(Yicai) June 26 -- China's convertible bond market is in the process of a deep adjustment amid concerns over potential defaults, credit rating downgrades, and the stock market delisting of the underlying stocks.

Ninety-eight, or 18 percent, of the bonds that can be changed into common company stock had dropped below their face value as of yesterday, according to financial data provider Choice.

The CSI Convertible Bond Index has declined by almost 3 percent this month. Among the constituents, China Grand Automotive Services Group has fallen the most, as the price of its convertible bond is down almost 60 percent this month, trading at 40 percent of face value yesterday.

“Low-priced convertible bond products have faced intense selling pressure, with the speed and extent of the decline arguably reaching historical levels,” Zuo Dayong, chief analyst of fixed-income assets at Industrial Securities, told Yicai.

This reflects market concern about sagging small and micro-cap stock prices, credit rating downgrades at listed companies, issuers facing pressure from bondholders exercising put options, the delisting risk of underlying stocks, and panic selling as the result of a liquidity squeeze, Zuo said.

The pace of the decline has picked up speed since June 19, Wang Yixi, an analyst at Guosen Securities, wrote in a research report. Even bonds that are not likely to default, have also fallen below face value, showing that the driving force behind this slump has changed from concerns about credit risks to panic selling, Wang added.

Default Myth Busted

The belief that convertible bonds never default was shattered on May 17 when casual clothing seller Souyute Group failed to repay bondholders. It was the first ever default on a Chinese convertible bond. As a result, more credit risks within the market are being exposed, further weighing on prices, according to industry insiders.

The sinkage below face values is also connected with the increasing risk of several underlying stocks being delisted. For example, Souyute was also forced to exit the Shenzhen Stock Exchange due to information disclosure violations.

The risks of default, credit rating downgrades, and delisting risks of underlying stocks have prompted investors to sell these convertible bonds at a faster pace, despite them already being ultra-low-priced, said Zhang Xu, chief fixed income analyst at Everbright Securities.

Delisting Risks

Of the 98 poorly performing convertible bonds, three of the underlying stocks have been identified by the stock exchange as at risk of delisting, while 16 closed below CNY3 (41 US cents) apiece yesterday, close to the delisting trigger of CNY1, according to Choice.

Shares of China Grand Auto [SHA: 600297] were worth less than CNY1 each for a fifth straight day today. If that remains the case for 15 more trading days, the company is in danger of being booted off the Shanghai market, which is a key factor behind the recent plunge in the price of its convertible bond price.

But Wang is cautiously optimistic about the near-term direction of the convertible bond market. In the context of historical experience and the shortage of financial assets in the market, the liquidity shock is expected to be alleviated soon as there is no lack of bargain hunters.

In fact, private investments funds are already diving in. After seeing bond prices slump for nearly a month, a Great Entropy Capital-backed fund has been buying the convertible bonds of D&O Home Collection Group, holding almost 21 percent of the total as of market close on June 19, the toilet maker said on June 21.

Editors: Tang Shihua, Emmi Laine