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Skip Navigation LinksHome :: Back Issues :: Market faces up to troubled calm after a perfect storm

March 2002

Market faces up to troubled calm after a perfect storm


Convertibles bankers are fretting about the lack of issuance so far this year. It’s hardly surprising, it was one of the most active markets in 2001. Some are hoping that the need to raise money quickly will help boost volumes but issuers may prove cautious.




       
Matthias Mosler
Just as equity-linked bankers are starting to get used to a high profile, it seems it may be in jeopardy. Last year, as convertible issuance shot up by more than 50%, their market suddenly became mainstream. From being a product that contributed between 10% and 15% of the business of the equity capital markets divisions of most banks, in 2001 it accounted for more than a third. But a quieter than expected start to 2002 is giving market participants the jitters.
They're right to be nervous. Since the beginning of the year, investors have had a very rough ride. January and February have been painful months, with equity valuations down and bond spreads widening on the back of a steady flood of negative news.
All of this means that they're demanding proper payment in return for the risks taken on. In the convertibles market that involves increasingly high bond floors - through a shorter final maturity and earlier or multiple puts. Issuers are having to respond and give them what they want in order to get deals done. In 2000, for example the average maturity of a convertible deal was 5.16 years, in 2001 it was 3.96 years.
The trouble is that these short-dated convertibles with puts just a few years into the life of a bond don't suit every issuer. It's fine for relatively sophisticated institutions to do this - those that can handle having to find money at short notice if their share price doesn't rise as fast as expected and investors put paper back to them, but less so for firms with a lower credit rating or those operating in more volatile sectors.
In April, for example, Italian bank La Fondiaria issued three convertible bonds on the same day, via Lehman Brothers and Mediobanca, exchangeable into Monte dei Paschi, Generali and Banca di Roma. These pay coupons of between 0.875% and 1.125% and have yields of 2.2%, 2.4% and 2.9% respectively. In order for any of the bonds to convert, share prices will have to rise by an average of around 35%, which looks unlikely before the date of the first puts in April 2003.
La Fondiaria has little cause for concern. Even if it has to refinance these deals, which seems probable, it has enjoyed access to cheaper funding than some sovereigns, despite being unrated. "For high-grade exchangeable issuers such as Fondiaria, I have no doubt that leveraging an equity option to achieve funding at an all-in cost significantly below where the Italian government borrows is attractive whether it runs for one, two, or three years," says Daniel Oakes, associate director in convertible bond origination at West LB Panmure.
It can be risky for less-mature issuers to follow this trend. In August 2001, UK company Shire Pharmaceuticals, which doesn't have a rating either, issued $400 million of convertibles with a 2% coupon and a 2% yield. The paper has a 10-year maturity but there's a put after three years, making CFO Angus Russell's claim to have arranged 10-year money at 2% sound slightly thin.
The bonds have an initial conversion price of £14.11 whereas Shire's share price is currently around £7.60.
Given the slim margin investors are being paid to hold the paper, they may well decide to sell out when the put comes around. So by next year, Russell will have to start making provisions for the bond to be put back, by which time there may be fewer refinancing options open to young biotech companies.
       

View graph.
In fact, there are a large number of outstanding deals due to be redeemed in the next two years that look unlikely to convert. France Telecom's e3 billion exchangeable into Orange is a case in point. The paper - which pays 2.5% - matures in February 2003 and has a conversion price of e12.70. Currently the share price is languishing around e6.60, meaning a rise of almost 50% is needed before it is worth investors' while to trade in the debt for equity.
Vivendi's e1.8 billion ($1.6 billion) convertible into Vivendi Environment requires a similarly optimistic increase in the share price for investors to consider converting when its first put date arrives in March 2003. It's trading at e44.30 on the Paris stock exchange and has a conversion price of e55.90.
In October, Finnish shipping company M-Real, formerly Metsa Serla, will face redemption of $350 million of outstanding convertible paper. At the agreed conversion premium, investors would only get back 63% of the value of the bond in shares. So it's a pretty safe bet what they'll be doing.
The reality is that non-conversion is now much more common. This is set to continue as long as stock markets stay depressed. "The world has woken up to the fact that convertibles do not always convert," says Martin Haycock, head of convertibles research at UBS Warburg. "For many years, issuers saw convertibles as delayed equity. In today's markets, issuers seek to issue cheap debt by selling volatility." The danger comes when non-conversion leaves a company in the lurch.
In a credit squeeze, the sort of discount that can be got in the equity-linked market is incredibly appealing. "Issuers can get a lower coupon rate than they would with straight debt, plus they can monetize a corporate asset that does not appear on the balance sheet - namely the volatility of their stock price," says Douglas Decker, head of convertibles research at Barclays Capital. For example, bonds issued by Alcatel due to mature at the same time and rated one notch higher than M-Real's - which pay a 4.375% coupon - pay a 7% coupon.
Adds Susan Lewis, head of equity linked at Citigroup: "Short-term financing has not necessarily been a major focus of this market, but I think it could be in 2002." Her peers at rival institutions are hoping she's right and that a need for fast cash will kick-start the convertibles market, which so far in 2002 has proved sluggish in contrast to last year.
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