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The US primary convertible bond market has grown rapidly this year, providing low-cost funding to highly rated corporates at a time when other sources of capital are running dry. The market's proponents claim convertibles have matured into a mainstream financing instrument. But the high degree of structuring suggests that many deals this year have been pure volatility plays sold to a new breed of hedge fund investors that might withdraw as quickly as they appeared.

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Larry Wieseneck

The huge increase in convertible bond issuance in the US this year has been heralded as evidence that the market is finally coming of age. Certainly the figures look impressive. By June 2001, 111 deals worth $56 billion had been issued in the US alone, according to data provided by convertbond.com, a convertible bonds news and data website owned by Morgan Stanley. The figure means that the market is responsible for more than half of all types of equity issuance.
That isn't so surprising given the dire state of common-stock issuance this year, but $56 billion is just $5 billion short of US convertible issuance for the whole of last year. What's more, most of the deals have been done for investment-grade corporates, which historically in the US have shunned the converts market in favour of straight debt or equity issuance. It's traditionally high-yield companies that tap the US converts market. (The opposite is the case in Europe.) "This year's issues have been dominated by much more solid, stable companies with larger balance sheets, liquid stock and investment-grade ratings," says Philip Jones, global head of equity product development and equity-linked capital markets at Merrill Lynch. Roughly 65% of volume and 51% of issues this year have come from high-grade corporates, compared with just 37% of volume and 24% of issues last year.
This market boom is the result of three key factors: the right conditions, desperation, and a heavy dose of luck. As yet it is unclear whether these factors have acted as a catalyst to make a more mature market, or whether they have prompted a short-term binge.

Lead underwriters of US convertible bonds (by volume)
Underwriter	2001 proceeds ($m)	2001 %	2000 proceeds ($m)	2000 %
Merrill Lynch	14,790	26.4	14,958	24.2
Goldman Sachs	9,068	16.2	12,429	20.1
CS First Boston	8,075	14.4	8,730	14.2
Salomon	7,831	14	4,469	7.2
Morgan Stanley	6,874	12.3	8,690	14.1
Lehman	4,455	8	3,897	6.3
UBS	1,575	2.8	900	1.5
Bank Of America	1,382	2.5	360	0.6
JPMorgan	625	1.1	1,115	1.8
Bear Stearns	425	0.8	550	0.9
Deutsche Bank	350	0.6	1,785	2.9
Robertson Stephens	400	0.7	1,271	2.1
CIBC World Markets	150	0.3	275	0.4
TOTAL:	56,000		61,687

Source: convertbond.com 31 May 2001

Innovation is strongly evident. Bankers have added new structures to the product to make it applicable in a wider variety of cases, most of which are designed to get a company more favourable tax or accounting treatment. The most obvious of these is the contingent conversion structure, which imposes a floor that the underlying stock must reach before it can be converted to equity. This was first used in the US last November when Merrill Lynch structured a $3.45 billion deal for Tyco so that the company could pay Lucent Technologies for a cash acquisition. The benefit to the company was that it allowed the deal to be accounted for as a debt transaction, avoiding earnings per share dilution.
At the start of the year a variant on the contingent conversion was introduced to the market - the contingent payment structure, by which investors in a deal are paid a lump sum not to convert a security into stock in the event of the stock price nearing the conversion price written into the deal. Since the Tyco deal in November, 41 deals with either or both contingency features have been issued.
The convertible bond was therefore becoming a much more user-friendly corporate finance tool, rather than just a cheap way for low-rated companies to raise capital.
And it also had another use. "We'd been telling issuers for a long time that converts could provide an elegant alternative to commercial paper, in the right circumstances," says Larry Wieseneck, head of US equity capital markets for Lehman Brothers.
As interest rates came down this year, and as volatility in the equity markets remained high, convertibles became an even more attractive commercial paper replacement. The ability to structure in higher and higher conversion premiums made possible zero-coupon, zero yield-to-maturity securities.
Virtually costless securities
For issuers, it was a no-brainer: here was a virtually costless security in an environment where capital wasn't cheap. So issuers jumped at the chance. "Many of the zero-zero issuers are using the proceeds to buy back their stock," says Doug Baird, head of US equity capital markets for Deutsche Banc Alex Brown. Others are also reducing their commercial paper and term-debt outstandings. Nothing wrong there but, he continues, "they could even buy US treasuries with it".
What has made such high primary market volume possible is not the regular convertible bond investor but the convertible bond arbitrage funds and the less specialist hedge funds. Says Baird: "The market's ability to value, market and trade volatility has increased exponentially. And an issuer launching a zero-zero convertible is selling nothing but volatility." These investors aren't interested in the coupon and yield, but the arbitrage opportunities between the equity component of the convertible and the underlying stock itself. And they like the larger, more established issuers because it's easier to short their underlying stock.
The conventional convertible investors, meanwhile, have been largely left on the sidelines. "They're looking for long-term returns from the yield and coupon, not the arbitrage opportunities," says a banker. "Any deals that have a conversion premium in excess of 30% just aren't going to attract the traditional long-term converts investors."
So far, then, there are hungry hedge fund investors looking for returns in excess of 15%, issuers agog at the opportunity to raise capital virtually for nothing, near-perfect conditions for convertibles issuance, and a shelf full of new structures to try out.
It's already sounding ominously bubble-like. But there are a few other factors to add. First, many of the zero-zero deals have one-year puts, which is unusual - in the past, puts wouldn't kick in until the third year at the latest. While making the security appear more like commercial paper, it also gives investors an opt-out clause.
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