TAIWAN'S DIRTY LITTLE SECRET
Taiwan's CFOs face the reality of convertible bonds
By Jasper Moiseiwitsch

When Taiwanese chipmaker Macronix raised US$80 million in convertible bonds last January, its share price immediately fell 12 percent. This is typical. Convertible bonds tend to go straight into the hands of hedge fund managers, who quickly enter a complex game of "dynamically hedging" the instruments. This involves short selling the underlying shares, with all the toxic effect this has on the stock price.

Using data from Dealogic, which tracks capital markets, CFO Asia compiled a list of all the US dollar convertible deals done in Taiwan in the past six months. In every case except one, the underlying share prices of the issuing firms fell in the five days before pricing, to five days after pricing.

When CFOs plan a convertible bond issue, a burst of short selling almost always occurs in the immediate period around pricing - a fact described as a "dirty little secret" by one banker. Confirms Shui-yee Leung, a convertible bond analyst for ING Bank: "In convertible deals, hedge funds usually start short selling the stock just before the issue is priced - in anticipation of share price decline - and just after, so they can hedge their equity position.".

Beware the Hedge Fund

It's not ideal, especially when stock markets are as weak and volatile as Taiwan's. When hedge fund investors push stock prices down, it could trigger a general sell-off. Hedge funds don't take a view on a company's fundamentals, yet can influence the bets of those who do.

Most CFOs hate hedge funds. The funds don't buy and hold, they repel long-term institutional investors and they engage in that nasty business of short selling. Most CFOs put limits on a deal's hedge fund distribution, but bankers involved in Asia's convertible markets say Taiwan's CFOs rarely do this.

In a recent deal (priced January 27) Far EasTone issued a US$115 million convertible without minding its majority hedge fund distribution. Champion Lee, the CFO of parent Far Eastern Group, notes that lead manager Morgan Stanley bought the deal and he wanted to give the bank a "free hand" in its distribution.

Lee says Far EasTone (FET), the island's third largest mobile phone company, saved two percentage points on the bonds compared to what it would have paid on a bank loan. FET's five-year convertibles pay a one percent yield-to-put and a one percent yield-to-maturity - cheap debt no matter how you slice it.

The company pays for that cheap debt with an equity option. The bonds can be converted into shares at a 17.5 percent conversion premium (set at FET's spot at time of pricing).

"We believe that the bond will be converted, [and] this is cost-effective equity funding," says Lee. "We will consider a DR [depository receipt] issue but, for telecoms, certainly share values are still very depressed and it is not really the right market."

Danny Palmer, a Morgan Stanley managing director who participated in FET's recent deal, says CFOs look at these deals in straight capital costs terms, and not in terms of the abstract valuations used by hedge funds. "CFOs are not options traders. They are selling the option outright [when they issue convertibles]. They are thinking about their absolute cost of capital, which in Far EasTone's case was very good."

Finance professors might note that the convertible's costs are not so abstract after all. Where FET saved on its borrowing costs, it had to pay in the form of opportunity costs: It gave investors an equity option that subtracts from FET's own opportunity to sell shares later at a higher price. And when you add to this calculation the hidden costs of selling to hedge funds, Taiwan's convertible market might not look so attractive.

Jasper Moiseiwitsch is a senior writer - Hong Kong for CFO Asia.