Top 250 2005 - Difficult conditions continue
Conditions in the equity-linked markets remain very patchy. European activity has registered a small pick-up over 2004 while even the usually robust US market has been hit by the poor performance of hedge funds and the prospect of massive redemptions. One bright spot has been new markets in Asia, such as India. By Jasper Moiseiwitsch, Stephen Lacey, Owen Wild and Brad Frischkorn.
In all regions, the tale is a similar one. Continuing low levels of volatility coupled with still uninspiring equity markets and continued cheaper financing opportunities elsewhere have conspired to make the convertible bond less attractive than it once was.
Perhaps the best news for the US convertible bond market is that conditions cannot get any worse. The meltdown of General Motors’ credit in March caused a crisis of confidence that prompted wholesale selling of convertibles as arbs braced liquidity for fund redemptions. Convertible hedge funds have lost 5.8% so far in 2005, according to CSFB/Tremont, and the 3.1% loss in April is the worst monthly performance in more than three years.
Not surprisingly, issuance dropped to US$938m for four deals the following month, the lightest period since September 2002. US issuance to mid-June 2005 totalled US$11bn, compared to US$28bn in the same period in 2004.
The widening credit spreads evident in the secondary market, and undervaluing by investors of already mute volatility of companies' underlying shares, have made the asset class a difficult pitch to corporate issuers.
“We have to wait for some the technical issues to work themselves out,” noted one US convertible originator. “Why would I buy a new deal when I can get paper cheaper in the secondary market? We’re talking to a lot of companies, but it’s a bit of a waiting game.”
Despite attempts to assuage investor fears through simple, cash-pay securities with earlier puts, or providing a built-in borrow from share repurchases, investment banks have found it tough to sell any product they have brought to market. “There is no real appetite from hedge funds for new deals,” said another convertible professional. “This has been one the most extended, challenging times that I have ever experienced.”
Take, for example, a US$250m overnight offering by sub-prime mortgage lender CompuCredit in May. To offset a difficult borrow, the company used US$100m of deal proceeds to fund share repurchases. Unable to attract interest at the backstopped terms, 3.625% coupon and 30% conversion premium, Banc of America and JP Morgan were forced to re-offer the 20-year, put seven bonds at 97, equal to their costs.
Unfortunately, this was a typical reaction. Of the 13 deals brought since the GM earnings shortfall in March, four deals were brought at a discount to par and another four priced outside of initial talk or were restructured. “There is no price leadership in the market,” said one the convert sources. “We’re going on a full year of down volume and more difficult pricing.”
Market participants remain cautiously optimistic in pointing to a pick up of more equity-like mandatory and convertible preferred offerings. Rising interest rates, should they ever materialise, also historically have made traditional cash-pay securities attractive vis-a-vis high-yield debt, but any pickup would be dependent on turnaround of equity volatility.
The European market has seen volumes slightly down from 2004, at around US$7.8bn compared to US$8.6bn. The market continues to be tough, with only six deals of over €300m reflecting the increased number of mid-cap issuers. The move to smaller companies has had two main impacts – more private deals and greater disparity on pricing.
With smaller issuers in the market, there has been a notable widening of credit guidance from bookrunners leading deals. Banks' views have sometimes diverged on pricing, leading to marked price movements in the aftermarket. These were particularly stark in the case of bonds issued by Jazztel and Sankyu. The €275m 5% 2010 Jazztel bonds opened at 99 but quickly traded down to a low of 76.875 one week after issue. In the case of the 0% 2009 Sankyu issue the bonds opened at 108.1 and have only traded down slightly from that level.
There has also been an increase in demand for credit protection from investors for a number of issues. Where spreads are below 100bp investors have little concern but spreads have been gradually widening and investors are keen to swap this out.
As banks seek out new issuers the issue of volatility remains a hindrance in convincing them of the advantages of a convertible over straight debt where it is available to them. Volatility has been on a downward trend since early 2003 and despite a brief respite earlier this year the trend looks set to continue. From February 2005 volatility began to increase from 23 to over 26 during March, but the move was short-lived, with vol falling to a five-year low of 20.9.
Significant among the new bonds were the issues from Allianz into BMW, Siemens or Munich Re, and the KfW deal into Deutsche Post – the latter being notable for being the first Uridashi deal, sold into the Japanese market. As the only significant exchangeables in the region, both deals served to highlight the gradual disappearance of that particular instrument as a means of disposing of stock. With markets beginning to trend up, many potential issuers prefer to remove crossholdings through direct sales of stock into the equity market.
Optimism drives Indian CBs
Asia ex-Japan and Australia has seen US$3.8bn in equity linked issuance year to date, compared to US$6.8bn in the same period last year. Much of the fall-off has been in Taiwan, where US-dollar equity-linked issuance year to date is only 16% of what was seen in the same period in 2004.
India now comprises about 43% of regional volumes – a remarkable statistic considering that the country has gone from practically zero volumes just two years ago. Indian issuance has remained strong because the CB product remains a relatively new and under-utilised instrument in that market. Offshore CBs only really became available to Indian companies in January 2004, when regulators relaxed rules on offshore borrowings.
India’s CB market suffers from the same afflictions as the rest of the world – rising interest rates, declining volatility and lacklustre equity markets. It has, however, one huge advantage: an irrepressible optimism emanating from its mid-cap sector. These companies have been issuing CBs that are very large relative to their market cap, typically with high conversion premiums. These deals tap into these companies’ expectations of high growth and strong forward share price performance.
For example, Amtek Auto, an Indian auto components manufacturer with a market cap of about US$400m, raised eyebrows in April when it issued a US$125m offshore CB. The deal came with a 25% conversion premium. The five-year deal redeems at 130.087, which means that the equity has to climb 55% to offer an attractive conversion at maturity.
“The high growth rates in developing markets like India are driving mid-cap issuers to raise funds and capitalise on the growth opportunities,” said Achintya Mangla, JP Morgan's head of Asian equity-linked.
“Given their inherent potential, a sale of shares at current prices or an annual cash outflow in terms of interest payments is sub-optimal for such issuers. In this context, convertible bonds provide the ideal "growth capital" – they minimise annual cash outflow [via zero or low coupon structures]. And, through the sale of shares at a premium to current price, CBs allow issuers to monetise future growth potential and raise funds to realise that potential."
Recent CBs issued by Bajaj Hindusthan, Glenmark Pharmaceuticals and Jubilant Organosys show similar traits – all these deals were came from mid-cap Indian firms that were raising aggressive levels of equity (relative to their market cap) on the back of a strongly performing share price.
Japan goes private
In Japan, the convert market is still alive but far more difficult to gauge than it has been in the past, thanks in large part to the emergence of private CBs over the last 18 months. In the first half of 2004, Japanese firms issued some US$9bn-worth of publicly traded paper, including a handful of banner deals such as those from Japan Airline Systems (¥100bn), steel maker JFE Holdings (¥90bn), and Toshiba (¥150bn), most of it in the form of zero-coupon Euroyen issues.
This year's tally is a mere fraction of that, as only a handful of issuers have come to market – and for a total of barely more than ¥100bn (less than US$1bn). Private CBs have clearly taken over, and are currently responsible for about 80% of issuance, something unprecedented in Japan.
While falling equity market volatility is the main factor in this migration trend, the present situation continues to look bleak for issuers. "From April through May, 2004 TOPIX volatility stood at around 20, but had fallen to 15 by end-September. Now it's about 12," explained one CB expert at a foreign brokerage in Tokyo. "That shows how far we still need to go to bring issuers back."
Despite a few anomalies, private converts remain in the domain of lesser-credit issuers. But since the government decreed that companies should stop mutually owned stock arrangements (mochiai) to avoid market risk a few years ago, the usefulness of private CBs has increased. Two of the largest recent private CBs, for example, those of Fuji Television Network (¥80bn) and internet portal operator Livedoor (¥80bn), were used in the same buyout attempt earlier this year.
On the buyside, bankers say that traditional hedge funds have a real problem with Japanese private CBs because they are usually too small to get their hands on. "If only they could get access and more aggressive terms, they would be happy," said another equity derivatives banker, "but even if they bought them, all the floating strikes and puts that private CBs entail would still leave large investors searching for a place to park their shares or paper, which would just push them back to the underwriting brokerages again."
Other factors affecting the public and private convert markets include the fact that Japanese securities laws require conversion applications (tenkan seikyu) to be filed with the trustee every time an investor wants to convert a stake – which is more than a minor inconvenience for some would-be investors. Mid- to longer-term, the dramatic improvement in corporate Japan's credit has also brought debt financing into a more competitive environment with equities. With little upsurge in sovereign JGB yields foreseen for the foreseeable future, spreads are expected to remain tight.