When IFR held its second convertible bond roundtable on February 17, the participants – Stephan Theissing of Allianz, Douglas Decker (Barclays Capital), Franck Cazaubieilh (BNP Paribas), Martin Fisch (Deutsche Bank), Manish Wadhwani (HVB), Viswas Raghavan (JP Morgan), Antoine de Guillenchmidt (Merrill Lynch) and Lorraine Lodge (Nomura) – had a lot to talk about.
The principal drivers of convertible market activity all came up for discussion – the impact of low implied volatilities on issuance and investor engagement, impediments to better deal flow, investment preferences and investor types, issuance modalities and investment strategies, and accounting issues.
The detrimental impact of low volatility on convertible issuance was the logical starting point, particularly in light of the dominance of stock option arbitrageurs on the buyside. Arbitraging option volatility lost its lustre as a viable investment strategy some time ago, so investors are now looking at alternative ways of playing the market, including capital structure arb or taking more classic directional views. And in a back-to-the-future scenario, outright position takers could once again take centre stage as the market dynamics play to their strengths.
Despite the collapse in option volatility, the dramatic tightening in credit spreads along with rock-bottom interest rates have supported extremely compelling financing opportunities for convertible issuers. And even if issuers can no longer achieve eye-popping conversion premiums, the inverse correlation between stock prices and implied volatility means that they can price off more robust stock price levels at the same time as achieving excellent all-in funding.
If the same market conditions have made straight bond issuance equally attractive, the convertible market has at least one advantage over the bond market in that it offers market access to issuers that would not pass muster with straight bond investors. Hence the emergence of small and mid-cap CB issuers, and emerging market issuers.
In fact, one of the interesting side effects of the recent dearth of convertible issuance is that issuers can achieve their corporate finance objectives in the market more easily.
Convertible investors need to put money to work, especially given a high rate of redemptions. That means they will look at almost anything, from unrated issuers, to emerging market issuers, issues denominated in exotic currencies, and innovative securities. For the banks, structuring and distributing complex instruments remains one of the few areas where they can garner decent economics.
As Stephan Theissing of Allianz points out, structural innovation has a lot to do with the trust and confidence of investors about an issuer, although even if that balance can be struck, there is a direct link between degree of innovation and the amount of cash an issuer can pull out of the market.
Beyond meeting strict corporate finance needs, the inherent flexibility of the convertible market makes it ideal for redistributing derivatives risk, with the underwriting bank either repackaging risk that it has warehoused from a non-related deal with a client, or laying off its own trading book hedge to the market.
These have been difficult times for the convert market in Europe, but as you can see, there is a lot to talk about.
