Convertibles grabbed centre stage last month as European and US
issuers took advantage of strong investor demand and the attractive
combination of rallying share prices and tightening credit
spreads.
Amid the surge of issuance the high premium structure made its
first appearance in Europe with Dutch semiconductor equipment
manufacturer ASM Lithography's seven-year e330 million offering,
managed and underwritten by Morgan Stanley.
Ever higher premiums have been a trend in
the US for some time but to the dismay of many European
investors the trend now seems to have started to take root in
Europe. At 75% the premium on ASML's is nothing exceptional by
US standards where premiums of over 100% have started to
appear. In April, Wells Fargo issued the second-largest
convertible of the year, a $3 billion 30-year non-call five
that carried a conversion premium of 110%. Maxtor beat that
with a 125% premium on its deal at the end of April.
The high-premium structure has become popular because it allows
CFOs to avoid what some equity-linked bankers refer to as the
"idiot factor" - giving away equity at prices they might later
regret. But a high conversion premium means that the bonds are less
likely to convert and the option is more likely to be further out
of the money.
For investors the option becomes more expensive in relative
terms and more risky. But many non-hedge funds have become more
willing to accept the risks associated with high conversion
premiums if the underlying credit story is strong because the more
generous coupons associated with these deals satisfies the demand
for higher yield.
"For ASML the high premium structure made sense," says Saul
Nathan, head of European capital products at Morgan Stanley.
"Higher premiums make conversion less likely and so it becomes
easier to sell the convertible on the basis of an improving credit
story, which is attractive from a dilution perspective. Given
ASML's credit rating and the point in the semiconductor capital
equipment cycle, this was also an improving credit play which
offered a high current yield."
The high premium structure helped the sub-investment grade (B2)
issuer achieve a much lower cost of funding than it would have got
with a regular bond, for which its implied cost of funding would be
a hefty 650 basis points over Libor.
ASML has issued four convertibles since 1998, and this latest
deal is expected to help refinance its $520 million 1999
convertible that matures in November 2004. That deal, by contrast,
offered a premium of just 23% and a coupon of 4.25%.
Although there was ample demand for the deal, non-hedge fund
investors found the high premium an annoying distraction and the
deal was bought for the credit story and coupon.
"We'd obviously prefer to pay less premium rather than more,"
says William Schatten, the portfolio manager of Gartmore's AlphaGen
WhiteOak Convertible Bond fund, who subscribed to the issue despite
the high premium. "There has to be a compelling credit story or
some catalyst for increased equity volatility for us to be able to
extract value. With the ASML bond we were comfortable with the
credit, and moreover the 5.50% coupon was attractive to us, given
the low interest rate environment."
The demand for convertibles has been insatiable on both sides of
the Atlantic. This May there were seven deals in Europe worth $5.5
billion and 36 in the US worth $10.8 billion, compared with eight
worth $2.6 billion and 11 worth $7.3 billion the month before. On
one day, May 22, three European deals worth over e3.2 billion were
gobbled up, with massive oversubscription. French holding company
Wendel Investissement's e251 million six-year exchangeable into
shares of consultant Cap Gemini Ernst & Young was 20 times
oversubscribed.
The massive demand from hedge funds and active managers has
allowed convertibles issuers, the majority of which opted for more
moderate conversion premiums of 40% to 45%, to offer miserly
coupons. BNP Paribas and Société Générale, the bookrunners for the
Wendel Investissement exchangeable which had a conversion premium
of 45%, cut the coupon to 2% from an initial range of 2.375% to
2.875%. The seven-year Siemens convertible offered a 46% premium
and a coupon of 1.375%.