Bank of America converts market conditions into bond success

After a slow first half, issuance volumes of convertible bonds in Europe are picking up again. The Europe, Middle East and Africa (EMEA) equity-linked team at Bank of America (BofA) believes the instruments are becoming more attractive relative to debt and common equity, and reckons that the year ahead will see a new wave of issuance.

Global equity-linked issuance surged in 2020 and 2021 under the influences of the Covid-19 pandemic. Two types of issuer accounted for the boom, according to Juan Rodriguez Andrade, BofA’s head of EMEA equity-linked transactions.

“The first were companies with challenged revenues, like airlines and travel businesses, who needed to replace revenues with debt,” says Mr Rodriguez Andrade. The second were growth businesses, typically in e-commerce, that were benefitting from the operating environment during Covid-19. They were not yet making a profit, but could exploit the fact that their share prices were high.

For both types it made sense to issue convertibles, bonds which can (and in some cases, must) be converted into shares in the issuing company. Conditions then deteriorated in the first half of 2022, as volatility in equities rocketed along with interest rates.

Rates on the rise

Now, however, a “perfect storm” is gathering for an uptick in convertible activity, according to BofA’s head of EMEA equity capital markets, James Palmer. He notes that elevated inflation rates in the US and Europe have provoked the US Federal Reserve and the European Central Bank to quicken the tightening of monetary policy.

Rising rates are also coinciding with higher credit risk premiums, particularly on the lower credit spectrum. “Widened credit spreads are further pressuring corporates to consider cheaper financing options,” says Mr Palmer. “Non-investment-grade and unrated issuers in particular have seen a sharp increase in their cost of debt.”

Before rates began to rise, a BB-rated company could fund itself with traditional bonds yielding between 3% and 4%. That has since risen to as much as 10%. The potential value of conversion, however, means that investors will accept a lower yield on a convertible. So today the same company could issue convertibles at a cost of between 4% and 5%, Mr Palmer says.

At the same time, he continues, individual stock volatility has started to normalise at elevated levels, and this can be monetised as a positive input in convertible pricing.

Regional differences

Issuer and investor attitudes towards the instrument differ from region to region, however. In France and Germany, issuers are quite used to them and see them as simply another funding instrument.

“In the UK, however, chief financial officers (CFOs) and boards have a more binary attitude: either equity or debt,” explains Mr Rodriguez Andrade. “It’s more difficult to persuade them to issue convertibles, though that might change.”

He adds that more than 80% of UK companies have never done convertibles. “Once you have got a convertible, it’s much easier to do another,” he notes. “Around 70% of all transactions are repeats.” Companies also find it easier to issue their first convertible if a competitor has done one, Mr Rodriguez Andrade says.

UK issuers are more sensitive to how much of a convertible deal ends up in the hands of hedge funds versus outright buyers, or ‘outrights’. “Hedge funds will buy the convertible and short the equity,” Mr Palmer points out. “Issuers like outrights because they lock the bonds away and don’t short.”

UK issuers and long-only investors are both sensitive to the increased share weakness and volatility that arise when a company invites hedge funds to play around in its shares, says Mr Palmer.

The American way

In the US, the convertibles market is more driven by growth, and healthcare companies, particularly biotech businesses, which have yet to make a profit and constantly need cash. “US biotech companies tend to IPO [initial public offering], do a follow-on and then a convertible – that’s a standard playbook,” Mr Palmer says.

In 2021, BofA was third in the EMEA equity-linked rankings, according to Dealogic. This year, by late November year-to-date, it had moved up to second place, after JPMorgan. As a house, it is now promoting the value of convertibles within the funding toolkit for CFOs, treasuries and CEOs. “Its value has gone up relative to other tools such as high-yield,” Mr Palmer insists.

Care still needs to be taken, however. Mr Rodriguez Andrade notes that, while investors have significant amounts of capital to deploy, they are very price-sensitive compared with last year. “So, you have to make sure the pricing is right,” he says. “We have done wall-crossing exercises to calibrate the price in 75% of recent deals, if they are not an investment grade issuer or a repeat transaction.”

An added attraction of wall-crossing is that it gives outrights more time to do their homework, compared with hedge funds, which can and will make decisions more quickly.

Convertible maturities usually range from three to seven years. In 2021, there were many seven-year deals and even one stretching out to 11 years. “In the past six to 12 months, however, investors have been more concerned about longer-dated deals, which are more exposed to possible movement in rates,” says Mr Rodriguez Andrade. “So, we have been seeing more five-year transactions, while seven-year deals have been more difficult to market.”

Premia stabilise

Conversion premia have reduced. Issuers typically have to choose whether they want the lowest-priced debt or the maximum premium – they cannot have both. “In a low-rate world, the difference between lower and higher rates is zero, so it’s all about the premium,” says Mr Rodriguez Andrade. “But now, issuers are happier to give up some premium to reduce funding cost.”

In 2020 and 2021, premia went as high as 70%, with 50% to 60% being relatively common. Today that has reduced to a typical 30% to 40%, with investors seeing less upside as companies choose to increase savings on the coupon, Mr Rodriguez Andrade reports.

Conversion is either mandatory or optional. Mandatory deals tend to have short maturities and may be given 100% equity treatment by the rating agencies. This makes them suitable for mergers and acquisitions funding where a company wants to protect its investment-grade credit rating.

One of BofA’s recent showcase deals was a Ä960m mandatory convertible for Siemens Energy (rated BBB), where it acted as joint global co-ordinator and joint bookrunner alongside JPMorgan. The proceeds of the three-year transaction were used to part-finance an offer for the 30% of Siemens Gamesa Energy that the issuer did not already own.

With a coupon range of 5.125% to 5.625%, the issue priced at the best end for investors: 5.625%. The 17.5% conversion premium was at the mid-point of the 15% to 20% range.

Options open

As well as being handy for acquisition financing, mandatory convertibles can also be used to refinance hybrid securities. “Hybrids are a permanent layer of capital, and can only be replaced by another hybrid, equity or mandatory convertibles,” Mr Rodriguez Andrade observes.

If mandatory convertibles are a substitute for equity, optional convertibles are a substitute for debt, and are treated as such by rating agencies. BofA was joint global co-ordinator and joint bookrunner with Goldman Sachs and UBS on a recent SFr95m ($101m) optional transaction for the unrated Zur Rose online pharmacy group.

That was enough to pay the bond and, because of the equity element, to deleverage slightly. Because the company was worried about achieving a certain level of premium, the deal was marketed with a fixed premium of 25%. In fact, it priced at 27.5%. The coupon priced at the top end of a 6.125% to 6.875% range.

The team expects convertibles volumes to accelerate once volatility has eased off a little more. “Volatility is good, but too much volatility makes it easy for the board to say ‘let’s wait’,” says Mr Rodriguez Andrade. “When a company’s shares have been coming down for two years, it’s difficult to persuade them to issue at the bottom. We need prices to go up a bit.”

He recalls that 2009 and 2013 saw a surge in issuance once shares started to recover. “In 2023, we will see the beginning of a wave, which will continue into 2024,” Mr Rodriguez Andrade predicts.