Remember mandatory convertible bonds? Bonds that automatically convert into shares acquired a dubious reputation when they were last issued in large numbers back in 2002. Yet they have staged a big comeback this year.
JPMorgan has just sold €1.6 billion of bonds that will be repaid in the shares of German insurer Allianz. UBS has sold €700 million of bonds that will be exchanged for shares in car maker DaimlerChrysler. And Fortis, the Dutch banking and insurance group, has sold $700 million of bonds that will be exchanged for shares in Assurant, a US insurer it used to own. That adds up to almost €3 billion of issuance in just a month.
Investors have clearly got over an aversion to these bonds that led to a hiatus in issuance. That occurred after the last wave provoked an angry response from shareholders. French media group Vivendi Universal and French telecoms equipment maker Alcatel sold mandatories during the bear market of 2002. These deals were controversial as they were effectively rights issues in disguise.
Securities with a stigma
The VU and Alcatel bonds had two important features in common. First, they were convertible into shares at the market price instead of at a premium. Second, all the interest due was paid up-front. This meant that investors who bought the bonds were not exposed to credit risk. Having sold shares short to hedge their equity position, they were effectively getting risk-free coupons – and very high ones.
This may have been a clever way for VU and Alcatel to raise money when they were in financial difficulties. But all they were doing was selling stock forward at a discount. That was especially annoying because they were using a mechanism that allowed them to circumvent pre-emption – so existing shareholders were diluted. Although not all mandatory convertibles were as controversial as these two, most were sold by cash-strapped companies looking to raise money quickly. The securities soon acquired a stigma.
After a period of rehabilitation, mandatories have returned. The stigma, moreover, has vanished. The companies selling the securities now are not acting from a position of desperation. Rather, they are exploiting the main virtue of the structure. Unlike regular convertible or exchangeable bonds, mandatories give the seller certainty that the equity will be sold. Like convertibles and exchangeables, however, they can give the seller the chance to sell at a premium.
Take the case of Allianz. If its share price is below the reference price of €90.50 when the bonds mature, they convert into shares on a one-for-one basis. But if the share price is up to 20% above the reference price, the exchange ratio drops on a sliding scale down to 0.83. That means JPMorgan gets to “keep” the first 20% of any upside. Finally, even if the share price is more than 20% above the reference price, the exchange ratio remains at 0.83. That means investors in the bond get 83% of the incremental upside and JPMorgan the rest.
This poses a question. If the sellers get the best of both worlds – the certainty of a sale and the possibility of a premium – what is in the bargain for buyers? The answer is a high interest rate. Both the Allianz and Daimler bonds offer an annual coupon of about 4.5%, plus any dividends paid on the stock too. The interest can be thought of as compensation for surrendering some of any upside in the share price.
High-yield appeal
Big coupons look alluring in a world of low interest rates and thin credit spreads. Investors are currently desperate for high-yielding securities. The sellers of mandatories are therefore capitalizing on demand.
Another reason why mandatories have resurfaced is that companies aren’t issuing many regular convertibles or exchangeables. This is principally because the volatility of equities is low by historical standards. This means that options to buy stock, which are embedded in regular equity-linked bonds, are also relatively cheap. Companies would rather sell options when they are expensive.
The absence of other opportunities means that convertible arbitrage funds are more likely to dabble in mandatories. Again, that helps the issuers find buyers for the bonds at a good price. On top of this, investors who buy mandatories are effectively selling the issuer an option to put the shares to them in a predetermined price range. That amounts to selling an option at a time when they are relatively cheap.
The new mandatory convertibles are certainly more welcome than their predecessors. But investors should remember that companies are selling them not because they are strapped for cash but rather because they think they are getting a good deal. That’s something to chew over before being seduced by the fat coupons these bonds offer.
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