A tale of two emerging markets
Although they form a global market worth more than $350 billion – and have a pedigree dating back more than a century – convertible bonds are all still regarded in many quarters as exotic and obscure instruments. Often associated with start-up or high-risk corporate borrowers, most convertibles are still domestic US issues.
But convertibles are coming into the mainstream of the international capital markets. Partly this reflects their growing use in emerging markets. Partly, it is because new structures such as synthetic Euroconvertibles are bringing highly rated corporate borrowers -especially blue-chip European companies – into the market for the first time. Driven by strong demand from institutional investors, issuance of Euroconvertibles is increasing rapidly in parts of the world where such structures were once a rarity.
In Germany, for example, the Euroconvertible is one of the fastest growing markets, rising from virtually nothing at the beginning of 1996 to the present total of more than $4.7 billion. According to Jeremy Howard, head of global convertible research at Deutsche Morgan Grenfell, this figure “is capable of growing by Dm5 billion [$2.8 billion] by the end of 1998 and by at least a further Dm25 billion before the turn of the century”.
Japanese premium
Another highly promising source of Euroconvertible issues, for slightly different reasons, is Japan, where between $10 billion and $20 billion of issues could be made over the next two years mainly from undercapitalized banks.
The country’s banks are desperate to recapitalize following the property write-offs which have devastated the balance sheets of corporations and financial institutions. Their balance sheets are further weakened by the network of cross-holdings in Japanese industry, and banks have been breaching their capital ratios.
Conventional convertibles would not qualify as the upper-tier capital Japanese banks require because investors have the option to take cash on maturity rather than equity. So the concept of mandatory convertibles has been devised; these are bonds which the investor must convert into shares upon maturity.
A number of institutions have already issued these bonds, including Bank of Tokyo-Mitsubishi, Fuji Bank, Sakura Bank, Sumitomo, Sumitomo Trust and Banking, Asahi Bank and Mitsui Trust. Bankers expect a steady flow of further issues over the next two years.
“It is a good deal for the investor because if the stock market continues to perform badly, they simply receive more shares when the issue matures,” says one Japanese banker. “The only people who get hurt by the convertible resetting more in favour of the investor are the shareholders. They don’t have a choice because it is the only way to restore the capital ratios of the banks. It is a fairly horrible situation because the only way they can raise the money they need is by issuing cheap paper.”
With Japanese bond yields at a historical low, these convertible issues are particularly attractive to Japanese institutional investors. For traditional bond buyers in all countries, convertibles offer a less risky exposure to the equity market than buying stock. They give investors greater confidence that they will get their money back at maturity and provide a coupon stream during the bond’s existence.
Defence tactics
Convertibles are defensive instruments for investors as they perform less well than straight shares in a rising market. They offer an element of safety over straight equities when it looks as if sentiment may be about to change.
“Equities are quite capable of halving in price while, if convertibles have a catastrophic performance, they go down by three or four points,” says one analyst. “Very often it is the convertibles which outperform in a falling market.” Convertibles are also attractive to those looking for income because the yield is generally higher than the underlying yield on a stock. In a rising market investors get both equity appreciation and a higher yield.
One drawback is that convertibles are not as liquid as stocks, but this may be changing. Up to three quarters of issues tend to disappear into the portfolios of long-term holders but the remainder are traded with increasing frequency. One London bank reports that its secondary market trading has more than doubled in the past year.
A key factor supporting the market for convertible bonds from borrowers in many countries is that much of the investment is from funds specifically aimed at the sector. With an average life of four years for convertible bonds, effectively a quarter of investors need to purchase new offers every year. “The knowledge that the demand is there will continue to stimulate more issues,” says one banker.
The rapid growth in the convertibles market in the past three years, particularly in Europe, has been underpinned by investment from US mutual funds. Large dedicated convertible funds have been set up, ensuring a steady flow of investment across the Atlantic. Mutual funds use convertibles to adopt a more cautious approach to an equity market which they believe is at or near its peak. They also see these instruments as a less risky way of entering emerging equity markets.
Continental European private banks represent a further important source of funds. These institutions represent wealthy individuals who, in the words of one analyst, “don’t care so much about getting much richer but do care tremendously about not getting poorer”. The convertible provides them with absolute confidence that, providing the company has not gone to the wall, they will get their money back at maturity.
The main attraction for issuers is that convertibles are very flexible instruments that can be used to meet a number of very different requirements. While Japanese banks use mandatory convertibles as a means of increasing their capital base, European issuers are using exchangeable and synthetic convertibles to unravel cross-holdings and to finance takeovers.
Possibly the most significant recent trend has been the development of the synthetic convertible market. These bonds are typically created by an investment bank and are convertible into shares the bank does not yet own. This can be profitable for the banks as the convertible’s volatility can be higher than the share’s historical volatility.
“As the stock rises and it becomes more likely that the bond will be converted at maturity (i.e. the stock price will be above the conversion price), the bank will be long the precise amount of shares necessary for converting bondholders,” says Deutsche Morgan Grenfell’s Howard. “If the stock falls and bondholders look like they will not be exercising their conversion right, the hedge is lightened to zero.”
“By combining some straight debt with some optionality purchased in the market, a synthetic can be formed and sold,” explains Hamish Bullough, head of convertible sales at Salomon Brothers. “The only way to make money since plainly you cannot create value is to create something which is worth, say, 97 and sell it for 100, and the three points is your profit. You can sell it for 100 because the supply-demand imbalance means there are sufficient people out there prepared to pay 100 even though they recognize it is only worth 97.”
Among the blue chip European companies to have issued synthetics are Henkel, Volkswagen, Deutsche Telekom, Bayer, Simonson and Nestlé. Alberto Romaneschi, Nestlé’s group treasurer, says he decided to raise the bond – $330 million on terms of 3% for five years and callable in three – because it was “an attractive source of funds where we avoided any earnings-per-share dilution. It was another intelligent way of taking advantage of the chance to raise cost-efficient funding. It was cheaper than what we usually achieve”.
German synthetics
Market conditions have been ideal for synthetics this year. Issues, which are only suitable for large companies, require a liquid share market so that the arranger or the equity swap provider can cover its position before the deal is announced. “They are based on arbitrage and volatility,” says one banker. “There is not too much room for a large number of transactions.”
Even so, Howard at Deutsche Morgan Grenfell says that the prospects for the sector are good, particularly in Germany. “The exact level of German issuance will depend on the level of overvaluation that persists in the market and the level of genuine company issuance,” he believes. “However, our best guess is that perhaps Dm1 billion of the Dm5 billion in issuance we expect in the last five months of this year will be synthetic.”
One advantage for synthetics over conventional convertibles stems from German shareholding law. “If you are going to issue new equity, you have to give the existing shareholders the first crack at it,” says one analyst. “The same applies for new shares issued through a convertible. Existing shareholders can decide for up to a month after the share is issued whether they wish to take them up.”
The overall volume of issues is evidence of the speed at which the German market has grown in the past year. Until 1996 German equity-linked bonds were restricted to a small number of domestic convertibles and bonds with warrants. But a total of 12 Euroconvertible issues were made between the second quarter of 1996 and mid September of this year.
“The growth has been so fast that investors can recreate almost 50% of the German Dax index using convertibles,” says Howard. “The current size of the market, its relative youth and the high number of very large issues, means that the market now enjoys the best liquidity, certainly on a bond-for-bond basis, in Europe. In 1997 the average monthly turnover of German convertibles has been $1.3 billion.”
And yet the German market remains small by European standards – growth of $9 billion would be required just to match the size of the Swiss market – and one consequence is that German convertibles have become overvalued. But that could start to change as more convertibles are issued.
“Until now German issues have been very expensive because of the scarcity value,” points out one banker. “As more are being made, the prices are starting to soften a little.”
One of the main growth areas is likely to be in the unwinding of corporate cross-holdings as pressure grows from shareholders for return on equity to be increased by the sale of non-core assets. According to the Bundesbank, industrial cross-holdings account for 42% of equity ownership. One of the most efficient ways to sell these assets has been by using exchangeable convertibles, where a company issues a bond which can be exchanged into another company’s shares.
A recent example was Deutsche Bank’s issuance of a bond effectively to sell 2.5 million shares of its stake in Allianz. “The advantages for Deutsche Bank in issuing an exchangeable rather than just selling the shares on the market are that the exchangeable allows the equity to be sold at a premium to the prevailing market price,” says Howard. “Because the premium on the convertible was 25% at issue, Deutsche Bank was effectively selling its shares for Dm384.4 versus a prevailing market price of Dm278.72.”
A more aggressive use of exchangeable convertibles is to finance takeover bids. In France, Canal+ wanted to take over Nethold, which itself held a non-strategic stake in Mediaset. Canal+ raised the money it needed, with the help of Lehman Brothers and UBS, to finance its bid with a ffr2 billion ($340 million) bond exchangeable into the Mediaset shares which it did not yet own (see Euromoney, March 1997).
“This was the first time this has been used,” says one banker. “It is a neat device to enable a firm to make use of a non-strategic holding held by its target company. Effectively they are preselling shares that they will only acquire if the takeover is successful so they can raise the funds for that takeover. It is neat and cost effective and it works well so long as you have a safety net to change it into another instrument if the takeover does not go ahead.”
Privatization angle
This is but one example of the imaginative ways European banks have tailored convertibles to meet particular needs.
Others include the privatization of the Italian insurance company INA. This $2.12 billion deal was a two-tranche two-currency issue (Italian lire and US dollars) of privatization-exchangeable notes. This, say analysts, managed to satisfy both local Italian buyers with the lira tranche and the international community with the dollar tranche.
“With a huge privatization programme ahead across Europe, governments will want to attract the widest possible list of investors,” says one banker. “So I think there will continue to be a mix of ordinary equity and exchangeable offerings.”
European issuance of convertibles is just beginning.
