Luckin Coffee’s US$400m convertible bond faces forced selling by index trackers

Georgina Lee

Exchange-traded fund managers who have been tracking Luckin Coffee’s US$400 billion convertible bond issued in January will likely have to sell out if the US Nasdaq exchange follows through on its intention to delist its shares.

Already, index provider Refinitiv Benchmark Services ejected Luckin Coffee’s convertible bond from its “Refinitiv qualified global convertible index” on April 15, the first index provider to do since the company’s accounting scandal. Other index providers could also disqualify it as a benchmark constituent.

The bonds are convertible into Luckin Coffee’s American depositary shares (ADS) before they mature in 2025. Refinitiv’s benchmark is tracked by a US$1.02 billion exchange-traded fund managed by State Street Global Advisors.

Refinitiv’s move came ahead of the Nasdaq exchange’s decision to delist Luckin Coffee’s ADS earlier this month, which the Xiamen-based start-up has said it plans to appeal.

The Refinitive index, which comprises over 200 constituents, is tracked by State Street Global Advisors’ SPDR Thomson Reuters Global Convertible Bond ETF that held US$2.75 million worth of the Luckin Coffee bonds, an April filing from Bloomberg showed. A State Street spokeswoman declined to comment on the ETF. 

With at least another US$10.8 million worth of Luckin Coffee’s bond still held by asset managers State Street and BlackRock as part of their ETF portfolios, Luckin Coffee’s accounting scandal has highlighted how passive investors in ETFs can get stuck in investments, even if an underlying stock is earmarked for delisting.

It also underscores the importance of checking the fine print of when and under what circumstance an index provider will stop tracking a security. The solace for passive investors is that ETFs track the broader market in a well-diversified portfolio.

A spokeswoman at Refinitiv Benchmark Services in London said Luckin Coffee’s convertible bond was removed due to the bond having fallen below its internal outstanding issue threshold for five straight weekdays. The bond has lost 75 per cent of its value since early March.

Apart from Refinitiv, a Bloomberg Barclays convertible bond index series also includes Luckin Coffee’s bond as a constituent. It is tracked by another State Street managed ETF listed on the New York Stock Exchange, which owned US$9.37 million of Luckin Coffee’s convertible bond, a May filing by Bloomberg showed. Bloomberg declined to comment on the index’s methodology.

Another US-listed ETF, managed by BlackRock, iShares Convertible Bond ETF, has a smaller exposure of US$1.43 million to Luckin Coffee’s bond, a May filing by Bloomberg showed. The ETF also tracks the Bloomberg Barclays index, which is rebalanced at the end of every month.

A rebalancing could result in bonds dropping out of an index. BlackRock did not reply to SCMP’s emailed questions about its inclusion criteria. 

It was unclear how many other indices have included Luckin Coffee’s convertible bond among their constituents.

Luckin Coffee’s Lu Zhengyao celebrates IPO on Nasdaq. Photo: finance.china.com.cn

Luckin Coffee’s chairman Charles Lu Zhengyao’s is attempting to rebuild investors’ confidence in the scandal-hit company that disclosed fabricated transactions by staff that amounted to 2.2 billion yuan (US$310 million).

If Luckin Coffee is delisted, its convertible bonds would likely drop out of indices, said Skander Chabbi, BNP Paribas Asset Management’s head of convertible bonds in Paris.

Luckin Coffee’s convertible bond is due to pay its first coupon, at 0.75 per cent, on July 15. The bond last traded at 27.5 US cents on a dollar last week; such a distressed level implies a high degree of likelihood in default, one analyst said. These investors are likely specialists in appraising the value of stressed firms.

“For a bond that is trading at a steep discount, the investor base would no longer be traditional fund managers but [instead] the high yield, distressed debt players who would seek to profit from the recovery of the bond value,” said Chabbi.

Passive investors also need to be clear, if Luckin Coffee enters administration their claims are likely to be towards the back of the queue of creditors.

Earlier this month, a group of banks led by Credit Suisse filed liquidation requests to the British Virgin Islands’ court, where chairman Lu’s family trust has domiciled its investment vehicle, as they try to recoup losses on more than US$500 million in margin loans. Credit Suisse was also a joint bookrunner for the convertible bond.

Among large companies in Asia, 20 per cent use international finance centres, such as the British Virgin Islands, and a further 36 per cent plan to engage with them in the next 12 months, according to a report by research and analysis firm East & Partners.

Additionally, lawyers said if eventually Luckin Coffee’s business fails in China, employees and suppliers’ claims would come ahead of offshore creditors’ demands.

Luckin Coffee operates in mainland China so potential claims on its assets from onshore creditors, including their employees, would likely prevail over Luckin Coffee’s offshore creditors and shareholders in the Cayman-Islands incorporated US-listed company.

So for investors in Luckin Coffee’s convertible bond, what’s brewing at the three-year-old coffee chain smells hard to swallow.

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