ECM 2006: Back in vogue
Convertible bonds are back in Europe, and the year 2006 looks set to be one of the best for the product for a long time. Volumes are already substantially higher than in 2005, and the resurgence of M&A activity is proving to be a significant driver. Accounting changes could also provide a boost in the future. Mark Baker reports.
After a quiet period for convertible bond issuance from European companies, the first half of 2006 saw a genuine resurgence in the product as a number of drivers came together to produce favourable conditions for the structure.
Volatility began to move upwards, although this is still not reckoned to be the driver that it once was. More significantly, issuance continued from debut names and companies that would struggle to tap the markets for other forms of financing. In addition, the uptick in mergers and acquisitions activity has provided an important new reason for companies to tap a still-eager investor base.
League table-eligible volumes in the EMEA region stood at US$16bn in early September, compared to US$9.8bn at the same time last year, and a full-year total of US$14.7bn for 2005. Last year’s themes of issuance from unrated companies and firms tapping the market for the first time have persisted, with investors continuing to take long-term views on both equity and credit stories in the absence of decent returns from traditional convertible arb strategies.
The theme of more exotic underlyings was illustrated by deals such as the €825m exchangeable issue from Weather Capital into Orascom, and the €610m transaction from Hungary’s MOL.
Some familiar names were still present, though. A US$927.7m zero-coupon issue came from STMicroelectronics, a repeat convertible issuer. The company was refinancing an outstanding issue but there was some resistance to the aggressive terms and the deal was reoffered at 99 for a yield-to-maturity of 1.6%, compared to an initial YTM of 1.5%. Nevertheless, the deal was still an indication of how confident seasoned issuers are in the current environment.
But even if the widespread use of CBs for balance sheet restructuring has not yet been revived, rising rates coupled with higher levels of volatility make CBs a more attractive M&A financing vehicle than straight debt, particularly for sub-investment-grade or unrated issuers.
This year’s bond from French cable-maker Nexans, which was intended to finance unspecified acquisitions, was a classic combination of several of these trends, especially since it came just days after a downgrade that took the company into sub-investment-grade territory.
“What will really continue to create a need for cash is M&A activity,” said one head of structured equity. “Investors may not be buying shares, but companies are certainly buying other companies, and with markets falling they are looking at alternatives to pure equity financing.”
The €2.3bn mandatory convertible from Germany’s Bayer in April, which was to help finance the company’s €16.3bn bid for Schering, was the perfect example of how M&A activity is proving a significant driver for large-caps, with the deal setting the record for European mandatories.
“Activity in the first half has been generally very positive,” said Julian Hall, who heads up convertibles at ABN AMRO Rothschild. “Even the traditionally quiet time of August saw a number of companies eager to go out into the market.”
Despite spiking up towards 30 just before the summer, volatility has now begun to trend back down below 20, and it is still a long way off 2002 levels of above 60. Nevertheless, it is well up from the low of about 12 in 2005, and the index is always tempered by the larger firms that tend to be less volatile. Bankers say that once a specific stock’s volatility hits the high 20s or low 30s, it becomes much more attractive for potential CBs, and there are plenty of small caps and mid caps in that area now.
“Conditions are moving in the right direction, but we are not completely there yet for widespread opportunistic investment grade issuance,” said Ken Robins, deputy head of ECM at Dresdner Kleinwort. “But with spreads having widened and hybrid markets difficult, convertibles are looking very interesting for sub-investment grade companies and for M&A.”
Others agree, but caution that low share prices mean that issuers will wait a little longer to see if the current conditions are a blip, or a revaluation of the market.
“From a technical perspective, with volatility increasing, the outlook is more attractive, but issuers might still hesitate given their low share prices,” said James Eves, responsible for CB origination at UBS. “The question that remains is whether companies’ financing requirements are sufficient to drive deal flow. They have been generating a lot of cash and, with low stock prices, are probably more focused on buybacks.”
In theory, that could still lead to issuance if Europe were to follow the recent trends in the US, where companies have rushed to issue large convertible bonds to finance share buybacks. But that is still unlikely, however, since such activity has been driven in part by a US accounting regime that offers a number of advantages.
Net-share settlement, a common feature on US convertibles, allows the issuer to settle the par value of the bond in cash, issuing stock to cover just the value above par and thus limiting dilution. This effectively allows treasury stock method accounting, but while attractive under US accounting rules, the treatment of this feature under IFRS makes the structure undesirable for non-US issuers.
However, the International Accounting Standards Board (IASB) is working on a proposal to amend IAS 33, the accounting standard that deals with the calculation of earnings per share (EPS). The change, if implemented, would alter the accounting treatment of convertible bonds and make the structure more attractive for European issuers.
The proposal is to include convertible bond issuance within the treasury stock method of accounting, currently limited under IAS 33 to options, warrants and their equivalents. Treasury stock method accounting attempts to reflect more accurately the true cost of issuing shares. It works from the principle that a new issue of shares is not dilutive to EPS if the company is able to generate a return on the new shares that is in line with or higher than its current return on equity.
The accounting convention used to explain the treatment is to assume that a company uses the proceeds of any issue to buy back its own stock in the market, at the average market price over the relevant reporting period. EPS dilution is therefore limited to the difference in the number of shares issued as a result of the original instrument and the number of shares purchased in the market. More simply, it is the difference between the strike price and the average market price.
The net result is that while an option is out of the money, the company need not account for any EPS dilution. Dilution only kicks in once the instrument is in the money, and then only to the extent that it is in the money, on a sliding scale.
Under IFRS, convertible bonds are excluded from this treatment and dealt with on an “if-converted” basis, meaning that the issuer must assume full EPS dilution for the entire potential share issue from the time the bonds are issued.
Extending the treasury stock method to convertible bond issues is seen as a logical move given that a convertible bond amounts to a bond plus an option, and IFRS already requires issuers of convertibles to bifurcate the structure into its bond and option components – so bringing the interest rate charge into the P&L.
The call-spread overlay is another structure frequently seen on recent US convertible bond issues but one that loses many of its attractions outside that jurisdiction. This structure involves the issuer repurchasing the call option embedded within a CB and then selling warrants at higher strike prices, with the net result being a higher effective conversion premium. The structure was used once in Europe, by Tui in 2003.
The US, with its very liquid derivatives market, favourable tax treatment and greater outright investor base, provides a far more suitable environment for the structure than does Europe, where the cost of bond plus overlay is not sufficiently attractive versus a simple high-premium CB, for example. In any case, European convertible investors have tended historically to accept higher conversion premiums than in the US.
While a rising interest-rate environment will add to the attractions of convertible bonds over straight debt, it also means that companies are unlikely to be calling CBs with a view to refinancing – a common source of activity.