Cracks are emerging in what has been the only hot part of China’s debt market this year – convertible bonds.
While other securities took a hammering from government efforts to deleverage, convertible notes saw a surge in issuance and, until recently, prices. So far this year, companies have sold 75.6bn ($11.4bn) of the debt which can be swapped for shares. 
The action wasn’t confined to primary markets, either: the monthly turnover on such notes has jumped more than five times from a year earlier, according to Shanghai Stock Exchange data.
From June to early September, convertible bonds behaved similarly to China’s frenzied market for initial public offerings: those who subscribed for the deals could bank on large gains when the securities started trading. 
But that’s now changing due to the avalanche of supply and a shift in sentiment in the equity market as the Shanghai Composite Index drops 4% from last month’s peak.
“Investors used to be reluctant to sell as the securities tend to surge on debut; now, with supply rising, investors tend to be more keen to sell, leading to shrinking demand,” said Wang Chen, a Shanghai-based partner with XuFunds Investment Management Co.
 “When it falls below face value on the first day of trading, it’s time for investors to become more rational.”
The S&P China Convertible Bond Index of yuan-denominated notes gained as much 10% this year through early September. But, with signs of a swelling pipeline – Tianfeng Securities Co estimates companies are considering about 400bn yuan of such sales – and redemption of bond funds due to deleveraging, the gauge has now erased the advance to trade 0.4% lower.
For much of the year, convertible debt offered benefits for both buyers and sellers. With onshore stocks outperforming bonds, the securities gave fixed-income investors a way to pad returns. For companies facing tightened rules on share issues and private placements, they’ve been a way to refinance at a relatively cheaper cost, given that coupon rates are lower than that on other debt. Plus, issuers don’t need to find cash to repay the securities, as long as they’re converted into shares.
Sales of such securities totalled 13.7bn yuan last month, data compiled by Bloomberg show. That compared with 71.6bn yuan of net financing through corporate bonds.
But there were other reasons for the market excitement, too. China’s securities regulator revised rules at the beginning of September, doing away with the need for individuals to hold a company’s shares before buying the debt, and cancelling a requirement that forced the lockup of funds before allocations were announced. This prompted brokerages to step up efforts to promote the niche market to individuals through their WeChat accounts and mobile applications, with some putting IPOs and convertible subscriptions under the same category.
“Most convertibles tend to be overvalued at issuance, given the complicated methodology for pricing, resulting in risks,” said Xiong Yun, an investment manager at Lingwang (Shenzhen) Investment Management Co. “Plus, some institutions only plan to reap quick returns after the notes start trading. By promoting the low risks of convertibles, it only helps to trick individuals who don’t have investment knowledge.”
Borrowing the IPO concept to attract investors won’t work as a long-term strategy, and it brings in investors who don’t have enough knowledge about potential perils, according to a commentary carried in the People’s Daily Communist Party mouthpiece on Monday.
There are signs that retail investors are growing less enamoured as the stock market retreats. Fresh fund inflows have been tepid, with only three new ones set up this year, compared with around 10 in 2016. Five dedicated to convertible debt are awaiting approval from the securities regulator.
The cooling of sentiment is being reflected in dwindling demand for new debt. Shanghai Baosight Software Co’s notes due November 2023 fell below their face value when they first traded on December 5. When lower-rated Beijing Join-Cheer Software Co issued a six-year bond in June, it climbed 16% on its first day.
“Compared with the surge in issuance, demand from fund managers, especially new products targeting convertibles, isn’t meeting expectations,” Tianfeng analysts led by Sun Binbin wrote in a December 1 report.


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