Fluctuating fortunes

Low interest rates and rising equity valuations, and an investor base desperate for paper, drove an increase in exchangeable bond issuance in 2015. Corporates hesitated to issue bonds convertible into their own stock but leapt at the chance to use large cross-holdings for cheap financing.

Minimal lending rates and a more positive tone to stock markets – at least during the first half of the year – sent out mixed messages to the structured equity market during 2015: there was good news for issuers of exchangeable bonds who were willing to sell down stock holdings in other companies, but convertible bond issuers had little need to sell options on their own shares as a means of subsidising internal borrowing costs.

That dichotomy is borne out by the data.

Exchangeable bond volumes in Europe, the Middle East and Africa to mid-October 2015 amounted to US$8.17bn from seven deals, according to Thomson Reuters data, compared with US$5.1bn from nine issues during the whole of 2014.

Primary convertible bond traffic, on the other hand, fell substantially. In 2014, there were 57 new issues amounting to US$26.3bn in debt raised, but in 2015 business fell to just US$10.1bn from 24 issues, to mid-October.

For companies that might have previously thought of turning to convertible bonds in order to reduce their cost of funds, historically low interest rates supporting the straight bond market meant there was little incentive to do so.

It was different in the world of exchangeable bonds.

“If the issuer has a stake in a company that it deems not strategic, is willing to sell it and likes the possibility of cheap financing, then terms that provide zero coupons and a high conversion premium make for a relatively easy discussion,” said Steven Halperin, co-head of EMEA ECM at Barclays.

Those discussions were obviously music to the ears of certain borrowers, judging by the size of deals launched in the market. America Movil issued a bumper €3bn (US$3.3bn) of bonds exchangeable into Dutch telecoms operator KPN – the largest ever exchangeable bond deal issued by a corporate – with a zero coupon and a conversion price representing a premium of 45%. Deutsche Bank and Barclays were joint bookrunners.

America Movil was so enamoured with the response that it returned four months later with a €750m mandatory exchangeable into the same underlying, through Deutsche.

There were also records set by Abu Dhabi government entity Aabar Investments earlier in the year. Its exchangeable into UniCredit shares was the largest exchangeable bond issued by an unrated entity, the largest in Europe since 2008 and the longest maturity, at seven years, since 2006.

It was able to issue €2bn of bonds split between five and seven years while settling its outstanding exchangeable into Daimler that was issued in 2011. The move saw paper paying a coupon of 4% replaced with new bonds with an average coupon of 0.75%.

Pushing boundaries

While the seven-year maturity is fairly rare with exchangeables (where the impetus for a deal is often a strategic disposal), the trend to borrow out past five years was more prevalent with convertibles, where there was little penalty for heading further out along the curve. And that was not the only sign of terms being flexed in an issuer’s market.

“There have been some examples of deals pushing the boundaries,” said Alex Large, managing director, EMEA equity capital markets, at JP Morgan.

“Negative yields have been around for a year or so, but it’s the first time since 2003 that we’ve seen premiums up around the 70% level.”

It was Telecom Italia that achieved that extraordinary 70% premium when it raised €2bn for seven-year money with a convertible bond in March. BNP Paribas and JP Morgan were the active leads on Telecom Italia’s seven-year deal, which continued the pattern of jumbo trades driving EMEA convert issuance.

Higher premiums were a trend across the board.

“The average premium in 2015 is 37% for convertible bonds,” said Frank Heitmann, head of EMEA convertible origination at Credit Suisse. “From 30.8% in 2014.”

Unmistakably, there was a shift in clout towards the borrower during 2015.

“Large-cap, investment-grade issuers have the pricing power,” said Halperin. “That has resulted in a few aggressive features appearing in the market.”

“Large-cap, investment-grade issuers have the pricing power. That has resulted in a few aggressive features appearing in the market”

Bankers point to two-way dividend adjustments as a further example of how the market’s boundaries are being pushed. The two-way dividend adjustment goes further than the traditional downward adjustment to premiums should dividend payments be higher than expected. In this form, the terms also accommodate an increase to the premium if dividends turn out to be lower than expected.

An indication of just how far terms could be pushed was evident with National Grid’s £400m issue of convertible bonds due 2020, launched in September 2015. National Grid fully hedged the deal by purchasing cash-settled call options on its ordinary shares to cover the exposure upon conversion of the cash-settled bonds.

“The whole transaction was cheaper than tapping the straight bond market,” said Heitmann.

Credit Suisse was the sole global coordinator on the deal.

Underpinning this whole pricing dynamic was the simple traditional pricing tension of supply and demand. Lower levels of supply in the new issues market during 2015 were exacerbated by high levels of redemptions.

That demand/supply imbalance resulted in the sector outperforming its peers in both bond and equity markets, according to bankers.

“The convertible bond market has performed very well over the past five years and even this year has held up well versus other asset classes,” said JP Morgan’s Large. “As a result, fund managers have been attracting fresh money, not losing it.”

And with diminishing levels of supply, the outperformance of the sector is reflected in the secondary market. Turnover is very quiet, due to the buy-and-hold nature of the investor base, and valuations are described as “very favourable” – for those who bought early.

Bonds that have been priced at aggressive levels have still gone on to rise by three or four vol points.

“Secondary market prices are strong for investment-grade issuers, with implied volatility relatively expensive, both historically and against option prices,” said Large.

Redemption opportunity

The mismatch between demand and supply is unlikely to change any time soon, with banks pointing to further redemptions in the market stoking an ever-stronger reception for bonds in the coming quarters.

BNP Paribas estimated that between October 2015 and January 2016 as much as €11.3bn of convertible bonds could disappear from the market from maturities, puts and calls. There is also another wave of redemptions and puts due in the first quarter of 2016, according to JP Morgan, of as much as US$6.6bn from Europe alone. These are meaningful numbers given the amount of issuance seen in 2015.

“A significant amount of that paper is from investment-grade issuers,” said Large. “And that’s a worry for many outright investors, whose mandates require them to hold significant investment-grade weightings.”

Outright investors form the majority of players in the market, especially in the investment-grade sector, with hedge funds finding the market so expensive that it’s difficult for them to find value.

The retreat of hedge funds is also likely to explain the lack of delta placement of stock in the new issues market during the year. Although placements have not been a feature on standard equity-linked transactions due to the outright buyers for those deals, there has been room for them to play in the mandatory deals.

Typically these placements have shrunk following launch as allocations are weighted towards outright investors, yet on America Movil’s mandatory, lead bank Deutsche eschewed any delta placing.

Supply conditions remain friendly for the last quarter of 2015 and beyond: the sector is outperforming, demand is buoyant and the redemption calendar is strong. The case for launching exchangeables looks unlikely to change any time soon and recent moves in the credit markets should also propel more borrowers into reconsidering convertibles.

Credit spreads were on a widening trend in 2015, with the result that the attraction of visiting the equity-linked sector to subsidise funding rates has increased. It has given rise to hopes of more issuance and new names coming to the market in 2016.