* Issuers may switch to convertible bonds for cheaper funds
* Spike in China yields to encourage demand for such hybrid bonds
* Corporates can monetise cross holdings via zero-coupon bonds
By Umesh Desai
HONG KONG, Dec 23 (Reuters) - As China's companies grapple with expensive borrowing costs and growing debt piles, more are likely to tap convertible bonds for capital as rising interest rates strain their balance sheets.
Convertible bonds are a niche product in China, much smaller than equity, bonds and loans as a source of corporate finance. But for firms with good growth prospects and lower credit ratings, such bonds would be a cheaper route to funds than straight debt.
Bankers say issuance may pick up from Asia's most prolific source of convertible bonds after the U.S. Federal Reserve raised rates in December for only the second time in a decade and signalled a faster pace of rate rises next year.
Uncertain conditions under Donald Trump's presidency and China's economic jitters are also stoking volatility in markets which could make borrowers hesitant to add to their debt burden.
"The amount in debt outstanding in Asia and the prevailing leverage ratios means that fixed income markets would struggle to refinance at the levels that the corporate borrowers want," said Miles Pelham, Mizuho global head for convertible bonds.
"The recent hike in interest rates both onshore and offshore would compel more Chinese borrowers to issue convertible bonds to secure refinancing at lower coupon levels."
Some companies with outstanding convertible bonds may return to the market for refinancing next year, bankers said. Those with put dates on bonds in 2017 include ENN Energy, Hengan International and Jinko Solar.
Asia ex-Japan volumes in the year to date fell marginally to $5.1 billion from a year earlier, the second straight annual decline. However, 2016's total excludes $6.6 billion raised in a deal that bankers say do not represent the broad trend.
"We are seeing increased interest in equity-linked financing where issuers can still enjoy zero or low coupons," said Gaurav Maria, executive director at JPMorgan.
He said such issuance also achieves attractive conversion premiums with no immediate dilution of a company's stock or their shareholding in listed companies, in the case of exchangeable bonds.
Chinese issuers, who account for more than half of Asia's dollar-denominated convertible bonds, raised $3.5 billion via these hybrid instruments this year, versus $3.6 billion last year and $4.6 billion in 2014. In contrast, they raised $77.1 billion in traditional bonds.
This year's tally excludes $6.6 billion raised by Softbank in a structure designed to offload Alibaba shares without hurting the Chinese e-commerce giant's stock price.
Rising interest in convertible bonds is a sign fundraising options are tight and companies feel their stocks are undervalued. The Shanghai Composite index trades at a price earnings ratio of 13 times while Japan's Nikkei is at more than 20.
"We are controlling our net gearing and debt because during a cyclical trough, it is cash that will save you," said Sebastian Liu, director at Jinko Solar.
"CBs will still be one of our options in the future to reduce our funding cost. We are trying to control our debt which may grow as we gain market share. It's a trade-off between growth and debt."
This strategy becomes increasingly relevant as bond yields spike onshore and credit conditions become tighter.
Chinese borrowers, who are sitting on billions of dollars of investments, could also look to monetise their cross-holdings by issuing zero-coupon bonds that can be switched for another company's shares.
State-run giants Baosteel and Yangtze Power liquidated their holdings in China Construction Bank at a premium, by selling zero coupon exchangeable bonds.
"We expect more and more cross holdings to be unwound in China through exchangeables as SOEs (state-owned enterprises) and conglomerates realise the value of their investments," said Mizuho's Pelham.
"These holdings could get them zero percent funding and the ability to sell their stakes at a premium in companies that are no longer part of their core strategy."
Editing by Jacqueline Wong