The convertibles market has experienced something of a resurgence in 2013, thanks to high stock prices and tight spreads, and this increase in issuance has brought diversity to the market.

In horticultural terms, convertible bonds are the rare orchids of the capital markets, requiring a finely balanced combination of share prices, interest rates and macro-economic environment, which in recent times have combined to create a hothouse atmosphere for the asset class.

The key in making convertibles work is volatility in the equity markets, which is used to price the bond’s option to convert into shares. The coupon the issuer pays is inversely correlated with the option price and other factors, including the liquidity and repo potential of the underlying stock. As shares hovered near record lows following the financial crisis, the convertible market went into the cold store. Now, as stock markets rally, it is booming.

“Companies have seen improving share prices, which has been a key driver motivating new issuance,” says Alex Large, managing director, equity capital markets at JPMorgan in London. “Outright investors have been willing to pay high value for the optionality embedded in convertibles, driving implied volatility levels to unusually elevated levels. The implication for issuers is that coupons have been heavily subsidised.” 

With absolute interest rates at historically low levels and credit spreads relatively tight, issuers are motivated to lock in lower levels of funding. Absolute coupon costs are at their cheapest level for 10 years, according to Barclays.

Back to life

Companies that have returned to the convertible market this year include French airline Air France, French telecommunications company Alcatel Lucent and National Bank of Abu Dhabi. At the beginning of the year, the world’s largest steelmaker, Arcelor Mittal, raised $2.2bn through a convertible bond and, in June, car manufacturer Volkswagen sold $1.6bn of securities. In the US, online travel company Priceline.com raised nearly $1bn from a seven-year convertible at the end of May.

In addition, a slew of new companies have issued convertibles, including Italian cable maker Prysmian and Spanish construction company OHL Concesiones, suggesting the confidence seen in core economies over the recent period has spread to the European periphery.

“If you look at 2012, probably 40% of [European] issuance came out of Germany, with names such as Siemens, Adidas and Deutsche Post,” says Bruno Magnouat, head of equity-linked origination at Société Générale in London. “What we saw towards the end of last year was appetite shifting back into the peripherals, and in July, 40% of issuance came from Italy, Spain and Portugal.”

Some 71% of issuance over the past two years was for “general corporate purposes”, according to Société Générale, with debt refinancing accounting for 20% and merger and acquisition financing for 9%.

“The market has been extremely active compared with the past two or three years, and we have seen uninterrupted issuance since last September,” says Alain Dib, European head of equity capital markets at BNP Paribas in London. “A rule of thumb is that if stock prices remain relatively high and credit spreads tight then it is a good time to sell convertibles.”

Investors, on average, are able to convert their instruments into equity when the share price is at a 25% to 35% premium to its price at the time of issue. With the S&P 500 touching an all-time high in May, confidence has risen that the balance between accepting a lower coupon and potentially obtaining shares at a discount has swung in investors’ favour.

Cash to spend

The year-to-date total return of the Barclays Europe, the Middle East and Africa (EMEA) convertibles index is 2.7%, compared with 7.3% in the same period last year, and 16.4% for the whole of 2012. The lower rate of return is a reflection of the widespread slowdown in market rallies, analysts say. On a 12-month view, European convertibles are likely to gain 9.7% if equities rise 25%, according to Barclays analysts. If equities are flat, they will return 0.5%, whereas if equities decline 25% they will lose 6.9%.

“Our 2013 convertible index return forecasts are about 5% to 7% for EMEA and 8% to 10% for Asia-Pacific, driven mainly by equities, with Japan outperforming substantially,” Barclays analysts said in a note published on July 5, 2013.

Globally, there has been $51.8bn of global convertible issuance in the year to the end of July, comprising 211 individual issues, according to data provider Dealogic. The US and Asia have been at the vanguard, accounting for 69 and 66 sales, respectively, with Europe lagging.

Meanwhile, redemptions of some large issues have put cash into the pockets of investors. Leading European redemptions in the first half of the year was the maturity of €4.6bn of bonds from German government-owned development bank KfW.

As share markets have rallied, investors have piled into convertible funds, going long through institutions and long-short in the hedge fund space, with a record net fund inflow of $4.8bn in the past six months, according to data from EPFR, which tracks the fund flows of mutual funds and exchange-traded funds. That follows three-and-a-half years of outflows from the asset class, and comes as high-yield bond investors have taken $14bn from investment funds this year.

The key motivation to participate from an investor point of view is not the coupon on the bond, which is usually at least two percentage points lower than on an equivalent bond, but the potential upside on the equity when the security converts into shares at a higher price on maturity.

“The convexity is upside participation and downside protection,” says Angus Allison, an analyst at Barclays in London. “If a fund is outright long it may buy and hold, whereas hedge funds might want to look at volatility relative value, which often means buying the convertible and having an offsetting short stop position on the underlying stock. In effect that means being immunised from directional trends in the share price and trading the option volatility.”

An art to it

One hedge fund to have been active in the convertibles space in the recent period is BlueMountain Capital Management, a $13bn hedge fund which set up a dedicated convertibles desk in 2012. Hedge fund participation in the convertible market is a double-edged sword for issuers, because if a fund is likely to short the underlying stock, the conventional dynamic of convertibles thriving in a rising price environment is undermined. However, for many that is offset by the price discovery provided by hedge fund activity.

“Shorting stock is not necessarily a bad thing. In fact, in normal market conditions, shorts are essential to efficient securities pricing and, of course, short positions also run the risk of being squeezed,” says David Puritz, a portfolio manager at BlueMountain in New York. “Convertible arbitrage accounts run a corresponding delta long due to the equity option embedded in the convertible. Shorting stock simply offsets this, isolating the volatility and credit components of the trade along with a few additional variables."

For Mr Puritz, the attractiveness of the convertible asset class lies in the challenge of valuing the equity option in the product against the coupon the issuer is willing to pay. “The beauty of the product is in working out the value of outcomes over a long period of time and what you are willing to pay for those,” he says. “It is the original capital structure arbitrage trade – the key is evaluating the correlation between volatility and credit.

“Many issuers lack either active credit default swap pricing or other liquid debt. Meanwhile, five- or seven-year volatility levels can be difficult to determine in the marketplace for even the more liquid single names. Then you throw in the idiosyncrasies around borrowing and funding and valuation can become a fairly subjective exercise.

"In addition, convertibles act more like credit or equity depending on their ‘moneyness’, so the impact of certain variables on pricing shifts with stock price, credit spreads and time. Convertible bonds can appeal to very different types of investors over the course of a given cycle. This is very much an art as well as a science."

Some 40% of convertible issuance between 2011 and 2013 has been unrated, according to Société Générale, with single A rated issuers accounting for 29% of issuance. Companies rated between BBB and B sold 31% of bonds.  

Further considerations for sophisticated investors include the value of the underlying stock in the repo market, which will often determine how easy it is to play short. However, while hedge funds still have an important part to play in the market, their influence is diminishing, bankers say.

“Before the financial crisis, the convertible business was dominated by arbitrage funds, which meant they had quite a significant impact on the share price,” says Société Générale’s Mr Magnouat. “However, since 2009, that has changed and I would say in the recent period about two-thirds of placement is to long-only players. From an issuer perspective, long-only may seem to be preferable, but hedge funds are important in driving the market, and they are often the guys who will give a sense of whether pricing is good or not.”

Building blocks

As the repo market has rediscovered its form in recent months, a parallel evolution has been the increased complexity of the asset class, manifested in the variety of structures and pay-offs. While ‘convertibles’ is the umbrella term for the bonds, the asset class in fact comprises three distinct formulas. Those are straight convertibles into the stock of the issuer; mandatories, where the optionality of conversion is removed; and exchangeables, in which the underlying security is the stock of another company. The latter is often the result of accelerated book builds.

“Blocks have formed a very high percentage of equity capital markets issuance this year, across initial public offerings and rights issues, and that is why we have seen more exchangeable bonds,” says BNP’s Mr Dib. “Companies are looking to get cheap funding by combining blocks and exchangeables and they see the equity market rally as an opportunity to monetise the assets they own.”

Examples of recent exchangeable issues include the sale by Portugal’s Amorim Energia of a €4bn security exchangeable into Galp Energia and the €1bn Groupe Bruxelles Lambert placement, exchangeable for French multinational electric utility GDF Suez at a 20% premium to the reference stock.

The benign stock market environment has also had a knock-on effect on the mandatory space, which has accounted for about 20% of issuance, bankers say, against 50% for vanilla convertibles and 30% for exchangeables. Mandatories are in effect a forward sale of shares, meaning from the issuer point of view they are akin to a pure equity transaction. The European market was reopened after a three-year hiatus last November, when Volkswagen launched a €2.5bn mandatory convertible.

“The Volkswagen deal represented a sea change because for a long period pricing in  mandatories didn’t work,” says Frank Heitmann, European head of equity-linked at Credit Suisse. “The good thing from the issuer perspective is that it cuts down on dilution, because assuming you get the upside you end up selling fewer shares.” 

One of the reasons for the Volkswagen deal’s success was because it was heavily marketed in the US, Mr Heitmann says, where a higher proportion of long-only investor meant there was less downward pressure on the shares. “The Volkswagen deal changed people’s attitude towards mandatories, and now more issuers are looking,” he says. “It is still a niche product but it is an interesting alternative.”

Companies to announce mandatory deals in recent months include Spain’s Telefonica and Dutch telecoms group KPN.

Uncertainty prevails

Another trend this year has been over-collateralised exchangeables. The distinguishing feature is that in the event of issuer default, bondholders have security over additional underlying shares, usually expressed as a multiplier of the number of shares in the exchange property. In recent deals, over-collateralisation has ranged between two and 2.65 times, according to Barclays.

“One attraction for issuers is being able to obtain a lower cost of funding, given they are also offering an option on the underlying shares,” says Barclays Mr Allison. “The over-collateralised exchangeable structure may enable some issuers to offer a bond that might otherwise have been too expensive using a standard exchangeable structure.”

From an investors point of view, over-collateralised exchangeables offer relative cheapness, and often higher yields, arising from the fact that the deals regularly emit from non-investment grade and infrequent borrowers. On the other hand, equity-credit correlation can be high as issuance is often out of a holding company, with the shares being the company’s only asset.

Despite the recent rude health of the convertibles space, issuers and investors remain acutely aware of the potential impact on the market of changes in the economic environment. When US Federal Reserve chairman Ben Bernanke hinted in June that the Federal Reserve may look to “taper” its provision of liquidity, there was an immediate plunge in equity market prices which put convertibles issuers on their guard. In addition, the uncertainty which continues to inflict the economy, particularly in Europe, means the market remains in opportunistic mode. 

“At the moment the market seems set fair with issuance continuing to flow, but you never know what will happen in terms of the macro environment and the equity markets, so it’s reasonable to be cautiously optimistic,” says Mr Heitmann. “However, if interest rates rise then the natural place for bond investors to migrate is into convertibles, while it will become more attractive for issuers to look for cheaper sources of funding.” 

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