Japanese companies have not fully participated in the global equity-linked issuance festival this year. But recent months have seen share prices surge, bond yields escalate and the economic outlook improve. There is a also a busy redemption schedule of numerous outstanding issues. EuroWeek asks if all this could be the catalyst for the long-awaited CB issuance bonanza?
Equity-linked specialists in Japan and the UK see a variety of reasons for the relatively quiet equity-linked market. First, underlying share valuations have until recently been depressed, meaning that issuers have been reluctant to step up to the plate.
Second, there have been some jumbo deals completed in recent years which have severely damaged the underlying share prices, which has scared many would-be issuers away.
Third, at least until bond yields surged after hitting their early June lows, domestic debt markets and borrowing rates have been so aggressive as to make even negative yields unappealing to issuers.
But many now believe that all the ingredients are falling into place for the long-awaited convertible bond issuance windfall for issuers, investors and arrangers alike.
The recovery in the equity markets and higher borrowing costs in the debt markets are making convertibles a more compelling option for issuers and most banks expect to see higher issuance levels in the next six months.
"We are approaching a different time," says Chris Mothersill, managing director and co-head of global capital markets at Morgan Stanley in Tokyo. "Yields and spreads have risen and the stock market has rallied. A more constructive equity market, combined with accelerated offerings which limit equity market exposure during deal execution, should help address issuer concerns about adverse underlying share price movements.
"The result is that the second half of this financial year (2003-2004) should be far more active."
However, this time last year, many CB specialists in Tokyo and London were hoping that this calendar year would be the turning point. They were expecting far greater issuance than has been seen.
"For years, the key factor holding back convertible issuance has been an aversion to share dilution by Japanese corporates as they have sought to increase their share prices and improve return on equity," explains Jason Milazzo, managing director and head of investment banking at Morgan Stanley. "This thinking has changed recently with a view that equity and equity-linked financings can be additive to shareholder value if the use of proceeds can be justified."
Earlier this year, lower share prices and attractive credit markets made convertibles un-appealing from an equity and a debt perspective.
In addition, the jumbo Fujitsu and Mitsubishi Corp CBs of 2001 live on in local folklore as warnings to issuers, arrangers and investors. In both cases, the stock prices slumped before pricing. In the case of Fujitsu, the low bond floor of just over 80% might have offered investors insufficient downside protection - before long, the underlying shares slumped to less than half the conversion price.
Higher bond floors help arrangers and issuers secure greater participation from outright buyers, rather than the arbitrage funds that tend to beat down the stock price as they set up their delta hedge strategies to take primary market exposure.
|Top bookrunners of Japanese Equity-Linked issuance - 2003 (October 15)|
|Rank||Bank||Amount ($ m)||No. of issues||Share (%)|
|4||Bank of Tokyo-Mitsubishi||398.16||4||6.83|
|5||Credit Suisse First Boston||396.49||2||6.80|
|8||Daiwa Securities SMBC||162.84||2||2.79|
|Total eligible issuance||5,832.51||33||100.00|
Both of these deals tainted the market and made large corporates reluctant to recommend convertible financings.
Stefan Green, managing director at Goldman Sachs, sheds further light on the lack of issuance. "The interest rate differential between straight bonds and convertible bonds is less in Japan than elsewhere, so CBs are relatively less attractive," he says. "In contrast to many international markets, Japanese issuers tend to focus on CBs as equity issuance and therefore on the strength of the equity story underlying the issue, whereas foreign companies often view CBs as attractively priced debt with the value of the equity option less story-dependent."
Activity to pick up
Green hopes that despite these factors, CB issuance from Japan should soon pick up. He notes that two-thirds of the outstanding universe of CBs is maturing within the next 12 months and much of that needs to be refinanced.
Another banker highlights the irresponsible issuance splurges by corporate Japan in the past. "Part of the current reluctance stems from the bad experience Japanese companies have had in the past," says Tomonori Ito, managing director and head of investment banking department at UBS Securities Japan. "They issued too much equity and equity-linked paper during the bubble period regardless of the need to do so."
Quite apart from depressed share price levels in recent years there has been a big shift in thinking about the price at which equity should be offered by companies. "Pre-1990," says John Howland-Jackson, CEO at ING Barings (Securities) Japan, "there was a cavalier disregard for the pricing of equity since the ever-rising market took care of the problem. But that is far from the case today. Furthermore, in a low interest environment it is hard to get value for the equity link - premium issue pricing and very high conversion premiums become unpopular. As the stock market improves and interest rates eventually rise, the stage is set for significant equity-linked issuance."
On the demand side, appetite for Japanese equity-linked paper is as robust as ever, especially in the Euromarket. One reason for the record issuance in the US and Europe is that equity markets there have been volatile while share prices remained far below levels at which companies were willing to sell new equity.
"In Japan, that dynamic holds true as well," says Jesse Bhattal, chief executive officer for Asia at Lehman Brothers, "but until recently, many Japanese stocks have been even more dramatically below historical levels, volatility had been trending down, and interest rates remained incredibly low."
Bhattal notes that the tightening of Japanese corporate credit spreads in the past year made straight debt financing more attractive, lessening the appeal of monetising equity volatility to reduce alternative funding costs. "This situation will no doubt change if interest rates return to more normalised levels and a greater equity culture develops among major corporates in Japan," he says.
Noriyuki Ushiyama, head of global investment banking at Nomura Securities and senior managing director of Nomura Holdings, concurs. "With interest rates now turning around after bottoming out, higher share price levels and a necessity for corporates to strengthen their capital, the situation is gradually changing."
Miki Niiyama, managing director and head of the ECM team at UBS in Tokyo, is similarly optimistic. "Since the equity market rally began in June, there are more mandates being awarded and we are optimistic about volume going forward," she says. "Rising bond yields, relatively high yields on equity from a historical perspective and surging volatility in a broadly rising market all make for excellent reasons to consider convertible issues."
Niiyama's colleague Ichiro Ouchi, executive director in the ECM group at UBS, adds: "Combine these factors with redemptions of outstanding, long dated convertibles of up to ¥2tr per annum in the next couple of years and there are compelling arguments for a boom in equity-linked issuance."
If such a boom does arrive, it will be the Euromarket that will soak up the bulk of the issuance.
Euromarket to take the strain
The offshore market has proved time and again in recent years that international fund managers are prepared to pay more for volatility than local investors.
"Most of the domestic issues have traditionally been sold to retail buyers, which have judged the issues by their own yardsticks," says Ouchi. "They are really not interested in volatility, or in downside protection of their capital. They want to see a yield and a relatively low premium, but the better quality companies can issue overseas with far more alluring terms. The only really strong argument for issuing at home is to bolster retail interest in a company, but that is not best served with a convertible issue."
The lack of institutional interest in the equity-linked market within Japan is also noteworthy. Funds in Japan have been trying to switch out of convertibles and into the underlying equity. Like the retail market, they do not ascribe much value to the option.
In the third week of August, Nomura helped CSK Corporation set a new record for a Japanese convertible bond, registering a 74% conversion premium on its ¥23bn Euroyen issue. CSK's 250 day historic volatility of almost 60% was vital to the high premium. When Alps Electric achieved its record premium of 47.1% in May, it was priced off a historical 250 day volatility of about 44.5%.
CSK's deal was, like all of the more aggressively priced deals in recent years, launched into the Euromarket, where investors are willing protagonists in the game of pushing out the envelope of equity-linked terms.
The trick in pricing the ¥23bn of eight year, zero coupon notes was in persuading investors to pay up for the volatility while obtaining a negative cost of funds for the issuer.
"The record premium was made possible by a particular set of circumstances all aligned in favour of CSK," says Duncan Beattie, convertible bond specialist at Nomura in London. "There has been huge demand for convertible paper across the globe this year, but Japanese issuers have been more notable by their relative absence from the party."
CSK's low yield of about 0.3% meant that the CB investors were not penalised for owning the convertible notes. And the stock borrow cost of just 0.75% a year is unusually low for a Japanese company.
CSK issued into a mood of growing optimism in the Japanese stock market. The major indices were all climbing sharply on surging volumes, the Nikkei 225 racing from a low of roughly 7,600 to above 10,000 at the time of issuance.
The high premium party began this year in the US and migrated into Europe, with one European issuer even achieving a 100% premium.
Although everyone had been hoping for a rush of Japanese equity-linked issuance, there has been little this year, giving CSK a clear run at tapping into what was and still is very high demand for the right deal.
However, the jumbo premium meant that outright buyers and the traditional European CB buyers were content to largely sit this deal out. This was one for the hedge funds.
Some Japanese issuers might be wary of dominant hedge fund involvement in their deals. However, in CSK's deals the underlying stock rose before and after the offer. "The reality is these days that the hedge funds are such a vital element of the market and they should be used to an issuer's advantage, as was the case for CSK," says Beattie.
On the button
There was some criticism in the market that Nomura priced CSK too aggressively, but the bonds quickly traded up to 103.5% and by early September were quoted stable at 106%. "All this confirms our view that the pricing was on the button," says Beattie. "We are firmly of the view that other Japanese issuers could achieve excellent terms if they snatch the opportunities on offer."
The CSK premium was more than 52% higher than the previous record, set by UBS as arranger for the ¥30bn Alps Electric CB in May. But that deal was concluded when the market was floundering, the Iraq war was only just over and bond yields were close to historic lows.
The 47.1% premium then achieved by UBS for Alps was therefore a striking accomplishment. It surpassed the previous record set on May 2, when unlikely suspect CSFB sold ¥33bn of Euroyen convertible notes for Takefuji at a nominal premium of 45%.
"Transactions this year have continued the trend of pushing the boundaries of what can be achieved in the equity-linked market," says Niiyama at UBS. "That has since gone further, but each of the new benchmarks represent reasons for corporate Japan to re-focus on the potential of the market."
All these transactions prove that the Euroyen CB market is more competitive than the domestic CB market, which has lagged behind in the terms it can produce for Japanese issuers.
The environment for pricing of this kind has been improving steadily in recent years. In February, Nomura lead managed a ¥23bn Euroyen CB for linear motion manufacturer THK. That deal achieved more than 25 times oversubscription and more than $5bn of orders.
Citizen Watch had been the last Japanese company into the Euroyen market when it sold a similar sized deal through Nikko Salomon Smith Barney in September 2002.
That helped set the tone for the THK offering, but again confirmed the price leadership of the Euromarket. The seven year notes were sold with a 34.5% premium and a 102.5% price to give a negative cost of funds to Citizen.
A spate of convertible bonds for Japanese issuers in the first week of September signaled both the end of the summer recess and the reinvigoration of the Japanese equity-linked market.
Perhaps the most intriguing of the new issues was the ¥8.5bn plus ¥1.5bn greenshoe 20 year Euroyen convertible for Autobacs Seven Co, which has a network of 500 franchised stores offering car parts and servicing.
Lead manager Merrill Lynch tried out its proprietary convertible bond 'HiPr' (high premium) structure for the first time outside the US market.
The structure allows an issuer to price its convertible notes at a higher conversion premium than would appear possible based on the headline historic volatility number.
The issue and redemption prices were par and the offer price 102.50. The yield to final maturity is -0.125% a year. However, to the first put at the end of year four, the yield is -0.625%.
The 40% conversion was high for a stock such as Autobacs. However, based on a rather complex formula, the investors also receive a capped quantity of additional shares if the share price rises above the conversion price.
Autobacs' 50 day volatility is 26%. That would normally imply a conversion premium of no more than about 20%, depending on the issue's other terms and conditions.
Moreover, the company's dividend yield of 1.57% and the lack of ready stock-borrow would both also hold down the conversion premium under normal circumstances.
The structure was designed to give Autobacs a higher conversion premium than such an issuer with low historic volatility could normally achieve.
Merrill's structure effectively offers investors additional call options, for which they are prepared to pay a higher price in terms of the nominal premium - more than doubling the premium Autobacs might have expected in a more plain vanilla CB structure.