India 2005 - Danger zone
India’s convertible market arrived from nowhere to become Asia’s most important source of new deals, and is thriving. However, as deal-making is increasingly weighted towards small, untested companies that issue at aggressive levels, participants are bracing themselves for the Indian market’s first big blow-up. Jasper Moiseiwitsch reports.
In the 20 months since India’s equity-linked market was liberalised, the quality of the country’s CB issuers has deteriorated steadily. In the first days of deal making, issuance was dominated by a who’s who of corporate India. Six Tata companies have used CBs alongside blue chips such as Reliance Energy, Bharti Tele-Ventures and Mahindra & Mahindra.
However, the quality of India’s more recent issuers has been heading downward, a fact best observed in issuers’ declining market caps. In 2004, the average market cap of India’s CB issuers was about US$2.2bn, according to Thomson Financial. In the first half of 2005, the average market cap was just US$661m.
Meanwhile, deal size (as expressed as a ratio over market cap) is becoming increasingly aggressive. In the first half of 2005, Indian firms issued CBs that were, on average 21%, of their market cap – more than double the ratio seen on deals priced in 2004.
All of which is causing many in the industry to feel more than a little nervous. “This is a disaster waiting to happen,” said one banker active in Indian equity-linked.
Of the more aggressive trades in the first half, an Amtek Auto CB came in at 33% of market cap, Maharashtra Seamless did a deal that comprised 29% of market cap and the Monnet Ispat CB came in at a hefty 61% of market cap.
None of these issuers are rated, and none of the bookrunners on these deals regularly issue research on the firms.
It is true to say, however, that investors have not gone blindly into these deals. Bond floors have been creeping up, as has demand for asset-swap protection. Deals are typically being pitched with hedging options for at least half of the credit.
But there are very limited hedging options for the equity, with offshore investors prohibited from shorting local stocks. Occasionally, investors are offered a synthetic hedge (extracted from an index future, for example) or there might be borrow available on an existing DR. However, as the issuers become smaller and more marginal, these options are quickly vanishing.
Bankers acknowledge that investors tend to buy these deals with the equity unhedged, typically with reference to the companies’ superb recent share price performance. For example, over the past 12 months the share prices for Monnet Ispat, Amtek Auto and Maharashtra Seamless have risen 71%, 95% and 98%, respectively.
Reflecting that performance and the unwavering optimism of the issuers, Indian CBs tend to come with very high conversion premiums. For example, a recent CB for Ballarpur Industries (Bilt) was priced to convert at a 52.47% premium. Calculating in the premium that these bonds accumulate at redemption at year five, the underlying share price will have had to rise by 107% to make conversion worthwhile.
That’s a long shot even for an out-performer such as Bilt. However, the high bond floor makes the offers attractive. Bilt’s bond floor, for example, was 98.2. Investors were essentially asked to pay 1.8 points for an option to convert into Bilt over five years. That seemed an attractive offer and the deal was heavily subscribed.
But if investors decide that conversion is unlikely, they have to wonder about the company’s ability to cover its liabilities when the bond comes due, given that each CB such a large proportion of issuer’s market cap.
“This is not going to happen for another three, four years . . . but it’s distinctly possible that the market will turn and an issuer will be stuck with a massive liability that it can’t repay,” said one equity-linked banker active in India.
Reflecting that growing sense of risk, the international banks have been increasingly wary of accepting credit via asset swaps for Indian CBs, the banker added.
For now, the financial risks are fairly minor and contained. A decent asset swap market has ensured that much of the credit risk on these deals is sitting with the domestic banks, and none of the recent Indian CBs are large enough to make much of a dent should an issuer default.
However, the reputational risks to India’s budding equity-linked industry are potentially large. Everyone remembers how a CB default by tiny Procomp Infomatics sent Taiwan’s equity-linked industry into a prolonged slump.