Convertibles to Decelerate from Torrid Pace
While no interest rate hike is forecast in the remainder of 2004 either in the US or in the eurozone, expectations that interest rates have reached an inflexion point could prompt a rise in new convertible bond issuance. As a reference, during the last round of interest rate hikes in the U.S. which commenced in June 1999 and lasted until June 2000, convertible bond issuance volume increased by 44% in the 12 months after the first interest rate action, in comparison with the 12 months before June 1999. In this round, even though broad equity indices globally have recorded visible gains since the start of 2003, the potential to capitalize on equity appreciation potential in specific sectors has certainly not yet been exhausted. If share prices continue to increase, however, the appetite for convertibles could dwindle, since firms would opt in favor of issuing lower-cost equity in place of debt. In the year to date (ending Mar. 10), the high technology sector continues to be at the forefront of new convertible issue activity, following a record performance in 2003. Issuers in sectors such as high technology, which suffered a multi-year slump in equity prices, are well placed to offer the opportunity of equity conversion at a premium to investors, while using the proceeds from the borrowing to rebuild liquidity.
A prolonged period of low interest rates has led to issuers taking advantage of the favorable funding opportunity in the convertible debt market to pay down existing debt, reduce overall leverage, refinance existing debt, rebuild reserves for potential acquisitions, or fund R&D programs. Relatively lower-rated borrowers-particularly at the ‘BBB-‘ rating designation-are taking opportunistic advantage of the favorable borrowing conditions, benefiting from the cashpreservation advantage associated with convertibles. Issuers positioned at this cusp between investment grade (‘BBB-‘ and above) and speculative grade (‘BB+’ and below) territory are likely at a stress point, and are therefore more apt to use this alternative funding mechanism. On the demand side, the deepening of the convertible bond market and improved evaluation techniques have fueled a broader base of investor interest from diverse domains, such as equity funds, insurance companies, and pension funds in addition to traditional players such as hedge funds. Data from Strategic Insight Mutual Fund Research indicates that net new flows into convertible securities funds increased to US$1.3 billion in Dec. 2003 vs. US$114 million in Dec. 2002. In the first two months of 2004, net new flows into convertible funds were running 27% above year-ago levels.
In 2003, convertible issuance reached near record levels with US$145.6 issued, slightly below the 2001 total of US$146.2 billion, which was the single largest volume of convertible issuance recorded historically (see chart 1). Convertibles gained market share in 2003, accounting for 7.9% of total new debt issuance vs. 5.5% a year earlier. In 2004 to date, convertible issuance is once again off to a healthy start, logging US$20.1 billion of issuance in the period ending March 10 vs. US$17.5 billion in the corresponding period a year earlier (see chart 2).
With US$79 billion in proceeds, U.S.-based issuers accounted for over half the convertible issuance in 2003, although volumes in the U.S. still remain below the peak recorded in 2001. Next in line were Europe and the Asia-Pacific regions, with US$39.4 of issuance (27%) and US$24.5 billion (17%), respectively (see chart 3). In terms of the rate of growth in volume, the U.S. outpaced the other regions, growing 134% in 2003 compared to the year ago. Europe also showed impressive growth, recording 41% in the same timeframe. In 2004 to date, the Asia-Pacific region has jumped to second place after the U.S. in volume terms, driven by strong issuance in Japan, Taiwan, and Singapore. Japan also recorded US$10.1 billion in convertible volume in 2003, maintaining the strong momentum that began in 2002. Promising signs of an economic recovery in Japan have raised expectations for increased capital spending by businesses, which along with rising stock market valuations, narrowing corporate bond spreads, and moderate volatility, has raised the appetite for convertible bond issuance in Japan. In Taiwan, strong demand for convertibles has been driven in part by the investment appetite of domestic banks with substantial deposits on hand. Taiwanese banks have typically purchased the debt from global hedge funds that strip the convertible bond into its debt and equity option components.
The majority of convertible issuance in 2003 emanated from the non-financial sector-in line with historical patterns-with the financial sector accounting for less than one-fifth of total issuance volume recorded. More specifically, high technology led the way within the non-financial category, raising US$34.8 billion in convertible bond proceeds, amounting to 29.3% of the global nonfinancial total of US$118.6 billion recorded in 2003 (see chart 4). Within the high technology sector, roughly half the issuance resulted from U.S.-based issuers, with the remainder roughly evenly split between Europe and the Asia-Pacific (largely Japan and Taiwan). Prominent among U.S.-based high technology issuers in 2003 were communications equipment companies, semiconductor manufacturers, and software service providers. In 2004, high technology constituted four of the top ten convertibles deals by volume recorded in the year to date.
Healthcare and media and entertainment also issued convertibles in significant numbers within the non-financial category, each sector raising US$13 billion in 2003 using this channel. The trend for non-financial issuers to dominate convertible issuance continues in 2004, as they have raised over 90% of the US$20.1 billion in convertible bonds this year. High technology and healthcare have continued to lead the pack in the year so far. Within healthcare, pharmaceutical companies are among the prominent issuers of convertible bonds. The promise of high margins and substantial equity upside in the event of technological advances draw pharmaceutical issuers to the convertible bond market. Low interest rates and narrow corporate bond spreads have offered an opportunistic financing window for all issuers, but not surprisingly, sectors such as high technology and media and entertainment especially favor convertibles as an attractive funding mechanism as they gradually begin to emerge from a cyclical bottom that was associated with relatively low stock prices and past equity-market volatility. Issuers in these sectors suffered a multi-year slump in equity prices and are currently well placed to offer the opportunity of equity conversion at a premium to investors, while using the proceeds from the borrowing to rebuild liquidity.
The favorable interest-rate environment is prompting issuers across the board to raise financing on very attractive terms. Convertible debt is attractive because it enables issuers to promise investors equity upside while keeping cash interest expenses very low. This cash-preservation feature of convertible debt makes it a very useful feature, especially for relatively lower-rated borrowers. It is therefore not surprising, that in 2003, the highest proportion of convertible debt emanates from the ‘BBB-‘rating designation, which accounted for 10% of the total proceeds raised (see chart 5). Issuers positioned at this cusp likely are at a stress point, and are therefore more apt to use this alternative funding mechanism. In 2004 to date, the convertible bond issuance is largely being done at the slightly higher ‘BBB’ rating designation, which accounted for 7.7% of the total issuance yearto-date in 2004.
In 2003, convertible bond issuance in the investment-grade category (‘BBB-‘ and above) overshadowed issuance in the speculative-grade category (‘BB+’ and below), in line with historical trends. Fallen angels-these are issuers that fall to speculative grade from investment grade- accounted for one-third of speculative-grade convertible issuance. In the current year, fallen angel entities such as U.S.-based electronics manufacturing company Solectron Corp, and airline companies Delta AirLines Inc and AMR Corp. have successfully issued convertible bonds.
One innovative type of convertible bond that is cost-effective for issuers is issued without coupon payments, as well as in some cases, no yield. Asia-Pacific based issuers were the heaviest issuers of this type of product, accounting for 62% of all zero bonds issued in 2003, with 31% issued by U.S.based issuers and the remaining 7% issued by European issuers.
Notwithstanding the 30% gains in the benchmark Nikkei index since the start of 2003, Japanese equities remain undervalued on a long-term basis. As long as interest rates remain low and the stock market remains relatively undervalued, Japanese issuers will continue to be drawn towards convertibles-rather than straight bonds-as a way of managing their corporate creditworthiness. European issuers have continued to favor mandatory convertibles-securities that are required to be converted to equity at a pre-specified date irrespective of share price.
Mandatories offer overleveraged European issuers a credit advantage because at shorter maturities (three years or less) they are not counted towards debt; instead they are counted as “equity credit” in calculating leverage ratios. In 2003, US$6.9 billion was issued in mandatory convertibles-accounting for 5% of total convertible volume-predominantly issued in Europe. The maturity distribution of previously issued convertible bonds (excluding mandatories) starting in 1998 shows a healthy volume of European bonds (minimum of US$30 billion per year) coming due in the 2004-2005 period. These bonds may need to be refinanced in the bond market, provided conversion to equity does not take place because the strike price was not reached. On the flip side, this raises the risk that a large overhang of European convertible bonds may need refinancing in the coming months, if the equity market fails to build on its 2003 gains. In the U.S., the maturity distribution of non-mandatories starting in 1998 shows a chunk (minimum of US$30 billion range per year) coming due slightly later, i.e. in the 2005-2008 timeframe, with about US$25 billion due this year.
Scott Holtzman contributed to this report.