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30 | ifr Top 250 Borrowers | June 2010 CONVERTIBLE BONDS

But 2009 saw a revival in the secondary market and the reopening of the primary market where both issuers and investors had a positive result. For 16 consecutive months from January 2009 through to April 2010, convertible arbitrage funds made positive returns, while outright funds were seeing performance that was just as good. By the end of 2009, a CB arb strategy had returned 47.35%. Yet since the sovereign debt crisis began in Europe in 2010 the convertible market has gradually closed. The nine months of continuous issuance in Europe since the market opened in March 2009 gave a run rate that over 12 months would have produced volumes back on a par with the record 2003. Then the sovereign crisis in equity and credit markets took hold in May, when there was no issuance in the region, and as June began, bankers were negative on immediate prospects. Asia saw one issue and the US four in May. Typically the convertible market has seen issuance cycles that are self-imposed as the constant effort to achieve tighter pricing than the previous deal ensured that each passing deal took the market a step closer to a deal that failed and the market closing.

In 2009 it was largely different. Companies were in greater need of funding so pushed far less on pricing, which helped to attract greater numbers of investors to the asset class as positive returns were easily achievable. There were some tougher demands made of investors in 2010 and oversubscription was far more limited, but nothing that should have closed the market.

Instead the market has been an indirect victim of sovereign debt worries. One of the attractions of convertibles is that they share in much of the benefit of rising equity markets, but are protected on the downside by bond floors that are rarely below even 90%. This was a large part of the marketing effort in late 2008/early 2009. The problem comes when falling equity prices are compounded by widening credit spreads, at which point losses on convertibles can accelerate very quickly. “It was very weak in secondary markets in late May. At that point comparisons to the difficulty of issuing in the primary market of March 2009 were accurate,” said one convertible bond originator. “There was a whole risk inversion so investors retained the best credits like KfW and dropped the non-investment grade names. Many desks stopped making markets at all.”

Falling prices were an inevitable result of credit spreads widening and equity markets falling. But these were compounded by investors reacting by selling to hold cash. Liquidity is light in the European market and, as sellers increased, the market dislocated.

“With the credit market hit then

convertible bonds were inevitably hit on the secondary side,” said one London-based head of equity-linked. “The low liquidity of the convertible market meant some bonds were hit by as much as eight points.”

Action continues in US

While the European market has become hamstrung by sovereign issues, the US continues to see new issues priced, even if just four issues in May is well below expec- tations for the typical size of the market. Part of the reason that there is any activity at all is down to a switch by investors. “The US market is super healthy because it benefits from the concerns in Europe,” said one head of equity-linked. “When the market sold off in May many investors were switching out of euro-denominated bonds into US dollar CBs. For many it was a foreign exchange-driven switch, and it has helped support prices in North America.” But even though each new issue shows the potential for companies to access funding at far lower cost than achievable from straight debt, it has failed to spark a pick-up in issuance, which remains at multi-year lows in the US. The recent cases of Salix

Pharmaceuticals and technology firm Xilinx illustrated some of the reasons that companies should be issuing convertible bonds. Xilinx managed to achieve attractive terms of a coupon of 2.625% and a conversion premium of 20%, where one trader modelled fair value at 99.5, even without using volatility assumptions based on more stable times.

The purpose of the deal was to finance a stock repurchase and was significantly better value than alternatives, such as financing the buyback with cash or issuing straight debt, which would have cost 7%- 8%. One originator said: “I’m actually surprised that we haven’t seen more companies turn to convertibles to repurchase stock.”

It was a similar picture for Salix, where the potential for growth and volatility inherent in the sector are attractive for hedge funds looking to play the arbitrage. Yet the reason the deal could be upsized by 50% was thanks to the demand from

outright accounts. Here the company benefited from the dearth of bonds within the sector.

Both firms also minimised the likelihood of triggering dilution by raising the effective conversion premium to 75% through a call spread.

The call spread is a significant factor in

convincing US companies to issue convert- ibles as they achieve massive savings over straight debt but with little concern about the dilutive effect of conversion. However there is a shortage of balanced convert- ibles, where the CB is trading at a price where it is neither equity substitute nor trading at its bond floor, on both sides of the Atlantic.

Bonds issued prior to the credit crisis ended up trading massively out-of-the- money, while many of those issued since 2009 are now well in-the-money having been issued off such low stock prices. The desire of many outright accounts to hold balanced bonds in their portfolios ensures new issues receive close attention that can be exploited by companies, as the aggressive pricing of Xilinx showed. The lingering difficulty for bankers trying to convince companies to issue con- vertibles is that market conditions are not good for any financing, and most good quality credits pre-financed last year. At present most discussions with companies capable of issuing convertibles are focused on 2012 refinancing, which is not urgent. “The trouble is that the companies that want to issue a convertible can’t, while those that could don’t need to,” said a head of convertible origination at a European bank. The one possible exception is financial institutions. Those that are struggling to issue straight debt could turn to the convertible bond market, but one originator suggested a convertible would not solve banks’ issues. “FIG is a whole other issue that isn’t going to be solved by issuing a senior convertible,” he said. However, exchangeable bonds could provide a benefit by taking an existing asset and making it work, such as the two bonds issued by Banco Espirito Santo in 2010 (see separate article in this report). The issues by BES also illustrated the need for potential issuers to be ready to move when there are market windows. Just a few weeks after BES issued the market closed, and Portuguese credits have signifi- cantly widened. After issuing with a 3% coupon in April, the BES bonds exchange- able into EDP are trading at 87 and offering a yield to put of 8.21%.

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