KCC issues another exchangeable into Hyundai Heavy

Korean construction materials manufacturer KCC Corporation last night raised $200 million from an upsized five-year exchangeable bond which will be used partly to repay a $153 million loan, and partly for new investments. The bonds are exchangeable into ordinary shares of Hyundai Heavy Industries and come only five months after KCC bought back part of another EB that was partly exchangeable into Hyundai Heavy through a tender. That earlier bond was trading well below par at the time of the tender and looked to have a minimal chance of being exchanged given the sharp decline in Hyundai's share price since it was issued.

Investors didn't seem to mind this giving and taking of cash by KCC -- the tender did provide some much desired liquidity at the time and the new bonds offer a much better chance of converting into equity -- and last night's transaction met with quite good demand despite a fairly aggressive pricing and the fact that the bonds cannot be hedged. According to a final term sheet sent out by bookrunner J.P. Morgan late last night, it was able to exercise one-third of the $75 million upsize option, which increased the size to $200 million from $175 million, and a source said the bonds were trading right at par shortly after pricing.

From the beginning, it was clear that the preference from the issuer was to increase the size before tightening the pricing and it was therefore no surprise that the coupon was fixed at 3.5% -- the wide end of the 2.8% to 3.5% range. However, the exchange premium was pushed towards the tight end of the 21% to 26% range and fixed at 22%, which may have been partly possible because of a 6.6% drop in Hyundai's share price yesterday. The premium was fixed over yesterday's closing price of W199,500, resulting in an initial exchange price of W243,390.

The five-year bonds were issued at par and can be put back to the issuer after three years also at par, which means the yield-to-maturity is equal to the 3.5% coupon. KCC can call the bonds after three years, subject to a 130% hurdle.

The deal, which was fully underwritten by J.P. Morgan, was said to have attracted about 50 investors and the fact that part of the upsize option was exercised suggests that there was at least some excess demand beyond the original deal size. The positive reception was also evident by the fact that the bonds were bid above 101% of face value in the grey market during the marketing process. In case that bid continues in the secondary market, the bookrunner still has the option of exercising the remaining $50 million of the upsize option.

Being only the second equity-linked issue in Asia this year after SK Telecom's $332.5 million convertible three weeks ago, the KCC issue is still regarded as an important test for the market, especially with regard to the demand since these bonds are being issued into an environment that has changed a great deal from just 12 months ago. In addition to the difficulty in obtaining a credit bid that would allow investors to hedge the bond portion of the offering, it has also become more difficult to hedge the equity option in certain countries. This includes Korea, which introduced a ban on short-selling of all stocks in response to the sharp sell-off in equity markets globally following the collapse of Lehman Brothers. If investors cannot go short the equity, they cannot hedge the equity option on a CB and consequently they will not be buying the bonds to play the volatility. (SK Telecom was an exception in this respect since it has American depositary receipts listed in the US that can be used for short selling.)

The lack of a hedge makes it more challenging to find the "right" investors, bankers say. According to the source, a large part of the KCC bonds went to outright investors, who were basically buying them for the potential equity upside, interspersed with a few select hedge funds. All-in-all the quality of the book was described as very strong. The SK Telecom deal was also largely placed with what people close to the deal referred to as "fundamental investors" which has lead to the trading of those bonds taking place almost entirely outside the usual CB community making them largely invisible, in turn adding to the speculation that the bonds were not fully distributed.

In terms of finding investors, it would have helped that KCC is a triple-B rated credit by the three major ratings agencies since equity-linked issuers of investment grade quality are typically far and few between in Asia even in bull markets. That said, there is no direct credit bid on the company in the market and most investors were said to have based their credit spread assumptions on the existing CB which trades at a spread just below 700bp, resulting in spreads on the new bonds ranging from 700bp to 750bp. Some specialists argued that the wide end of that made the other terms on the EB look quite unattractive with the implied volatility ending up at 36%-37%. However, the historic volatility is above 70%.

Investors will be compensated for dividend yields above 2% and given the inability to sell short, the stock borrow cost was assumed at 5%.

Like other stocks, Hyundai Heavy, a Korean ship builder, has been on an upward streak over the past month, adding about 17% since the beginning of March. However, KCC may have been better off to launch the deal a day earlier as the sharp drop in Hyundai Heavy's share price yesterday - aside from making the exchange premium a bit more palatable - did remind everyone that there are still a lot of risks attached to the current stock market rebound. To be sure, the stock is still down 98% from where it traded a year ago.

The original KCC bonds into Hyundai Heavy were issued in October 2007 as part of a three-tranche deal that could also be exchanged into treasury shares of KCC itself and marine transportation company Hyundai Merchant Marine (HMM). The Hyundai Heavy tranche was the most popular of the three, thanks partly to the high liquidity in the stock and because it was, at the time, shortable, but the issuer didn't want a disproportionate allocation into this tranche and in the end it accounted for $272 million of the $1 billion issued across the three tranches.

In November, KCC bought back $183 million of the EB at 82% of face value versus a market price at the time of 75%. According to market watchers it was the first Asian company to buy bank equity-linked paper through a tender for more than 10 years. Those original bonds have since traded up to about 95%. KCC had offered to buy back up to $200 million and received bids representing about $400 million worth of bonds.

The tender turned out to be a good move by the issuer which put its excess cash to work to buy back the bonds at a time when the credit spread on Hyundai Heavy was about 1,800bp.

According to the term sheet, Barclays Capital acted as a co-bookrunner on last night's deal -- a somewhat unclear role since it was not directly involved in selling the bonds to investors and will not receive any league table credit.