Convertible bonds: Is this love, or a teenage crush?

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.

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.

Second, being 144a-registered deals, it’s easy to price and market the securities within 48 hours, if not overnight. “You wouldn’t think twice about a straight debt deal being sold overnight,” says David Ballard, co-head of convertibles for the Americas at CSFB. “So why should convertibles be any different, especially when the zero-zeroes with one-year puts have at least a 90% debt component for that first year.”

That’s a good point, although few investors are buying them as debt securities, and hedge funds strip out the credit component anyway. And regular converts investors prefer roadshows.

The third and most crucial point, however, is deal-hungry bankers. The convertible bond market has this year become the life-saver for equity capital markets desks desperately seeking business. “There is a laser-like focus on our business within the bank,” says one banker. “And it’s the same at our competitors. We all enjoy a much higher profile internally than ever before.”

Limited-risk buys

In such a favourable environment for issuance there appeared to be little danger in buying deals. “In this environment, even if the deal is mispriced, the one-year put limits the risk to the bank,” says one banker. “If you’re wrong, the worst a zero-zero can trade is 98 cents.”

That creates an environment where bankers kicking their heels in a tough market see an opportunity to make some money, or at least keep their jobs, with little downside risk. This means, says one conventional investor, “that the converts market became a league table business. In fact, it’s looked a lot more like the agency debt business than the converts business of late.”

This raises the near-inevitable prospect of banks pricing deals too aggressively just to win the business, of being unable to distribute them, of being forced to hold them on their books. And some might even want to hold the paper and act as a quasi-hedge fund, shorting the underlying stocks and trading the volatility. “The market fundamentals are so benign right now that some banks will consider buying a deal and putting it on their own books purely to get market share,” says one banker.

Whether or not a bank has fully distributed a deal will always be a moot point, relying on rumour-mongering competitors, gossipy staff, loose-tongued investors, or all three. One way is to check if the greenshoe, if there is one, has been exercised. If not, it might be a sign of a bought deal. “A good rule of thumb,” says one banker, “is whether a bank brings a deal, especially a large deal, which its peers think is badly priced or ill-thought through. If that bank then retreats from the market for a while, that’s a good sign they’ve taken on too much and their internal credit people have told them to hold back.”

CSFB was widely believed to have kept $1 billion of the $2.25 billion deal it underwrote for Tyco in February. Its co-head of converts for the Americas, Lee Cole, says of the rumours: “We had to laugh every time we heard that. The truth is we made money on that deal.”

The bank issued its next 144a deal over two weeks later.

Goldman Sachs is a more recent victim of the rumour mill, with claims that it might have been forced to hold $700 million of a $3 billion zero-coupon deal for Verizon that it launched on May 9 2001.

Its relatively quiet showing as an underwriter in converts during the first three months of the year has heightened speculation that Goldman has been tempted to do market-share-winning deals.

David Ryan, Goldman’s head of US equity-linked capital markets, denies there was a problem. “We fully distributed Verizon on the first day.”

Salomon Smith Barney has also come in for some criticism for buying deals. Starwood was one such deal, and, says a rival, “the deal for Mirant was the single worst deal out there. The company’s stock collapsed right after the convertible was issued.” Bankers at Salomon did not return calls requesting comment.

Each bank vehemently denies such rumours, of course, but there is a positive flip side to this: once bankers start complaining of bought and mispriced deals, it usually implies a market is maturing.

Even if conditions have been favourable, and even if some deals have been bought, the fact remains that a lot more companies from different sectors and from across the credit-ratings spectrum have been tapping the market.

And bankers are taking that as a sign of the growing maturity of the convertible bond market. By May 8 four US asset-management firms had tapped the convertible bond market, and they did so within two weeks of each other.

“Asset managers are not usual issuers of this kind of paper,” says Jones at Merrill Lynch and the man responsible for bringing all four of the deals, starting with Stillwell Financial’s 30-year zero-coupon $690 million issue on 25 April. The other three were Neuberger Berman, Affiliated Managers and Franklin Resources. “So to have that many within a couple of weeks indicates how this market is growing beyond the more common users such as telecom and media.”

Energy companies are returning after staying out of the market for years, and corporates in the leisure sector are bringing deals. As Ballard at CSFB puts it, “We are hearing so many CFOs of large-cap single-A rated corporates who have shunned convertibles for 15 years or more suddenly asking us why the market looks so appealing at the moment.”

It could well be that companies all across the credit spectrum will come to regard convertibles as a valid and integral part of their capital-raising tool set, and the evidence over the past eight months is encouraging. “As a result of the issuance we’ve seen over the past eight months, convertible bonds have to be in the lexicon of every CFO,” says Wieseneck. “With blue-chip, Fortune 20 companies getting in on the act, it’s difficult for converts not to be taken seriously now.”

But already there are signs that the exuberance of investment-grade companies is on the wane. After the record issuance month of $20.43 billion in May, June settled down to a more manageable $6 billion or more in deal volume, and for more regular, higher-yielding companies which go on roadshows and target the standard converts investors. The percentage of greenshoes being exercised is up as well.

The reason for the drop in investment-grade issuance is the drop in equity volatility of late. That’s hit the hedge funds, which had had four months of easy profits but which are now nursing some losses. So they’ve become much less active investors, and the number of zero-zero deals and one-year puts have dropped markedly in just the last four or five weeks.

Issuers might not take too kindly to a market with such fickle investors. And if volatility doesn’t increase, they might be even less happy as of next January when the first deals become puttable.

That might pose a problem. “We told issuers this year that they should only do one-year puttables if they were indifferent to whether the deal would be put back to them, converted, or held to maturity,” says one banker. “But we don’t think all our competitors have been doing the same.”

In fact, he says, some bankers have been telling clients that precedents show that investors rarely put converts back to the issuer. “But that is based on deals with three- or four-year puts issued within the last decade. And that was in a huge bull market, so putting the bonds would not make sense.” But it does for volatility-seeking investors who’ve taken a hit on deals during a downturn and who have the option to get out early if poor market conditions continue.

Corporate executives who have issued a convertible and used the proceeds to pay down existing debt or buy back stock in the belief that the deal won’t be put back within a year, could find themselves suddenly strapped for cash if investors surprise them.