PRIVATE-EQUITY SELLERS, investment bankers and corporations have been toasting the return of the IPO in 2004. But the biggest change in equity capital markets this year, the near disappearance of equity-linked issues, has gone largely unremarked.
Data from Dealogic show that the total volume of convertibles issued in Europe fell to e3.2 billion in the first quarter of 2004 compared with e10.9 billion in the previous quarter – a decline of nearly 70% – and e4 billion in the first quarter of 2003.
Equity-linked issues accounted for just 9% of equity capital market deals in Europe in the first quarter of 2004 compared with 26% in both the first and fourth quarters of 2003. This fall is even more marked than the increase in IPOs, which accounted for 19% of ECM deals in the first quarter of 2004 compared with 3% in the fourth quarter of 2003 and 4% in that year's first quarter.
It is somewhat surprising that so few chief financial officers have opted for equity-linked deals given the favourable primary market conditions and unsatisfied appetites of convertibles investors.
"Demand is undoubtedly very strong," says Tareen Hussain, head of convertible bond research at BNP Paribas. "One easy way to measure it is by looking at the technical valuation of convertibles in the secondary market. Implied volatilities are very high at the moment, which means that convertibles are very expensive compared with benchmarks such as the underlying equity volatility. And that is a reflection of the strength of demand."
The paucity of new issues has left dedicated convertibles funds with fewer investment opportunities. Because many of these funds have to stay invested, they are snapping up the few new issues coming to market. And European investors are looking farther afield, to the US and Asia, for buying opportunities.
In April, for example, JPMorgan helped Harmony Gold, a South African mining company, get away a R1.7 billion ($249 million) five-year convertible, the first ever rand-denominated international issue. The deal offered a fixed coupon of 4.875% and a conversion premium of 22.7%.
"There has been almost a voracious response to the deals that have come," says
Viswas Raghavan, head of EMEA equity capital markets at JPMorgan. "We have seen very aggressive pricing and some deals like Delhaize have met with such enthusiastic demand that terms have been repriced above the premium range. The success of the rand-denominated Harmony Gold deal shows that investors are even inclined to buy deals in more exotic currencies."
Redemptions shrink the market
The scarcity problem for investors is being exacerbated by the magnitude of redemptions. "Not only is demand strong because we haven't had much issuance but also because we are right in the middle of a lot of redemptions," says James Eves, head of equity-linked at UBS. "A lot of bonds issued in 2000 and 2001 had puts in them and many of those are getting exercised, so there's a lot of cash coming back into the market."
UBS expects over $20 billion of convertibles to be redeemed, put, converted, or called this year in Europe alone and $45 billion in 2005.
Worldwide, the figure is over $90 billion for 2004 and $120 billion for 2005. Other estimates are even higher.
Although this means that it is getting harder for convertible arbitrage players to make money, potential issuers can benefit from the situation.
The Barclays Capital Convertibles Cost Index, which looks at the implied coupon/ yield to maturity of a European convertible (defined by Barclays as a five-year, BBB, non-call, non-put, par-par structure) to give a measure of the financial cost of issuing a convertible, is at the same level as it was last summer. Convertibles issuance in Europe during that period was at record levels, with a total of $16.3 billion raised in the third quarter alone.
Demand is not the only factor favouring convertibles issuance. Interest rates are still low and share prices have performed quite well. The one factor that was slightly less positive in the first quarter was the lessening of volatility as the market improved, making it more difficult to extract value from the imbedded option.
The options in convertibles are still relatively cheap compared with the plain-vanilla equity options market but investors are getting less value in absolute terms than they did last year.
The decrease in volatility and conditions in the convertibles market, however, are not sufficient to explain the fall in issuance.
"Last year was unusually active," argues Saul Nathan, head of equity-linked at Morgan Stanley. "Companies had a lot of financing and refinancing to do. There were extraordinarily attractive conditions for selling options and issuers also took the opportunity to do a lot of pre-financing. This means that a lot of companies probably over-achieved their financing ambitions. There was a lot of uncertainty last year about the economy, the dollar and rates, and convertibles provided a helpful buttressing hedge in case the outcomes were not so good. This year, with volatility down and share prices up, issuers are able to come straight to the equity market so the value trade-off between convertibles and straight equity has changed."
European equity-linked new-issue volume was the highest on record in 2003 at $47.2 billion, 4% higher than the previous peak in 2001. Equity-linked issuance counted for nearly half of all ECM business in 2003 compared with typical past shares of between 12.5% and 25%, as estimated by BNP Paribas.
Equity-linked specialists baulk at the suggestion that their structures are essentially bear-market products but the truth is that equity-linked issuers generally fall into two categories: those who feel their shares are currently undervalued (bear issuers), and those that issue opportunistically.
Bankers and analysts are confident that the product will regain some ground in the
second half of the year as stock markets begin to lose some of their upward momentum or even give up gains.
"It looks like '04 earnings estimates made in 2003 may have been overly optimistic, so it is possible that the equity market will come off during the second half and give back some ground," says BNP Paribas' Hussain. "That in turn means that equity volatility will rise again and the equity market will become less attractive."