Bond Market 'Arbitrage' Opportunities

The recent investment risks in the convertible bond market have surged, but the opportunities in the current convertible bond market outweigh the risks.

The prices of some convertible bonds with normal debt repayment capabilities have plummeted, mainly due to panic selling, with an extremely low possibility of default risk.

Rational investors should adhere to the principles of value investing and buy and hold those convertible bonds that are severely undervalued.

The convertible bond market has continued to decline and set new lows.

On August 16, the China Convertible Bond Index broke below the low point at the beginning of February 2024, closing at 368.26 points.

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The downward trend did not stop, and on August 22, it fell to its lowest point at 359.91 points, setting a new low not seen since February 2021 for over three years.

Convertible bonds have dual attributes of equity and debt, and their risks are usually lower than those of stocks.

With the Shanghai Composite Index not yet breaking below the low point of 2635 points at the beginning of February 2024, the convertible bond market has plummeted and set a new low for over three years.

What is the reason for this?

If the downward trend continues in the future, what impacts will it have?

How should rational investors respond?

The author believes that multiple factors have overlapped, leading to a significant underperformance of the convertible bond market compared to the stock market since 2024.

First, the stock market has seen an increase in stabilizing funds.

Since 2024, state-owned institutions represented by Central Huijin have been continuously increasing their holdings of the 300ETF fund to maintain the stability of the A-share market, while the convertible bond market lacks similar stabilizing institutions' increases.

Second, there have been multiple default events in the convertible bond market, triggering market concerns about convertible bond defaults.

On May 17, 2024, Soutec Convertible Bond failed to pay the principal and interest of the convertible bond buyback on time, becoming the first convertible bond to default in China's bond market.

On June 27, Hongda Convertible Bond defaulted on the buyback, becoming the second convertible bond to have a substantial default.

On August 13, Blue Shield Convertible Bond matured and failed to pay the principal and interest to investors as stipulated in the contract, constituting a default.

The above three convertible bonds all had their stocks delisted before the default, and the delisting of stocks and convertible bonds became the prelude to these defaults.

On August 14, Lingnan Convertible Bond matured and failed to pay the principal and interest to investors as stipulated in the contract, becoming the first convertible bond of a state-controlled listed company to default in the domestic bond market, and its corresponding stock, Lingnan Shares, is struggling on the brink of delisting due to poor stock performance.

In addition, Guanghui Auto, the stock corresponding to Guanghui Convertible Bond, was delisted on August 28, and Guanghui Convertible Bond was also delisted, with a closing price of 44.267 yuan before delisting.

Since the previous three delisted convertible bonds all had substantial defaults, the market expects Guanghui Convertible Bond to also default due to delisting.

Although some bondholders proposed that their custodian call a bondholder meeting, asking Guanghui Auto to provide additional guarantees for the bonds to protect the legitimate rights and interests of small and medium investors, the custodian refused on the grounds that the bonds had not yet defaulted substantially.

Finally, the main institutional investors in convertible bonds are bond funds, and the market downturn may trigger redemptions and stop-loss sales of bond funds.

For a long time, the convertible bond market has been running smoothly, attracting a large number of bond funds.

Upon review, the author found that the top ten holders of convertible bonds are mainly bond funds, and some convertible bonds are even entirely held by bond funds.

Since May 2024, with the continuous occurrence of convertible bond default events, the convertible bond market has seen a continuous decline, and the holders of bond funds are mainly low-risk investors.

The decline in the net value of bond funds will trigger redemptions from investors, and bond funds will take the initiative to stop losses and reduce their holdings of convertible bonds.

The emergence of stop-loss and panic sales has further exacerbated the irrational decline of the convertible bond market.

Impact on the capital market As a financing tool, convertible bonds have been present in the A-share market since the 1990s and have been running smoothly for over two decades; due to their debt attributes, they can become a haven for investors and provide stable investment returns even during periods of significant stock market fluctuations.

However, in recent months, the investment risks have surged, and the convertible bond market has seen a significant decline, with the decline exceeding that of the stock market during the same period.

Currently, the balance of convertible bonds in the Shanghai and Shenzhen markets is 796 billion yuan, with a market value of more than 800 billion yuan.

If the convertible bond market continues to decline, it may have multiple impacts on the capital market.

The most direct impact is that the withdrawal of bond funds will lead to further tightening of liquidity in the stock market.

For many years, the main institutional investors in the convertible bond market have been bond funds.

Since 2024, the continuous decline in the convertible bond market has triggered redemptions from investors, and bond funds will continue to sell convertible bonds to hedge risks and cope with investor redemptions.

So, who will take over the convertible bonds sold by bond funds?

Under the current market conditions, it is very unlikely that bond investors will enter the market to take over.

It can be reasonably speculated that the main players entering the convertible bond market should be some low-risk stock investors from the stock market.

If this is the case, then when bond funds withdraw from the convertible bond market, they will actually withdraw liquidity from the stock market.

At a time when the stock market is facing continuous redemption pressure from stock funds, this will make the capital side of the stock market even tighter.

Looking at the historical trend of the A-share market, when the market experiences a double kill of stocks and bonds, some low-risk stock investors will shift their funds from stocks to bonds, and the bond market will often stabilize and rebound first.

Before the bond market stabilizes, the stock market remains in a continuous weak state.

For reference, the A-share market from 2004 to 2005 is a case in point.

In April 2004, old shareholding stocks such as the Delong system collapsed due to a break in the capital chain, and a significant part of the funds of these institutions came from entrusted treasury bond management and financing through treasury bond repurchase.

As the shareholding stocks collapsed, the related treasury bonds were forcibly liquidated, and the treasury bond market also showed a significant decline.

Short-term bonds with a maturity of less than five years fell to around 90 yuan, and some medium and long-term treasury bonds fell to more than 70 yuan, and the market showed a double kill of stocks and bonds.

In the more than half a year that followed, the bond market continued to be sluggish, with the prices of some medium and long-term treasury bonds remaining at the level of more than 70 yuan, until more than a year later in May to June 2005, when the prices of some medium and long-term treasury bonds that had fallen to more than 70 yuan gradually returned to the par value of 100 yuan; at this time, the stock market was still in a state of extreme depression, and in early June 2005, the Shanghai Composite Index hit a historical low of 998 points.

In addition, a large area of defaults may lead to the collapse of the market's credit system.

Many years ago, after LeEco's debt default, its actual controller was listed as a dishonest person and stayed abroad for many years without returning.

It is worrying that since May 2024, after the defaults of Soutec, Hongda, Blue Shield, and other convertible bonds, the relevant listed companies and their executives have not been held accountable so far.

If the issuers of convertible bonds do not need to pay a price after defaulting and can escape from debt without risk, then such debt default events are likely to have a bad effect on the market.

Recently, some convertible bonds of listed companies with low asset-liability ratios, sufficient book cash to cover the amount of convertible bonds, and normal debt repayment capabilities have also shown a more obvious decline in prices, reflecting the market investors' concerns and panic about the malicious default of listed companies.

If the credit system of the convertible bond market is impacted, then listed companies will pay higher financing costs and accept more stringent financing conditions in the future.

The losses will not only be borne by the vast number of small and medium investors but the entire market.

Opportunities in the convertible bond market outweigh the risks.

The current differentiated trend of the bond market reminds the author of the treasury bond market in 2004.

At that time, treasury bonds were divided into two types: certificate treasury bonds and book-entry treasury bonds.

The coupon rates of treasury bonds with a term of more than five years were generally above 3%, significantly higher than the one-year bank deposit interest rate of 2.25% at the time.

Certificate treasury bonds sold at bank counters were queued up by investors, while book-entry treasury bonds listed and traded on the exchange fell to prices far below par value.

Both are treasury bonds issued by the Ministry of Finance, showing an extremely differentiated market situation.

Rational investors should obviously buy book-entry treasury bonds at a significant discount to par value in the exchange market, instead of being driven by panic and selling book-entry treasury bonds at low prices, and queuing up at bank counters to buy certificate treasury bonds.

Similarly, since May 2024, impacted by frequent default events, the convertible bond market has declined significantly, and bond funds have sold convertible bonds and rushed to the treasury bond market.

The prices of medium and long-term treasury bonds have hit new highs, while the prices of some convertible bonds with normal debt repayment capabilities have fallen sharply below par value.

The convertible bond market and the treasury bond market have shown a polarized trend, reflecting the current bond market's extreme risk aversion and investors' concerns and panic about the malicious default of the convertible bond market.

The author believes that the current convertible bond market has more opportunities than risks.

The significant decline in the prices of some convertible bonds with normal debt repayment capabilities is mainly due to panic selling, and the possibility of default risk is extremely low.

Rational investors should adhere to the principles of value investing and buy and hold those convertible bonds that are severely undervalued, instead of selling convertible bonds at low prices and chasing the central bank's multiple risk warnings since 2024 to buy medium and long-term treasury bonds.