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					Insight
Exchangeable Bonds
Protecting the Non-Tradable

13 Jul. 09

The introduction of exchangeable bonds last year was chiefly to mitigate the impact of non-tradable shares becoming tradable. As well as diversifying and boosting the bond market, it was designed to help non-tradable shareholders in financial straits and assuage stock market investor concerns about significant numbers of them selling down when the shares become tradable. This should, in theory, support the stock market during the resumption of IPOs. The first to issue them will, however, be the loss-making 8.7bn yuan healthcare company, Joincare, in order to raise funds to repay bank loans, replenish working capital and fund R&D. The company on which it raised the bonds was HK$7.9bn healthcare company Livzon Pharmaceuticals, of which all shares are tradable. Their use may therefore be fairly limited, but it does indicate a greater openness to bond financing developing in the current markets.

Background
On 5 September 2008, the CSRC released Trial Provisions for the Offering of Exchangeable Bonds by Shareholders of Listed Companies (“Provisions”). The CSRC stated that the issuance of Exchangeable Bonds was to improve the capital market structure as they would facilitate the balanced development of stock and bond markets and, more importantly, ease the capital shortage for non-tradable shareholders. To limit the risks and protect creditors' interest in the issuing of exchangeable bonds, a listed company's net assets had to be at least 300m yuan. In addition, some key changes were made, including shortening the lockup period of shares, lifting their lower limit prices, clarifying their legal status and covering the proceeds for guarantee.

Exchangeable Bond and Convertible Bond
In November 2008, there were 37 CBs in the market (although this number has now decreased), but no EBs. The CSRC considered the introduction of EBs would be a welcome addition to CBs because EBs bear lower risk than CBs and are non-dilutive to earnings.

Table 1: Convertible vs Exchangeable Exchangeable Issuer Shareholders of listed companies Purpose Non-specific investment projects Source of shares Shares held by issuer in other listed companies Equity dilution No Collateral Shares for exchange Debt-to-equity term Twelve months post issue
Source: CSRC

Convertible Listed companies themselves Specific projects Issuers’ new offering Yes Provided by a third party Six months post issue

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China Policy In-depth

EBs Prevent Shareholders Selling Down

• First, EBs provide another channel for shareholders of listed companies to manage their market value and conduct debt financing. EBs’ interest rate is generally lower than ordinary corporate bonds and the bank lending rate, thus saving on interest payments. When all stocks are tradable on the securities market, shareholders can use this financial instrument to manage their market value. • Second, it is a new liquidity management tool for listed company shareholders. Instead of having to sell their shares to meet urgent capital needs, shareholders can issue EBs. The Provisions stipulated that bond investors can exchange their bonds for the share of companies only twelve months after closing the issue and in a gradual manner in order to minimize the negative impact on the secondary market. It can also mitigate the impact of the large scale release of non-tradable stocks on the market. • Third, as the EB has already set the future debt-to-equity exchange price in advance, this should mean that most of the bond holders are investment institutions which recognize a long-term investment value in the company. This should help stabilize market expectations and guide long-term and rational investment. • Fourth, it was hoped that this new product would strengthen the connection between stock and bond markets, as investors’ interests are aligned with both the interest income and the equity performance. Risk diversification and the low risk of EBs make them suitable for insurance funds, the NSSF, pension funds and enterprise annuities, which are at present around 90% invested in fixed income rather than equities.

Requirement for issuing EBs
For the listed companies whose shares are going to be used for the debt-to-equity exchange, they should have net assets of no less than 1.5bn yuan, or a weighted average net asset income rate of no less than 6% in the previous three fiscal years. The issuance amount should be no less than 50m and cannot exceed 70% of the market value of the shares used for the exchange, so only those shareholders with holdings of more than 72m yuan can issue bonds. Data from Wind show that about 1,152 companies can meet the above requirements and many of them are in the fields of chemical engineering, transportation, machinery equipment, information services, chemicals, nonferrous metals and real estate. According to our estimates, of the 1,152 companies, 2,100 shareholders have restricted shares with a market value of more than 100m yuan and 1,492 of them have holdings of more than 5%. Most of those which quality for EB issuance are big non-tradable shareholders (ie those who have more than 5% non-tradable shares).

Comment
Non-tradable shareholders which want to manage the market value of their restricted shares are the main candidates for issuing EBs. The problem here is that releasing nontradable shares is a stage that China’s stock market has to go through and, although most companies can count on some substantial shareholders and some policy support, expecting these to sustain market prices is unrealistic. Instead of offering an efficient solution for the problem of non-tradable shares, the initiation of EBs is designed to provide some comfort for investors after the resumption of IPOs, especially with China Construction trying to raise 40bn yuan. In order to avoid an overly negative impact on the market, favourable policies will be released in order to counter this effect. For instance, shortly after the IPO resumption announcement was released, the policy on state-owned shares transfer to NSSF also came out. As with this latter case, however, the Joincare issue shows that the policy may not deliver quite as promised.

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