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Monday, 21 April 2014

Troubled Nokia illustrates magic of convertibles

Convertibles are cool. I’ve always liked them and am confounded by how little they’re used. At times over the 20-plus years I’ve been following the market, they’ve threatened to hit the big time as a discrete asset class with an ever-widening group of investors prepared to put the time and effort into understanding their technical underpinnings. But more often than not, they’ve been a backwater, spurned and often forgotten.

IFR Editor-at-large Keith Mullin

IFR Editor-at-large Keith Mullin

In EMEA, convertibles account for 14% of ECM equity and equity-related issuance year-to-date. That doesn’t sound too bad but then again the numbers are flattered by the incredibly bad year straight equity issuance has had, just managing to push over the US$100bn mark so far this year. Last year, converts accounted for less than 9% of EMEA ECM issuance of US$158bn.

It shouldn’t be like that. I’ve championed converts because they’re as adaptable in terms of the funding profile they offer issuers as they are flexible in terms of the investment proposition they provide to buyers. They can be as convoluted as you like at the back end, demanding sophisticated options modelling skills. But at the front end, they’re pretty simple. That’s part of their appeal.

Back in the day, UK convertible buyers (mainly equity income funds) used simple discounted cashflow analysis and based their decision to buy on nothing more than the higher of coupon NPVs or expected dividend income. I recall the arrival of binomial options modelling and valuation into the UK in the early 1990s, a US import. It sent some of the UK old boys over the edge, spluttering into their midday port. I remember getting a call from a well respected convertibles team at a traditional UK house asking me to explain it all to them. Notions of standard deviation and option volatility just hadn’t been on their radar.

How things have changed. Those days also saw the beginnings of convertible arbitrage as an investment strategy in London. In the early days, it was a little unsophisticated. Quite often, the market cap of convert issuers fell by more than the size of the convertible as stock borrow desks lent cheap and arbs shorted the socks off the underlying stock with abandon. Over time, arbs came to dominate the market. In fact, they did so until the global financial crisis when the bottom fell out of the hedge fund world. These days, outright holders are back in the game, matching the hedgies dollar for dollar.

Nokia’s €750m five-year convertible was greeted in some quarters as signs of a market renaissance. I get a little tired when I consistently hear single issues being heralded as marking the return of a market. EMEA has seen fewer than three dozen decent-sized issues so far this year, mainly converts, but with a smattering of exchangeables, too. While each issue helps sustain the story, I still see individual issues as episodic. To me, for a capital market to be viable it has to produce a couple of issues per week at a minimum. We’re not there in Europe.

In so many ways, though, Nokia was a perfect candidate to show the benefits of the convertible instrument. Without putting too fine a point on it, the Finnish communications company has had a torrid time of it recently. Unceremoniously downgraded into the nether regions of sub-investment grade, the company is struggling to compete against the likes of Apple and Samsung; its new models aren’t making the grade in the eyes of customers; its cash position is dwindling; profits are sub-standard; it’s got some troublesome debt redemptions looming and it would find accessing the straight bond market a stretch, even in the bubble environment that the credit market has become.

The stock has been extremely volatile. The high for the year was above €4, achieved in January. Shares had collapsed all the way to €1.38 by mid-July. The premium on the convert was struck at €2.6116, so well in the range of where the shares have traded this year. But with so many problems on its plate, achieving that level looks to be a stretch especially with the market playing the stock heavily off the short side.

Nokia five-year CDS are quoted around 930bp and the company would have to pay as much as 9% to get an issue away in the straight bond market. So even though pricing of the new convert was at the generous [for investors] ends of both coupon and premium ranges (the deal priced at the top of the 4.25% to 5% range and the premium was struck at the bottom of the 28%–33% range), that 5% print equates to a €150m saving on debt service over the life of the bond against what it would have to pay in the bond market.

Not bad. Nokia said it intended to use the net proceeds of the offering “to prudently manage its capital structure, proactively address upcoming debt maturities while preserving existing pools of liquidity and for general corporate purposes”. Its decision to opt for converts to achieve this was right on the money.

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