Japanese companies turn to convertible bonds for funding

Fri Aug 29, 2014 1:16am EDT

* Japan CB issuance through August nearly double year-ago period

* Most CBs issued with 20-40 pct premium to current stock price

* Companies include conditions to offset dilution risks

By Lisa Twaronite

TOKYO, Aug 29 (Reuters) - Convertible bond issuance by Japanese companies in 2014 nearly doubled from the previous period, and is on track for a banner year as firms tap a cheap source of funding and a pause in Japan's recent stock market rally reduces conversion risks.

Japanese firms issued about $5.0 billion worth of convertible bonds in the year through August, compared with $2.6 billion issued in the same period a year ago, according to Thomson Reuters data which showed issuance hit an eight-year peak in the first half of 2014.

A convertible bond has an embedded option to convert to a company's shares at a fixed conversion price. The hybrid fixed-income/equity instrument allows companies to raise funds without some of the disadvantages of either a straight bond or a standard share offering. A zero-coupon CB will not increase a company's debt burden, and high conversion premiums reduce the chances that a company's shares will take a hit.

Most CBs are issued at a 20 to 40 percent premium to the level where the stock price is currently trading, according to Tokyo bankers.

In 2013, the Nikkei stock average surged more than 56 percent, riding hopes for Prime Minister Shinzo Abe's ambitious programme to beat deflation and spark sustainable growth. But so far, the Nikkei has given back about 5 percent this year, after an April hike in the national sales tax dragged down consumption.

Japanese CBs carry a zero coupon, meaning a company faces no debt servicing costs as it would if it issued a straight bond. CBs also allow issuers to sidestep the immediate share dilution of a straight stock offering.

"Practically, you're issuing at a premium from the current market price. If you do a public offering, it's diluted right away, but with a CB, investors don't convert into shares right away, so the impact to the stock price is light compared to POs," said Shaw Kitahara, director at Daiwa Securities in Tokyo.

"Of course, no matter how high the conversion premium is, there is no guarantee that the CB will not be converted. There's always a chance," Kitahara added.

Therefore, some Japanese companies include clauses in their CBs spelling out further conditions to blunt any potential impact on their stock price.

Some CBs, including those issued in May by Toray Industries and Yamada Denki, contain net-share settlement clauses. If the company's stock price at the bond's maturity is above the conversion price, it can repay the principal amount in cash instead of shares, and only give investors shares for the value above the conversion price.

Such issues usually have an upside "contingent convertible" or "coco" clause, making conversion "contingent" on set conditions, such as the share price exceeding a fixed level for a specified time.

Moreover, some companies, including Toray and Yamada Denki, which each issued 100 billion yen worth of CBs, used some of the funds they raised to buy back their own shares, which supported their share price in the near term.

"The idea of dilution down the road - who cares? If the stock price goes up by that much, then the company's doing something well," said Chris McGuire, chief executive and chief investment officer of Chicago-based Phalanx Capital Management, a fund primarily focused on Japanese convertible bond arbitrage and holds about $1 billion of the instruments.

"If the shares don't go up, the company just pays back the money, after not paying any interest on it. They've just received a free loan," he said.

McGuire estimates there are about $40 or 50 billion of Japanese convertibles outstanding, roughly 10 percent of the global supply of the instruments.

He typically sells away the fixed-income portion of the convertible through an asset swap, and keeps the equity option.

"Even though it's zero-coupon, based on the credit worthiness of the company, we can sell away the fixed income to a counterparty, who then will sell us back an option," said McGuire. "A Japanese pension fund, or trust fund, or regional bank that wants yield is happy to buy it."

(1 US dollar = 103.7800 Japanese yen) (Reporting by Lisa Twaronite; Editing by Simon Cameron-Moore)