The Japanese convertible bond market has shifted into overdrive in 2004. The lion's share of the activity has been in the Euromarket, with the domestic market relegated to second best. Outlook is as good as ever.
International bankers in Tokyo have for several years been predicting the eventual arrival of an inflexion point at which corporate Japan would decide that convertible bonds are back in favour. That moment arrived this year.
?The convertible bond market has made great steps forward in the past 18 or so months,? says Christopher Mothersill, managing director at Morgan Stanley in Tokyo. ?More companies have warmed to the structure. The deals are larger, more issuer friendly and the rapid bookbuild execution of deals combined with positive sentiment has resulted in generally minimal impact on the stock price.?
Whereas Japanese firms had for many years tended to look cautiously, often unfavourably, on the CB market, sentiment has changed sharply during the past 12-18 months.
The terms have not only become compelling, but the generally more positive sentiment towards Japanese equities has meant that the negative impact on stock prices is usually much less than the theoretical dilution effect.
These factors, often combined with structural features that will encourage conversion, make an enticing cocktail for those Japanese companies seeking to sell equity forward at a premium and also in the meantime obtain zero or sometimes negative cost of funds.
In the process, the Euromarket has finally beaten the domestic market into second place. ?The international market offers much better terms, as well as ease and speed of execution,? says Mothersill. ?As in other global markets, the terms today are not as aggressive as earlier in the year. But there is still plenty of international money out there seeking interesting opportunities to play the Japanese market and CBs offer issuers and investors a fair equation of limited downside and tangible upside.?
CB specialists report that many of the traditional European CB funds and outright buyers had earlier in the year been swept aside by the deluge of hedge funds and other new-to-Japan money that had bid up pricing in what was a global wave of euphoria. During that time, Japanese and other Asian issuers were literally inundated with money.
Salim Salam, a director in the equity syndicate at Nomura in London, says that the CB market has, since the middle of the year, returned to more conservative pricing levels. ?This is a global phenomenon, whereby price leadership is again driven by the specialist CB funds and outright buyers,? he says.
Salam notes that there are again three main players in the Japanese CB market ? the CB arbitrage funds which are the traditional buyers, continental European banks active in Japanese equities and wanting to increase their exposure, and private banks.
?Even during those times when pricing became very expensive,? explains Salam, ?we tried to maintain our focus on these three main constituents in order to provide our clients with access to a slightly longer term buyer and to achieve stable secondary market performance.?
There were numerous landmark transactions during the first nine months of 2004. An early deal, which was priced in late February, saw Japanese camera manufacturer Nikon became the first Japanese issuer of a convertible bond with a soft mandatory conversion provision, raising ¥30bn through Morgan Stanley.
The soft mandatory provision means that, whatever happens to the underlying stock, the issuer is assured of converting all the bonds into shares at maturity. But if the underlying shares have fallen in value below the principal amount of the bond, the company will have to pay the difference in cash.
For Nikon, this meant that even if the share price falls below the conversion price of ¥2,058, the firm will be able to issue all the 14.8m shares that underpin the bond. But it will have to pay the difference between the share price at maturity and conversion price.
Says Mothersill: ?This was a breakthrough for Japan as we imported for the first time a soft mandatory call provision, a feature that had been pioneered in the European equity-linked market by issuers such as France Télécom. In the case of Nikon, it is an example of a structural innovation to help an issuer achieve its conversion objectives at the same time as achieving a full and fair pricing.?
When Morgan Stanley priced the much larger ¥100bn convertible bond issue for JFE Holdings in late May (see box on page 75), the most issuer-friendly pricing available in the CB market had already passed. Nevertheless, the terms available to the high quality end of the issuer market, in other words to many Japanese companies, remained alluring enough ? although not quite as compelling as in the early months of 2004.
The JFE Holdings CB, for example, was priced at par and offered not at the standard 102.5% but at 105%. ?This is the record offer price for a large CB from Japan,? says Mothersill. ?Combined with the early low hurdle [110%] call feature, this enabled us to maximise the terms available to JFE but also to secure a relatively high likelihood of conversion. The structural feature broke new ground and illustrated an elegant use of the various tools that a CB can offer to meet issuer objectives.?
Not only did JFE obtain the optimum pricing available at that time, but the structural features should also produce a high likelihood of conversion into the underlying equity JFE is aiming for.
EuroWeek asked Tetsuo Miyazaki, executive vice president of JFE Holdings, for his views on the transaction.
In June, you sold a ¥100bn CB for JFE Holdings, guaranteed by JFE Steel Corporation. What was the objective of the transaction and why the timing?
We issued the CB with a conversion premium of 40% at ¥3,465 per share, a level at which we are confident that the bond will convert, thereby accelerating the strengthening of our balance sheet.
There were three reasons for opting for the Euromarket issue. First, it enabled us to minimise the earnings per share (EPS) dilution impact by setting the conversion price significantly higher than the market price at launch. Second, it enabled us to accelerate the strengthening of our balance sheet through conversion as our share price rises. Third, it enabled us to minimise the interest costs until the bond converts thanks to the zero coupon feature.
We had also considered an equity offering, but believed that our share price did not fully reflect all the upside stemming from the merger and the current strong business conditions. In addition, we considered the EPS dilution, which would have resulted from an equity offering, would be too large.
In terms of timing, we saw positive market conditions and launched after announcement of annual results and current year forecast on May 20. These results were the first to reflect the full consolidation of Kawasaki Steel and NKK in April 2003 under JFE Holdings. We believe that the exceptionally successful merger between two major steel companies was one of the key factor for the success of the CB issue.
The soft call after three years at 110% also broke new ground for a Japanese CB issue. Can you explain the objective of incorporating that feature?
As this was JFE's most important capital markets transaction since it was formed through the merger of Kawasaki and NKK in 2002, what was the key message you wanted to convey to investors?
Plenty of steel
This was JFE's most important capital markets transaction since it was formed through the merger of Kawasaki and NKK in 2001. The deal also represented another major breakthrough for Morgan Stanley. It was the firm's first sole bookrunner role for a jumbo Japanese convertible, although it had won such roles on a number of smaller CB offerings in recent years and had earlier been joint bookrunner with Daiwa SMBC for the ¥100bn NEC Electronics CB.
Ichiro Ouchi is executive director at UBS in Tokyo and runs the firm's CB thrust. UBS has won and converted several prestigious CB mandates this year, building on the platform the firm has constructed in the past several years in Japan.
The bank helped Kobe Steel raise ¥30bn in January. ?The company had not visited the equity-linked market since the early 1990s, so this was in many ways a breakthrough transaction and to some extent indicative of a sea change in the approach of Japanese companies to issuing either CBs or equity,? says Ouchi. ?The company had a very positive outlook and wanted to raise fresh equity, but not at the levels at which the stock was then trading.?
UBS had launched the deal with two variables, the offer price and the premium, and priced it at the top end of both ranges ? a price of 103.50 and a 60.3% premium. The terms translated to implied volatility of 43%, close to the historical figure of 50% for the previous six months.
On all three counts, the pricing underlined the demand for Japanese equity-linked paper as well as the bullish outlook for the steel sector. The terms were all the more impressive, as the shares had risen more than 130% since January 2003.
UBS also navigated Japan Airlines to a smooth landing for its jumbo ¥100bn convertible that touched down in the Euromarket in mid-March. The deal sold out in less than three hours.
Asia's largest carrier by sales had the previous week announced its plan and earnings forecast for the next three years. The fundraising was also part of the re-organisation that followed Japan Airlines' merger two years ago with Japan Air System.
?Timing of the deal says much about the approach of Japanese companies to the equity capital markets,? says Ouchi. ?Corporate leaders are eager to sell deals when they have a good story to tell. In this case that helped the stock hold up well, slipping less than 3% the day after pricing, although the theoretical dilution is 12%.?
Toshiyuki Kawarabata, vice president and general manager, finance, at Japan Airlines, says: ?We need funds to accelerate the integration of the two international and domestic airlines, to upgrade aircraft and IT systems, and to unify the brands. The CB gave us a low cost funding and assuming conversion will strengthen the balance sheet. We now aim to be the world's top airline group in terms of service quality and business volume.?
Printing money overseas
Toppan Printing's ¥60bn CB, also in March, was a variation on the CB theme, structured with a long maturity and more for low cost funding than as deferred equity.
Merrill Lynch incorporated the CoCo (contingent conversion) feature and a maturity of 20 years, with regular puts throughout its lifetime. This is very rare for a yen denominated CBs ? there had only been two others at that maturity, Autobacs Seven and Nipro in 2003.
Conversion will take place at a premium of 53%, but only if the stock price reaches 120% of the conversion price for 20 consecutive days in any three month period. This feature lowers the probability that the bonds will convert and means Toppan will not yet have to dilute its earnings per share.
The structure and the use of treasury stock underlying the issue resulted in minimum dilution to existing shareholders. ?For a highly rated credit, convertible bonds such as this with controlled dilution offer the client an attractive alternative to straight bonds,? says Alex Woodthorpe, managing director and head of equity capital markets at Merrill Lynch in Tokyo. ?The CoCo feature has the added advantage of allowing the issuer to defer accounting for the issue as issued equity, and hence diluting its earnings, until it converts.?
NEC Electronics' next step
NEC Electronics Corp concluded one of the most successful large IPOs of 2003. The company's next major equity capital markets exercise came in May of this year after the usual end of financial year lull, when it raised ¥110bn through a Euromarket CB issue (see box below). The deal should be seen in the context of the NEC group's adept and timely use of the capital markets.
?NEC is a poster child of enlightened restructuring,? says Mothersill. ?The company has earned a reputation for testing the market's response to its restructuring through a series of planned and staged market sorties. And with every deal having been so well received, investors have clearly voted in support of the company. Other Japanese companies have been encouraged and emboldened by NEC's example and we will see more dynamic use of the equity market by Japanese issuers.?
NEC Electronics' ¥110bn issue was priced after the worst day of trading on the Japanese stock market since September 11, 2001. Yet the offer was more than four times covered through the efforts of joint bookrunners Daiwa SMBC and Morgan Stanley, the same two banks that arranged its July 2003 listing.
Last year's IPO was priced at ¥4,200 a share, and the stock closed at ¥6,660 on the day of pricing the CB. The conversion price was set at ¥9,860 ? a premium of 48.05% to market and 135% above the IPO price.
The bond was the same as 40 days' trading in the shares and 30% of freefloat, which was itself 30% of the company. NEC owns 70%.
Nomura peaks with Toshiba
Nomura has long been a market leader for CBs and this year is no exception. Nomura and Nikko Citigroup in February priced Pioneer Corp's ¥60bn debut CB. The transaction was at that time 2004's largest convertible from Japan and one of the world's biggest.
Nomura had enjoyed a remarkable week in March, launching three CBs for Showa Denko, NTN and Kawasaki Kisen. ?The deals came from different industry sectors and offered a variety of credit ratings and equity stories, but the common theme was the very enthusiastic demand,? says Norio Nakamura, director of the equity syndicate at Nomura.
Nomura's landmark deal of 2004 was also the year's biggest. Toshiba Corporation in early July sold a blockbuster two tranche ¥150bn issue with Mizuho International and Nomura International as joint bookrunners.
Toshiba sold a ¥50bn tranche of five year zero coupon bonds and another ¥100bn of seven year zero coupon notes. The conversion premium for the smaller tranche was set at 30.16% and for the larger issue at 20.18%.
?At the time, there was a growing confidence in equities, especially in Japan, where the market indices had been performing well,? says Salim Salam at Nomura. ?The Toshiba deal has been one of the most accurately priced deals targeting the Euroyen markets. In addition, the bonds were placed with long term sophisticated investors who were attracted to the company and the CB instrument.?
NEC Electronics preaches to new investors with ¥110bn convertible bond
Joint bookrunners Daiwa SMBC and Morgan Stanley, the same two banks that arranged the company's July 2003 listing, priced the ¥110bn CB with a conversion price of ¥9,860, a premium of 48.05% to market and 135% above the IPO price.
Keiichi Yoshida, general manager of the treasury division, finance unit at NEC Electronics, gives his views on the issue.
To what do you ascribe the strong demand for the bonds, despite the aggressive pricing?
Why did you opt for the CB route rather than an equity issue?
Did you consider the terms you could have achieved in the domestic Japanese CB market?
What was the key equity message you wanted to convey to investors at the time of the issue?
The stock closed at around ¥5,300 on September 3. Does it concern you that the effective premium is now more than 85%, or do you consider that the CB investors are well placed by owning bonds that have low downside and tangible upside?