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Link to Latest Post (on 2021 MCBs)

LATEST UPDATE: SIA has announced the issuance of a 2nd tranche of MCBs in June-2021. Read our rationale on why you SHOULD NOT subscribe for the 2021 Rights MCBs (published 6 Jun 2021). This is the same link as what’s above.

SIA issued S$850m of convertible bonds in mid-Nov. What does this mean for SIA shareholders & MCB bondholders? Here our article published 15 Nov 2020: “SIA Issues S$850m of Convertible Bonds: What does it mean for shareholders and MCB bondholders?”

Separately, we published an in-depth look at SIA shares earlier on 28 Sept 2020: “If SIA’s profits returned to pre-Covid levels tomorrow, is it a “BUY” at today’s price?”

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Difficulty: Nightmare

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1)  Mandatory Convertible Bond (MCB): Two possible outcomes

2) At S$0.90, what’s the expected return of the MCBs?

3) What’s the minimum return a rational investor should require?

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Appendix 1: Valuing the components of the MCB individually

Appendix 2: What if a 2^nd tranche of MCBs is issued?

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The InvestQuest’s View

At the current price of S$0.90, we estimate the expected annualized return for SIA’s MCBs to be 7.47%. In our view, this is fairly priced. Overall, we were surprised to find no mispricing, despite the low trading liquidity and added complexity around the instrument. Nonetheless, we will be paying close attention in the upcoming months…

Note: SIA’s MCBs are tradable on SGX at minimum lot sizes of $100.

Disclaimer: We are expressing our personal views for our own investment decisions. The information presented here should not be relied upon for your investment decisions.

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1)  Mandatory Convertible Bond (MCB): Two possible outcomes

Assuming SIA does not default, MCB investors will face two possible outcomes:

• Scenario 1: SIA redeems the MCB before maturity
• Scenario 2: SIA DOES NOT redeem the MCB before maturity. As a result, the MCB is converted to SIA shares

For investors who subscribed to the MCBs at $1, what’s the return in Scenario 1 & 2?

• Scenario 1: Investors will enjoy a 4-6% yield per annum depending on when the MCB is redeemed.
  • If the MCBs are redeemed…
    • Within the first 4 years, 4% per annum
    • Between the 5^th and 7^th year, 5% per annum
    • Between the 8^th and 9.5^th year, 6% per annum
  • With regard to the yield, note that the MCBs do not pay out coupons. Instead, the MCBs “accrue” the returns resulting in a higher redemption price.
  • The returns are compounded semi-annually.
• Scenario 2: Investors may receive positive/negative returns depending on SIA’s share price on the maturity date (8 June 2030). As long as SIA’s share price is $2.68 (calculation: $1 divided by 0.373) and above, investors who subscribed to the MCB will break-even.

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2) At S$0.90, what’s the expected return of the MCBs?

Investors subscribed to the MCB at $1 per MCB. Now, some of them are selling the MCB on the secondary market for S$0.90 each.

So, what’s the expected return of the MCBs if you buy them at S$0.90? To answer this, we’ll look at

• MCB returns in Scenario 1: If this scenario is realized, MCB returns will be positive
• MCB returns in Scenario 2: If this scenario is realized, returns can be either positive or negative
• Expected return of the MCB as a whole (calculated after weighing probabilities for Scenario 1 and 2)

Scenario 1: MCB is redeemed by SIA

Recall that the MCBs accrue returns of between 4%-6% p.a. on its $1 issue price, which is factored into the MCB’s redemption price. If you bought the SIA MCBs at today’s price of $0.90, the yield of the MCBs would be HIGHER than 4%-6% p.a. – since the cost base is lower.

Assuming an MCB purchase price of S$0.90, here’s the MCBs’ yield-to-call on the various redemption dates (highlighted in green).

Should Scenario 1 be realized, buying MCBs at the current price of $0.90 offers a 7%-8% yield (if SIA redeems the MCB in 2023 onwards), which at sounds pretty attractive to me at face value. In the next section, we look at the potential returns should Scenario 2 be realized instead.

Scenario 2: MCB is NOT redeemed by SIA by maturity date. This triggers a conversion to SIA shares.

The table below shows what your annualized returns would be if the MCB is converted to SIA shares in 2030. The returns vary across MCB purchase prices (left column) and SIA share prices at the time of MCB maturity in 2030 (top row).

The row highlighted in orange shows expected annualized returns based on today’s MCB purchase price of S$0.90.

Let’s assume you purchased SIA’s MCB today at S$0.90 and it is converted to shares in 2030

• As long as SIA’s share price is trading above S$2.41 in 2030, you’ll receive a positive return
• If SIA’s share price is still trading at around today’s current price of S$3.47, your annualized return would be approximately 3.9%.

Expected return for MCB as a whole

At MCB’s current price of S$0.90, we estimate that the annualized expected return would be roughly 7.30% + 0.17% = 7.47%.

Our computation is based on the following assumptions made:

1. Probability weighted return of Scenario 1, which depends on
   • Probability that Scenario 1 occurs: 85% (our rough estimate)
   • Assuming Scenario 1 occurs, probability distribution across redemption dates: See table below, second right column. We think that a MCB redemption is more likely to happen only in 2023 and after.
   • Under such assumptions, we calculate a probability-weighted expected return of 7.30% (bottom right cell in below table).
2. Probability-weighted return of Scenario 2, which depends on
   • Probability that Scenario 2 occurs: 15% (our rough estimate)
   • Assuming Scenario 2 occurs, probability distribution across SIA share prices: See second table below, highlighted cells. We assume that there is an equal chance that SIA shares will trade at S$2, S$2.5, S$3 and S$3.50 on the MCB conversion date.
   • Under such assumptions, we calculate a probability-weighted expected return of 0.17%. Computations: [3.75% * (-1.9% + 0.4% + 2.3% + 3.9%)] = 0.17%

Of course, investors need to be aware of the key risk for buying MCBs now, which is the risk of a second tranche of MCBs being issued. We discuss more in Appendix 2.

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3) What’s the minimum return a rational investor should require for the MCBs?

To answer this, we need to value the components of the MCB individually.

One can roughly mimic SIA’s MCB using two instruments

The MCB can be decomposed roughly into two separate parts, with some tweaks made subsequently:

1. Buying a SIA Zero Coupon Callable Bond, maturing 8 June 2030:
   1. Investors should demand a yield of 3.96% p.a. on our estimates.
2. Selling a Put Option on SIA stock, at a Strike Price of S$4.84, maturing 8 June 2030
   1. Investors should demand a yield of 4.61% p.a. on our estimates.

Details of how we valued each of the above two components may be found in Appendix 1.

Summing both parts, an investor should demand a yield equating to 3.96% + 4.61% = 8.57% p.a.

Adjustments need to be made

We do have to make some adjustments because the MCB is still different in some aspects to a “zero coupon callable bond + selling a put option on the stock”.

Difference 1:

• Selling a put option on SIA stock implies that a share conversion would only happen if SIA shares are trading BELOW the S$4.84 conversion price at the maturity date.
• For an MCB, the above can happen. But in addition to that, it’s possible to have a stock conversion while SIA shares are trading ABOVE the conversion price of S$4.84.
• This would be a beneficial outcome for MCB investors. The MCB investor would not only benefit from the accrued yield of the MCB but also make a capital gain from the share conversion.

Difference 2:

• Selling a put option on SIA stock implies that you are 100% obligated to buy the shares if they fall below S$4.84 on the maturity date.
• For the MCB, you are obligated to buy the shares if they fall below S$4.84 at maturity, ONLY if the MCB lasts till the maturity date.
• This is a beneficial aspect for MCB investors, since the chance of a share conversion is lower than in the case of the put option.

As the above two scenarios are beneficial to the MCB investor, investors could consider a 1% downward adjustment to the 8.57% p.a yield mentioned earlier. This implies that a rational investor would only invest in the MCB if the return expected is at least in the mid-7% range.

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The InvestQuest’s View

At the current price of S$0.90, we estimate the expected annualized return for SIA’s MCBs to be 7.47%. In our view, this is fairly priced. Overall, we were surprised to find no mispricing, despite the low trading liquidity and added complexity around the instrument. Nonetheless, we will be paying close attention in the upcoming months…

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Appendix 1: Valuing the components of the MCB individually

A) Buying a SIA Zero Coupon Callable Bond, maturing 8 June 2030

We have listed all of SIA’s outstanding bonds in the table below. We estimate that for a maturity extension of one year, SIA bondholders would require approximately 0.2% increase in yield.

As the SIA 3.13% 2027 bond has a yield-to-maturity of 3.36%, we would expect a SIA bond with a 2030 maturity to yield 3.96% (3.36% + 0.2%*3).

B) Selling a Put Option on SIA stock, at a Strike Price of S$4.84, maturing 8 June 2030

We estimate that a SIA put option at the above-mentioned terms would likely cost S$1.90 (54.8% of SIA’s current share price of S$3.47). Expressed as an annualized option premium, it would be 4.61%.

The above computation is based off the following assumptions, fed into a Black-Scholes Model.

• Current SIA share price: S$3.47 (30 Sep 2020 closing price)
• Strike price: S$4.84 (MCB conversion price, which is 39.5% above the current price)
• Assumed annualized volatility: 29.5% (similar to the most recent 90 trading days)
• Risk-free rate: 1% p.a.
• Time to option maturity: 9.69 years
• SIA Forward dividend yield: 0% (if dividends are paid, the put option premium would increase)

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Appendix 2: What if a 2^nd tranche of MCBs is issued?

On 15 April 2020, SIA management proposed an additional S$6.2bn issuance of Rights MCB, which was approved by shareholders (see SIA filing for details). SIA now has until July 2021 to decide if it wants to go ahead with this 2^nd tranche of MCB issuance.

If the issuance is announced, we are likely to see negative sentiment on SIA shares, given the higher potential risk of share dilution (see chart below) and higher interest expenses to be expected for the upcoming years. However, the impact of share dilution may be mitigated by the fact that the share conversion price would be set at a large premium to SIA’s current share price.

Similarly, we can expect the market price of the 1^st MCB tranche to trade lower in unison.

How likely will SIA issue the 2^nd tranche of Mandatory Convertible Bonds? At this point, SIA’s estimated cash balance of S$7.4bn is still sufficient (see chart on SIA cash balance and debt outstanding below), as the Group had on average operated with approximately S$2bn of cash balances in 2019.

In our view, issuance of the 2^nd tranche of MCBs will only be used as a last resort. The reason is because SIA has the option to tap on secured borrowings or bonds to raise capital at a cheaper cost, and unlike MCBs, these options will not be dilutive to shareholders.