Markets Oct 30

Chinese regulator steps in to cool convertible bond 'casino'

CSRC issues new rules to curb rampant speculative investment in convertible bonds  

Chinese regulator steps in to cool convertible bond 'casino'
A worker in protective suit takes body temperature measurement of a woman inside the Shanghai Stock Exchange building, at the Pudong financial district in Shanghai on February 28, 2020. File photo by Aly Song for Reuters.

(ATF) As Chinese investors stampede to the convertible corporate bond market for quick money, China’s securities regulator is introducing new rules to cool the frenzy and reduce risks.

The China Securities Regulatory Commission said in a statement last Friday it had introduced rules to improve the systems related to convertible bonds, with rules aimed at “enriching enterprises’ financing channels” and “protecting investors’ rights and interests”.

These are China’s first set of rules created specifically for convertible bonds. As a future-proof consideration, the “New Third Board” over-the-counter market is included in the scope of the rules.

Previously the general rules for bond trading, which were much more relaxed than stock trading, had been applied. They did not match the “stock nature” of convertible bonds, CSRC said in a statement.

In addition, as bondholders convert the bonds into stocks, the market cap of one company’s convertible bonds become smaller, making it easier for speculators to manipulate the market. This vulnerability, coupled with a relaxed policy, have been exploited. As a result, the prices of several companies’ convertible bonds have recently moved up or down abnormally due to excessive speculation, CSRC said.

Investors’ new favourite: 'Easy to manipulate'

The convertible bond is an interest-yielding bond issued by a listed company that can be exchanged for common stock in the same company. They typically offer much lower coupon rates than straight corporate bonds, making them a cheaper financing option. They can also save the companies from repaying debt if bondholders choose to convert them into shares.

In China, convertible bonds are investment vehicles with a “floor” but no “ceiling”. Their repayments, often due in six years, are backed by commercial banks, while their prices may soar far beyond their par values. No convertible bond in China has defaulted on repayment to date.

"Because of the weak performance of the stock market recently, some speculative capital has flown to the convertible bond market," Zou Kun, a fixed-income security analyst from Huaan Securities, said in a commentary. 

“The trading rule for convertible bonds that use a T+0 settlement cycle and no price limit, makes convertible bonds very suitable for speculation. The convertible bonds with small caps below 200 million yuan (US$29.9 million) are especially easy to be manipulated, over and over, by floating capital,” he said.

Because a convertible bond can be exchanged for stocks, the prices often rise and fall corresponding to the movement of the underlying stock – showing its stock nature. Investors can earn profit by buying low and selling high. They can also choose to convert a bond into stocks based on a conversion price if they expect the stocks to provide higher returns.

A T+0 settlement system means you can buy a convertible bond, and sell it on the same day to make quick profit. Stocks, on the other hand, use a T+1 settlement system.

Many investors in China have turned to the relatively new convertible bonds as stock trading becomes more cautious with the US presidential election coming up. The total turnover of convertible bonds hit a historic weekly high last week of 500 billion yuan ($74.8 billion), according to Wind.

Critics said the atmosphere of speculation has literally made the convertible bond market like a “casino”, especially for small-cap convertible bonds. 

Just a day before CSRC announcement, the prices of 13 companies' convertible bonds rose by over 10%. Among them, that of Zhejiang-based smart card solution provider Zhengyuan Zhihui almost tripled – it rose by 176%. And that of Guangdong-based "intelligent-equipment" maker Golden Milky Way soared by 73%. 

On the day of the CSRC announcement, Golden Milky Way’s price plunged 56% from its intra-day high, and closed at 3.9% lower than the opening price. Besides Golden Milky Way, 33 other convertible bonds dipped over 20% from their intra-day high points. Some investors complained on social media that they lost money worth as much as a house in a single day.

Speculation has continued to linger this week with both the convertible bond index and trading volume at high levels.

The regulator’s new rules

CSRC has ordered bourses to draw up trading rules to prevent excessive speculation and set up a cross-financial-product price monitoring and intervention system.

They are advising the stock exchanges to create a system to manage investor suitability, and for security brokerages to evaluate the "investor suitability" of their customers.

The CSRC rules also ask issuing companies to alert investors of “forced redemption” risks in a timely manner. Once they forsake their rights to forcibly redeem the bonds, they are not allowed to change their mind within a certain period, according to the new rules.

A “forced redemption clause” is triggered when the underlying stock trades above 30% of the bond’s conversion price for certain days in the last 30 consecutive trading days, or the total par values in circulation drop below 30 million yuan ($4.5 million).

When triggered, the issuing company can force bondholders to sell the convertible bond back to the company in a early redemption. In this case the investor would need to act fast to sell the convertible bond on the market or convert it into stock, or else they would end up receiving the principal and interest only.

“CSRC’s measures will, to some extent, reduce the room for speculation of convertible bonds,” Zhu Linning, a security analyst from Bohai Securities, said in a commentary.

Both the Shanghai and Shenzhen stock exchanges responded that they will step up real-time monitoring of convertible bond transactions.

They had already released a policy in July that requires investors to sign a letter of confirmation with their security brokerages to verify that they understand the risks of trading convertible bonds. The deadline for those notices was Monday.

Changes anticipated 

“Under the current rules, price changes in an underlying stock are easily magnified in the convertible bond price,” Sun Binbin, an analyst from TF Securities, said in a commentary.

Sun expected that stock exchanges would introduce price limits for convertible bonds similar to ones they have for stocks, which is 10% on the Shanghai Stock Exchange and 20% on Shenzhen Stock Exchange.

Shanghai and Shenzhen stock exchanges currently have different requirements for companies to notify investors of forced redemption risks. Shanghai has stricter rules, while Shenzhen is more lenient. 

Some companies have chosen not to execute their forced redemption rights for fear of diluting their stocks or paying dividends that are higher than the bond interest. They sometimes change their mind later.

“This year alone, five companies have changed their decisions on forced redemption. Only 20-40 days after they announced they would not use their forced redemption rights, they chose to redeem,” Sun said. “Hopefully the stock exchanges can provide clearer rules about forced redemption disclosure so that investors’ risks will be reduced,” he said.

An overheated market

After a record 126 convertible bonds were sold in China last year, raising a combined 269 billion yuan ($53.66 billion), this year's has topped that with 165 deals in the first 10 months. Rushing in have been smaller and lower-rated firms, who tend to have increased credit risks.

Trading in convertible bonds on China’s stock exchange has set new highs in several rounds of speculation.

In late March, convertible bonds of companies in masks, Covid-19 treatment medicine, and “new infrastructure” industries were highly sought after and their prices surged significantly.

In mid-April when the A-share market rebounded, convertible bond speculation resurfaced.

Then in mid-August, many convertible bonds had their debut and brought another market rally.

While speculation in the past was driven by stock price surges and centred around popular sectors, recent speculation has been random. The price of a number of convertible bonds has significantly surpassed their values if converted into stocks, showing less of a connection between their prices and the underlying stocks’ prices.

Investment opportunities 

Zhu from Bohai Securities said: “Because of forced redemption risks, investors should be cautious of high-price and small-cap convertible bonds... We suggest that convertible bond investors follow the fundamentals of the issuing companies, the trends of their stock prices, and the value of convertible bonds when exchanged for stocks. Keep away from those with high premium rates, high turnover rates and high closing prices."

iChangtou.com, an investor education company, said in an article that it is very risky to purchase convertible bonds at high prices because the company may decide to force redemption. 

“Suppose you buy a convertible bond at the unit price of 200 yuan ($29.80). When forced redemption is triggered, you either convert it into stock that is worth 130 yuan ($19.30), or sell it back to the issuing company for around 104 yuan ($15.50). You can also sell it on the stock exchange. One way or another, the price is often halved,” it said.

Zhu expects investment opportunities in domestic consumer, equipment and manufacturing, as well as artificial intelligence industries.

“We would continue to pay attention to the sub-sectors that will benefit from China’s 14th Five-Year Plan, such as semiconductor and high-end devices,” he said. 

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