Shape-shifters

The past 12 months have seen top borrowers embrace equity-linked bonds for the first time in many years. In Europe, the Middle East and Africa, issuance in recent years has struggled to keep up with bond redemptions, in large part due to the rarity of investment-grade issuers and reliance on small bonds from high-yield issuers.

Finally, blue-chip issuers have woken up to the opportunities on offer, breaking records for high premiums and making negative yields a regular feature of the market – even back when Bunds still offered a positive yield.

The attractions were not simply down to high premiums and low running costs for issuers but also the flexibility offered by the structured equity market, as illustrated by Vodafone with the largest deal of the year.

Vodafone raised £2.88bn from mandatory convertible bonds in February, the largest ever sterling equity-linked transaction by a factor of four. Yet the UK telecoms operator will not dilute shareholders, as it will buy back the same amount of shares as underlying the bonds at maturity to offset conversion. In order to insulate itself from share price moves in the interim, Vodafone bought calls and sold puts to the lead banks on the transaction, JP Morgan and Morgan Stanley.

The mandatory convertible monetised US$5bn of loan notes received as receipts for the sale of its indirect stake in Verizon Wireless in 2014 that have maturities of 18 months and three years. The company had no particular interest in convertibles, just to monetise those notes.

The deal was unconventional – there was no premium and 45% of the bonds were retained by the banks as a hedge for their derivative exposure – leading to catcalls from rival bankers worried about the impact on league tables. Privately, competitors were pleased to see such creative use of the product to attract an issuer with zero interest in the traditional offering.

Leveraging the product to suit companies with no desire to issue convertibles has been a theme of the past year.

Welcome back

Investment-grade issuance has risen sharply in two forms. One is the traditional convertible or exchangeable bond, where issuers have been able to exploit credit and rate environments to issue bonds with huge premiums – 62.5% in the case of Airbus last year – and negative yields, as low as –0.78% for Safran in January.

Since September 2015, there has been a rush of non-dilutive cash-settled convertible bonds – which quickly became known as synthetics – where exclusively investment-grade companies issue convertible bonds to the market as normal but then purchase cash-settled call options matching those embedded in the CBs to remove the threat of dilution.

“Investment-grade has opened up over the last 12 months in both dilutive and non-dilutive form,” said Bruno Magnouat, head of equity-linked origination at Societe Generale, the lead bank on Airbus. “The terms achieved by Airbus were the trigger for a run of deals in dilutive format with big premiums. Some issuers are not interested in dilution, but the synthetic product brought them to equity-linked.”

Slow start

German healthcare company Fresenius pioneered the synthetic CB – once Credit Suisse came up with the idea – through a €500m five-year issue that priced with a zero coupon. The company had recently issued equity for an acquisition, so dismissed a traditional convertible. A call spread overlay could have boosted the conversion price to extremely high levels but dilution would still have been a possibility. Fresenius instead opted to repurchase the calls, making the issue 100% debt and an alternative to a high-yield bond.

A particular strength of the structure is that investors are broadly insulated from it, with a multi-day VWAP-based reference price the main difference from a vanilla CB. This was shown in Fresenius achieving a bumper book of 300 lines.

The deal was such a success that, six months later, subsidiary Fresenius Medical Care followed its parent’s example with a €400m synthetic convertible.

FMC’s deal was back in September 2014 and, while it suggested that the structure was more than just a one-off, it did not seem to have found traction – until a full year later, when National Grid came to market.

That lit the touch-paper as three others followed in November alone, including a US$1.2bn fundraising for Total, and there has been one each month of 2016 up to Valeo’s US$450m five-year synthetic in June.

Best price

It seems obvious that companies would jump at the opportunity to cut the cost of borrowing without any economic consequences on their part.

“Issuers of synthetic convertibles have sophisticated treasury functions that are used to issuing in multiple currencies, fixed or floating, and different structures as they seek arbitrage opportunities,” said Steven Halperin, co-head of EMEA ECM at Barclays. “Synthetic convertibles are another way for them to reduce funding costs.”

So why the delay? Clearly, not all banks are willing (able) to sell a call lasting five to seven years over hundreds of millions of euros in a single stock. Hence, it is only investment-grade names that can issue synthetics, with Fresenius and FMC the exception but referred to as the best of the high-yield universe.

One banker also cited the challenge in achieving pricing terms that ensure the convertible plus the expensive call are cheaper than an equivalent straight bond – and assuredly so, to ensure that the preparatory work is worthwhile.

Fresenius Medical Care was a success but also a warning of how tough it would be to follow.

One key output from a convertible bond pricing model is the implied volatility. When measured against realised volatility, implied vol is a measure of whether a bond is theoretically expensive or cheap.

In the case of FMC, the implied volatility at the final terms – the worst end for the issuer – was 19 versus a fair vol of 16–17 and just 15.5 over 100 days. Anything flat to realised vol is expensive; this was seriously premium pricing. Had the bonds priced at the best end of guidance for the issuer, the implied vol would have topped 26.

Pricing has become easier as realised volatility across the market has increased since the Fresenius trades, while convertible bonds also trade rich in the secondary market – that is with high implied volatility compared to realised levels – making it easier to sell expensive bonds to investors.

But a lack of supply was a major reason for secondary market levels, and a steady stream of investment-grade issuance would quickly correct this.

It is therefore little surprise that some deals have struggled along the way. Total’s US$1.2bn synthetic is the largest yet and was the first to price at the worst terms for the issuer, while the conversion option had to be rewritten on Telefonica’s €500m five-year during bookbuilding in March. The next month saw ENI slash its fundraising by a fifth to €400m and price outside of launch guidance – though still with a negative yield.

BP’s bond in May eased concerns that the window may have passed for synthetics, backed up by Valeo’s smooth execution in June.

“In September, it was easy to make the saving versus straight debt, as new issue premiums were 25bp–50bp or more and the convertible market was pricing the first few deals out at the mid-points of price talk or better,” said Barclays’ Halperin. “The opportunity is still there, even if it is harder now as everything has to be right – the structure, issuer, timing, currency and size.”

“A few lessons have been learned from the non-dilutive issuance,” said SG’s Magnouat. “Maximising price tension is crucial to getting better terms than a straight bond, so the deal cannot be too big. Terms should not be too aggressive from the start or investors will reject the bonds. Striking a balance means aggressive terms that are still attractive and then optimising pricing.”

Notably, the two most recent deals have seen a move away from euros in order to make the headline terms more attractive to outright investors put off by huge premiums and negative yields. “There are people who buy CBs for share price upside over seven years – those are the buyers we need,” said another CB originator.

And these issuers are much needed by the equity-linked market. Forever occupying a limbo between debt and equity worlds, it is frequently home to only high-yield or struggling issuers. But synthetics have created a whole new, rather bizarre, group of issuers – investment-grade companies with no interest in convertibles.

“A significant number of synthetic convertible issuers are attracted to this market because the bonds are not dilutive but provide access to a new investor base and offer a funding advantage,” said Frank Heitmann, head of EMEA convertible origination at Credit Suisse, who started this trend with the equity-neutral convertible for Fresenius in 2014.

“It opens up a whole group of high-quality companies to convertible investors that would not otherwise have come to this market.”

As Valeo’s issue showed that even the ECB’s corporate bond buying programme could not wipe out the savings from issuing synthetics versus straight debt, it looks set to continue.