Mark Wightman of SunGard looks at two of the most common and popular convertible bond structures in Asia, and explains the various issues and considerations for investors and advisers.

Date: Mar 2011

Tags: Convertible bonds, Coupon, Equities

•  The most common convertible structures in Asia at the moment are reverse and contingent convertibles (CoCos)
• Investors buy reverse convertibles for a yield play, picking up a bigger coupon based on their view that the share price will not fall to the trigger level
• CoCos are also a yield story, so investors must understand the criteria for the trigger being hit – and they need to be comfortable with the creditworthiness of the structure
• Standard & Poor’s expects to see US$1 trillion of CoCo bonds issued over the next five to 10 years – given that these structures fit under the new Basel 3 capital definitions

Other than conventional convertible bonds, there is a family of convertible securities available in Asia, some of which are equity-like and others more debt-like, said Mark Wightman in an interview.

The most common structures in the market at the moment are reverse and contingent convertibles (CoCos), he explained.

However, there also the following: mandatory convertibles, where conversion is forced; perpetual convertibles, which have no fixed maturity date; exchangeables, where the bond will convert into the underlying in a different company; and also cross-currency convertibles, which applies in reality to many of the bonds which exist in Asia.

Understanding reverse convertibles

Whereas with a typical convertible bond, investors receive a relatively low coupon and in return have the option to convert into the underlying equity at a premium to today’s share price – with a reverse convertible, investors typically get a higher coupon – perhaps 9% to 10%. But with higher risk.

Specifically, said Wightman, investors are forced to convert into the underlying when a trigger is hit, meaning in reality when the share price has fallen by a certain amount.

If the underlying company is performing badly, therefore, the investor must convert into the underlying shares.

Yet investors buy this for a yield play, he said, picking up a bigger coupon based on their view that the share price will not fall to the trigger level.

A closer look at CoCos

With CoCos, Wightman said the key thing to understand is that investors are paid a reasonable coupon subject to taking some risk that at a trigger level, they will be converted into the underlying shares of the company.

It is also a yield story, he explained, so advised investors to understand the criteria for the trigger being hit. Plus, he added, they need to look at the creditworthiness of the issuer and be comfortable holding this structure.

However, given that CoCos are relatively new structures, certainly compared with reverse convertibles, Wightman said there is a certain amount of discussion related to the fact that the terms are not standardised in the industry.

In some of term-sheets, for example, there is specific terminology relating to contingency or viability events – but it might not be completely clear what drives these.

At the same time, added Wightman, where these structures are positioned within the overall capital structure of a company is still something being understood.

But this hasn’t stopped the product being offered through some of the private banks, and some of the larger institutions are either using – or talking about using – these structures to raise their capital ratios, he said.

CoCo trends

In particular, Wightman said Standard & Poor’s recently revealed that it expects to see US$1 trillion of CoCo bonds issued over the next five to 10 years – driven largely by the fact that these structures fit under the new Basel 3 definitions for capital which can be set aside.