Stimulating Korea s Convertible Bond Market and Proposed Improvements

Transcription

1 Stimulating Korea s Convertible Bond Market and Proposed Improvements Kim, Pil-Kyu A convertible bond is a type of debt security that provides an investor with the right to convert the bond into the shares of the issuing company when a certain time has elapsed since the bond issuance. Demand for convertible bonds in Korea has surged following the recent launch of KOSDAQ Venture Funds. The issuance volume of convertible bonds has risen 12.4% yearover-year in September 2018, and the proportion of KOSDAQ firms in the convertible bond market also has gone up to 68.0%. Currently, the vast majority of convertible bonds in Korea are issued in private placements. This leads to a lack of disclosure, low market transparency, and likely emergence of issues related to the protection of current shareholders. Furthermore, refixing the conversion price could give rise to the share dilution of current shareholders. Convertible bonds are the source of funds well suited for innovative firms. Given that, key factors that affect financing facilitation for and sustainable growth of innovative companies are improving institutional arrangements for sound development of the convertible bond market and enhancing market participants capabilities. To facilitate the sound market development, it is important to revamp the disclosure regime for convertible bonds to ensure greater market transparency, and to consider the introduction of restrictions on the refixing frequency, period and ceiling in the long run. In addition, it is advisable to come up with ways to enhance convertible bond investors ability to conduct a corporate analysis. All opinions expressed in this paper represent the author s personal views and thus should not be interpreted as Korea Capital Market Institute s official position. Ph.D., Senior Research Fellow, Capital Markets Department, Tel: , pkkim@kcmi.re.kr 1

2 A convertible bond is a type of debt security that provides an investor with the right to convert the bond into the shares of the issuing company when a certain time has elapsed since the bond issuance. Demand for convertible bonds in Korea has surged following the recent launch of KOSDAQ Venture Funds. Such a rise in convertible debt issuance produces a positive impact, namely, facilitating access to finance for innovative firms. On the other hand, it can adversely affect sustainable development and stability in the convertible bond market if such issuance growth is spurred by pseudo demand generated to include convertible bonds into funds rather than voluntary demand for financing. In this context, this article outlines the current state of the Korean convertible bond market and highlights the issues and challenges facing the convertible bond market. Lastly, it discusses ways to ensure that convertible bonds will become a stable source of finance for innovative companies. Legal and regulatory changes related to convertible bonds As explained earlier, convertible bonds give bondholders the right to convert their bonds into a fixed number of shares of common stock in the issuing company when a set period of time has elapsed since their issue. Following the exercise of conversion rights, the bonds are converted into shares. The issuing company must issue new shares if convertibles are called. Convertible bonds offer a low coupon in exchange for the option to convert into shares. One advantage of issuing convertible bonds is cheaper cost of funding for issuers. In practice, convertibles are a primary source of financing for low-rated companies with high growth potential in Korea. Furthermore, they offer investors the option to convert the bonds into shares and realize a greater yield when the price of the company s stock goes up. Before 2009, only publicly traded companies in Korea were allowed to issue convertible bonds. In 2009, however, the Commercial Act was amended to allow firms, both public and private, to issue convertible bonds, exchangeable bonds and participating bonds. Meantime, the Regulation on Securities Issuance and Disclosure has provisions restricting the issuance of convertible bonds by listed firms and the exercise of conversion rights. A listed company, in the event of a dispute over its ownership or control, cannot issue convertible bonds by any means other than share allotment or a public offering. And convertible bonds may be issued and sold either through a public placement on the condition that the bonds must be called at least one 2

3 month after issuance or through a public placement on the condition that the conversion must take place at least one year after issuance. Korea s Regulation on Securities Issuance and Disclosure allows for the adjustment (or refix) of the conversion price above the pre-set minimum adjustment price 1) when the issuing firm s stock price falls. Korea s convertible bond market Trends in convertible debt issuance show that convertible bond issues soared in 2016 and then dropped slightly, but has begun rising again in The issuance volume, which had been just KRW billion in 2013, grew steadily and reached KRW 3,726.7 billion in The issuance of convertible bonds fell slightly in 2017 as compared to the previous year, but has soared again in The issuance volume rose 12.4% year-over-year to KRW 3,039.6 billion in September The main reason for the remarkable increase in convertible bond issuance in 2016 and thereafter is that medium-sized firms increased funding through issuing convertible bonds in the face of worsening funding conditions as evidenced by the shrinking primary market for corporate bonds, the weak stock market, and banks conservative stance on lending. Another driver of the growth in the issuance volume is a broader base of mezzanine investors underpinned by a growing number of investors such as hedge funds, investing in privately placed bonds, and the rising amount of mezzanine investment funds. In the meantime, the most recent surge in the issuance volume has been driven mainly by an increase in temporary demand for convertible bonds following the introduction of KOSDAQ Venture Funds. KOSDAQ venture funds can enjoy preferential allotment of 30% of the publicly offered shares newly issued on the KOSDAQ market 1) 1 Price equivalent to 70% of conversion price at the time of issuance (that is, downward adjustment within 30% of the initial conversion price) 2 Minimum adjustment price: (i) minimum adjustment price determined by a firm s articles of incorporation: (a) minimum price applicable (minimum adjustment price) where conversion price has been adjusted, and (b) where the causes and amount of convertible bond issuance subject to minimum adjustment price are specified, or (ii) minimum adjustment price determined by general shareholders meeting: where conversion price adjustment is delivered to general shareholders meeting as a matter of special resolution, and where (a) minimum adjustment price and (b) price of the bonds concerned are specified at general shareholders meeting at the time of convertible bond issuance. 3 The conversion price shall be the lowest price in case of an issuance through a public offering [the highest price in case of an issuance through a private offering] between (i) the arithmetic weighted average of the closing price for the past one month and for the past one week, (each of which is counted from the base date or one day prior to the date of adjustment) and of the most recent day, and (ii) the arithmetic weighted average of the closing price of the most recent day. 3

4 if at least 15% of the fund assets is invested in new shares of venture firms or mezzanine bonds. Amid the rush of money into KOSDAQ venture funds, demand for convertible bonds issued by KOSDAQ firms has skyrocketed and convertible bond issuance has surged as a consequence. Figure 1. Trends in convertible debt issuance Source: KOSCOM Trends in convertible debt issuance by issuer type reveal that KOSDAQ-listed firms have represented the biggest share of convertible bond issues. The proportion of KOSDAQ firms in the total issue volume was 59.8% in 2017 and has risen further to 68.0% as of September Among convertible bond issuers in the KOSDAQ market, the proportion of mid-cap firms is high, whereas that of high quality firms is low. These findings indicate that convertible bonds are used by mid-cap companies with relatively low credit quality to raise capital at a lower cost in exchange for giving investors the conversion option. 4

5 Figure 2. Trends in convertible debt issuance by issuer type Source: KOSCOM Trends in the issuance volume by placement type show that private placements have constituted the vast majority of convertible bond issues. In 2013 and 2014, the total convertible bond issues were private placements. In 2015, publicly offered convertible bonds increased and took up 18.6% of the total issues. Later, the proportion of private placements grow sharply again, reaching 99.9% of convertible bonds issued for the first nine months of The high proportion of private placements is due mainly to convertible bond issues targeted to professional investors and greater convenience offered by private placement issuance. Most convertible bond issuers tend to prefer private placements to reduce regulatory costs and shorten the issuance period. When issuing bonds through a public offering, issuers must receive a credit rating on such an issue. However, because of poor creditworthiness, most convertible bond issuers are strongly motivated to issue convertibles based on conversion value or others without obtaining a credit rating. Present issues facing the convertible bond market Present issues facing the Korean market for convertible bonds can be summarized as follows. First of all, current shareholders would not be fully protected when convertible bonds are issued in a private placement. A private placement would entail insufficient disclosure of information about the issuance. Not only that, it could cause problems with the protection of existing shareholders because a prohibition on the issuance of new shares via a third party allotment aimed to protect current shareholders is not applicable. For example, current shareholders may 5

6 not be able to respond to the issuance of convertible bonds in a timely manner if the issuance disclosure is made immediately prior to the date on which investors must make payment to buy convertible bonds (the payment date). Another problem in the domestic convertible debt market is that a refix of the conversion price could lead to a dilution of the holdings of existing shareholders. In Korea, a refix feature is added to make convertible bonds more attractive to investors. The refix option allows the conversion price of convertible bonds to be adjusted when the stock price falls. But refixing the conversion price would affect the conversion ratio, thereby undermining the interests of current shareholders. In the United States, the conversion price is determined by applying the premium or discount to the average price per share over a specified period prior to the issuance date. The adjustment of the conversion ratio is allowed only in a limited number of cases including a stock split and a reverse split. In contrast to the US, the refix is frequent for convertible bonds in Korea when the share price of the issuing company falls below the conversion price. Furthermore, most of domestic convertible bonds do not have credit ratings. Investors have no choice but to depend on their own ability and judgement to assess the credit risk of an issuer or convertible bond issue. Some marginalized firms repeatedly issued convertibles in small amounts and got delisted from the stock exchange. A convertible bond default or issuer delisting could weaken investor confidence in mezzanine funds investing in convertible bonds. Finally, supply and demand in the convertible bond market could be distorted by the transitory demand for convertible bonds that has been created as a result of the recent launch of KOSDAQ venture funds. Since KOSDAQ venture funds were introduced in April 2018, investment in those funds has grown in demand. KOSDAQ venture funds have turned to convertible bonds as a means to meet requirements for tax benefits, resulting in the sharp rise in demand for convertible bonds. An increase in convertible bond issuance could adversely affect the sustainable growth and stability of the convertible bond market if such issuance growth is shore up by pseudo demand to include convertible bonds into funds rather than natural funding demand from companies. Not only that, some marginalized firms could take advantage of the growing demand for convertible bonds and increase the issuance of convertibles. Such competition for convertible bonds among investors to include them in the funds could undermine market stability in the long run. 6

7 Proposed improvements for market facilitation Convertible bonds are the source of financing well suited for innovative firms. Sound development of the market for convertible bonds is important in that convertible bonds provide investors with an investment instrument generating high returns, while offering companies an effective funding tool that they can choose depending on their specific conditions. Hence, the institutional arrangements for the convertible bond market should be gradually revamped to address the challenges confronting the market as discussed earlier. For starters, the disclosure regime for convertible bond issuance should be improved. More specifically, convertible bond issuers should be required to disclose information about the cumulative volume of prior and new convertible bond issues. In addition, it is worth considering the compulsory disclosure of issuance information one week before the payment date for privately placed convertible bonds. Also, more attention should be given to nurturing the primary market for convertible bonds issued in a quasi-public offering. The use of the qualified institutional buyer (QIB) market needs to be considered to introduce the market structure where professional investors can invest in convertibles, along with the provision of incentives for convertible bonds issued in the QIB market. In addition, it is required to consider imposing restrictions on conversion price adjustment in the long run. By adopting rules for restricting the refixing frequency, period and ceiling, the share dilution of existing shareholders caused by the overuse of the conversion price refix should be prevented. If the refix prohibition is to be introduced soon, convertible bonds would lose their appeal to investors. Therefore, gradual improvements should be pursued. Moreover, it is important to create an environment where professional investors can make rational investments based on the analysis of a firm s growth potential and credit quality. Towards this end, more information about the creditworthiness of convertible bonds needs to be available. For instance, it is worth considering the mandatory assignment of credit ratings to privately placed convertible bonds if the issuance amount exceeds a particular amount. Additionally, investors in convertible bonds need to have an enhanced ability to assess the credit risk of companies. KOSDAQ venture fund managers in particular should further strengthen their capabilities to analyze the financial characteristics and creditworthiness of innovative firms. 7