India 2007: Challenges stack up for Indian equity-linked
India continues to be the motor that drives the regional converts industry. By mid-2007 the country had handily surpassed issuance volumes of 2006, which was a record year. The Indian CB market is also well positioned to shrug off global credit concerns, given that it is an issuer’s equity story rather than its creditworthiness that drives primary volumes. However, the industry will have to battle investor fatigue and a policy bias against mid-cap issuers.
In the 3-1/2 years since opening up, India’s offshore CB market has earned a reputation for intense cyclicality. The market does not coast gently up or down, it lurches from boom to bust. However, at the core is a vast issuer base that sees the CB product as the perfect instrument for capturing equity upside.
With the Sensex up about 160% since the CB market opened in January 2004, getting exposure to that upside is no small matter. Investors have largely made money in this market, which has explained continuously keen demand-side interest. No matter how mispriced or mis-structured, nearly all Indian CBs share the virtue of making money for fund managers.
A great case in point is Vedanta Resources. In January 2006 Barclays led a US$725m 20-year CB for the London-headquartered, India-based mining company. Barclays offered investors a bond that converted into depository receipts with no voting rights. Unlike two convertibles led by Citi in India (using the so-called CARS structure, which priced in mid 2007), the Vedanta bonds did not compensate investors for the discount of the non-voting DRs, and did not address potential illiquidity of the DRs. The Vedanta deal flopped.
However, in the 1-1/2 years since, Vedantas share price has climbed about 90%, largely thanks to a continued boom in metals prices. The upshot is that Vedanta CB has traded into the money.
A surging underlying equity price saved that deal, as has been the case in so many other aggressive Indian convertibles.
That equity resilience stands as the great hope of Indian CB pipeline. Notably, Indian share markets largely withstood the sell-offs seen in much of the rest of the world in early August as the sub-prime crisis started to bite.
“A year and a half back, India would have significantly underperformed regional markets, amidst similar global volatility. This year Indian markets have been fairly robust,” said Achintya Mangla, JPMorgan’s head of Asian equity-linked and corporate equity derivatives. “The strength of India’s equity markets is attributable to the good core fundamentals of the Indian economy and the growth and profitability of Indian companies.”
Nevertheless, the Indian converts industry has been hurt by the global credit squeeze. By way of rough guidance, the State Bank of India CDS traded at 50bp over Libor before the sub-prime crisis. At late August, high season for the sub-prime contagion, the benchmark credit traded at a Libor spread of 90bp-plus. The effect on lesser names has been more dramatic.
It was noteworthy that in mid-August Standard Chartered had to back up the US$875m CB for Tata Steel with a letter of credit. The BB rated (S&P) entity is among India’s best. However in the thick of sub-prime crisis this issuer found it difficult to access markets under its own steam.
On another front, the Reserve Bank of India’s (RBI) desire to push Indian companies away from offshore borrowing is affecting converts issuance. In August the RBI implemented strict new rules limiting such borrowings of greater than US$20m to specific end uses. In implementing the new rules the RBI was cutting the inflow of foreign dollars into the country to stave off inflationary pressures and appreciation pressures on the rupee. The regulator was also seen to be looking to restrict the offshore market to Indian mid-caps, which have used CBs aggressively.
The RBI was right to be concerned about mid-cap issuance. The Indian CB issuer universe is increasingly populated by marginal, unknown issuers of negligible equity capitalisation.
This year has seen issuance from many of India’s lesser known corporate names like Pioneer Embroideries, Aarvee Denims & Exports, Kamat Hotels and Pyramid Saimira Theatre. Fingers crossed, all these issuers will trade into the money and be able to repay their debts.
However, no Indian CB has hit its maturity date since the market reopened in 2004. The default scenario has yet to be tested – no one knows what the impact a bankrupt issuer would be, especially on the many lower-grade credits.
In that vein, the RBI may just be acting prudently by curtailing this market. The regulator’s decision in May to cut the borrow cap from 350bp over swaps to 250bp was also seen as an attempt to weed out weaker credits from the offshore market.