which results in less underwriting risk as compared to common stock offerings.

The anti-dilution adjustment formula used in some Chinese convertible bonds reveals its equivalent nature to equity offerings. If a convertible bond issuer offers new common shares at a later time, the conversion price will be adjusted as follows:

P1= (P0 + A*K)/ (1+K)

Where:

P1 = new conversion price after anti-dilution adjustment

P0 = current conversion price

A = offering price of new shares

K = % of new shares on current outstanding shares

Following such an anti-dilution adjustment, if additional shares are issued and priced higher than the bond's conversion price (i.e., A > P0), the conversion price will be increased accordingly. Similarly, if new shares are offered at a lower price (A < P0), the conversion price will be adjusted to a lower price. In other words, the conversion price, the price at which the issuer sells stocks in the future if the bond is converted into shares, changes in accordance with the current value of the common stock price on the stock market.

Low Conversion Premium/Conversion Price

The low conversion premium in Chinese convertible bonds illustrates the stock offering's essence. The "Implementing Measures for Convertible Bond Offerings by Listed Companies" issued by China Securities Regulatory Commission (CSRC) provides that the conversion price shall be the average trading price of the stock for the thirty days period prior to the offering, plus a "certain premium." With full discretion to set the pricing terms, Chinese issuers and underwriters have typically set the conversion premium at or around 0.1%. Furthermore, the "Provisional Measures on Administration of Corporate Convertible Bonds", approved by China's State Council in 1997, permits issuers to set the conversion price at a discount to the spot stock price, if the issuer is a major state-owned enterprise (SOE).

As a result, most convertible bonds in China have a conversion price that is only slightly higher than the stock price was at the date of issue. For convertible bond investors, the stock price does not need to appreciate much before it becomes economic to convert. By contrast, many U.S. issuers look for structures to achieve a high conversion premium to limit potential dilution. They intentionally issue convertible instruments that are similar to debt, with features like "contingent conversion" to make conversion very unlikely. Furthermore, many U.S. issuers have been purchasing call spreads concurrently with convertible offerings to increase the effective conversion premium and to reduce dilution.

Conversion Price Annual Reset

In addition, many of the convertible-bond issues in China have empowered the issuers to reset conversion price downward annually if the price of shares falls significantly. This reset feature offers investors more shares if the stock price declines, with the goal of keeping the bond's conversion value at par.

These bonds are similar to the reset convertible bonds that were popular in Japan in mid-1990s, when, due to their large real estates exposure, Japanese banks were considered a risky investment. As the stock market was depressed, equity issuance was not an option to raise capital. The reset feature in Japan's convertible bonds was included to give investors insurance against the decline of the bank's stock. Similarly, the reset feature in China protects investors against a significant drop in the stock price, as it aims to keep the conversion option "in-the-money" when the stock price declines significantly.

The ability to reset the conversion price makes convertible bonds more valuable to investors. However, due to stock price fluctuations, this feature is difficult to value because the reset conversion price is also determined by the past history of stock price; hence, it is "path dependent." In other words, a later reset of the conversion price depends on the conversion price set on the immediately preceding reset date, which in turn depends on the conversion price set at an even earlier date. Further complicating the valuation, the issuer determines the date to reset the conversion price annually, instead of at a fixed reset date.

In the case of China's convertible bonds, pricing difficulty may give way to non-economic considerations, namely, that many convertible bond offerings are intended to result in the issuance of a common stock. A low conversion premium, combined with the ability to reset the conversion price, significantly increases the likelihood that the bonds will be converted into shares. When a Chinese corporation won approval for a record 10 billion yuan (US$1.2 billion) convertible bond sale - equivalent to a fifth its market value, minority shareholders strongly protested the potential dilution impact. Consequently, the issuer agreed to mollify the minority shareholders by reducing the convertible offering size and pledging not to lower the conversion price for three years.[3]

Financial Innovation Discount

Convertible bonds are still new to China's stock markets and Chinese investors. For instance, rules concerning China's convertible bond offerings require a higher return on equity (ROE) and earnings strength for convertible offerings than normal common stock or debt offerings.

At maturity, if the convertible bonds have not been converted into shares, most convertible bonds will provide investors with extra coupon compensation. Similar to the premium put feature seen in other Asian regions, such coupon compensation at maturity is attractive to investors' interested in a high yield-to-maturity.

Furthermore, both the coupon and principal repayments are usually guaranteed by commercial banks. Such credit support is typically used to enhance the credit profile of convertible issues, to lower coupons or increase the conversion premium. However, that is not the case in China. Instead, the commercial bank's guarantee, a higher ROE requirement, and the extra coupon compensation are a form of "financial innovation discount." They provide additional incentive for investors to feel comfortable investing in convertible bonds, a relatively unfamiliar investment vehicle in China.

Short Selling Mechanism to Come

Currently, short selling is illegal in China. Chinese securities laws have yet to permit domestic or foreign investors to borrow stock. As a result, when investing in Chinese convertible bonds, foreign investors cannot use short selling to manage risk or to lock in trading profits. For instance, they cannot implement the popular "convertible arbitrage" strategy seen in the U.S., where convertible bond investors short sell underlying stocks to hedge out stock price risk and focus on trading the implied volatility of the embedded call options in convertible bonds.

The regulatory landscape in China is likely to change as many regions in Asia are opening their markets in line with international standards. For example, the Financial Supervisory Commission of Taiwan is expecting Taiwan's parliament to pass revisions to their Securities Transaction Act by December 2004, enabling overseas investors to borrow stock for purposes of short selling.[4] As China's QFII system shares many common features with Taiwan's, it is not implausible that China may take similar measures in the near future to lift the ban on short selling by foreign investors. Once a short selling mechanism is put in place, the economic terms and trading behavior of Chinese convertible bonds will change dramatically.

Conclusion

Convertible bonds in China have unique features which reflect the character of China's regulatory system and stock market. They are more akin to equity offerings as the low conversion premium and annual reset of the conversion price make it highly likely that the convertible bonds will be converted into shares. Additional investor-friendly features, such as the extra coupon compensation and the commercial bank guarantee, are added to encourage investors' participation in this new investment system in China.

Combining the low conversion price and solid bond floor, China's convertible bonds provide an alternative approach for investors seeking exposure to Chinese stocks. Because a short selling mechanism is not yet available, specific trading strategy and risk management should be developed in accordance with the Chinese convertible bonds' distinctive financial terms.