Source: www.breakingviews.com is Europe’s leading financial commentary service
Date: July 2003
By Mike Monnelly
Companies are selling convertible bonds by the bucket load. And investors are snapping them up as if they are going out of fashion. Can both be right?
May was a phenomenal month for the convertibles market. US companies raised $12.5 billion, the highest monthly total in a year and a half. Europe had its second best month over this period, with sales of $5.5 billion. Low interest rates, narrowing credit spreads and a fairly high level of volatility on the stock market have produced ideal conditions for launching convertibles.
Nevertheless, some of the deals have been done on unbelievably advantageous terms – for the issuers. Take April’s $750 million deal from US internet portal Yahoo! Not only do the bonds pay no interest, investors must pay a 68% premium to convert them into stock. Or consider last month’s deal from German engineer Siemens. It pays a 1.4% coupon, half the dividend yield of the ordinary shares, and is convertible at a 46% premium.
It is easy to see why companies are printing these bonds as fast as they can. They are a dirt-cheap alternative to raising regular debt. True, a bull run on the stock market could send share prices shooting up over the conversion threshold – and most recent issuers have volatile share prices. However, the threshold has been set extraordinarily high, in some cases at double the underlying share price. There is a fair chance that shares won’t breach these levels. And even if they do, shareholders probably won’t make too much of a fuss. After all, they will be better off, too.
If companies selling the bonds are getting such a good deal, though, why are investors buying? Convertibles have produced mixed returns in recent years. Investors bought bags of them in 1999-2000, which never converted because share prices collapsed.
One reason is that buyers are not necessarily gambling on the debt converting into shares. They are taking a subtly different punt – on the value of the option embedded in the convertible.
Most recent convertibles (estimates suggest three-quarters of the total) have been bought by arbitrageurs. By hedging the bond’s exposure to interest rates and credit quality, they isolate the value of its option to convert into shares. How much this option is worth is determined by how volatile the shares are.
Arbitrageurs, can work out from the price of a convertible bond an implied level of volatility in the stock. If they think the actual volatility will be higher, they buy the bonds and sell the shares short, making sure to adjust their exposure to the stock as its price swings up and down. So long as the stock is more volatile than implied by the bond, the option embedded in the convertible goes up in value.
Stocks have been increasingly volatile for a couple of years now, making this arbitrage profitable. The snag is that the copycats have caught on. Too many investors have put on the same trade, depressing returns. This has shifted the balance of power between companies that sell bonds and arbs that want to invest in them. And that is evident in the pricing of convertibles.
This does not necessarily mean that investors will lose money. They will make profits so long as actual volatility is above the implied level. But it does raise the cost of playing the convertible-arbitrage game. The higher the implied volatility, the smaller the returns available and the greater the risk of losses.
That investors have been playing the game regardless suggests that the market is getting frothy. But the winds of change are blowing. Alcatel, the French telecoms equipment maker, has just been forced to sweeten the terms of a very aggressively priced deal. The top of the market may finally be within sight.
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