The equity-linked bond market is, apart from securitization, the most Protean of capital markets. For a product so simply and strictly defined — a bond that can turn into equity — its ability to morph into weird and wonderful new shapes, and to be used for myriad purposes, is astonishing.
But although structures can be stretched in all directions, and the market’s composition changes constantly, in one way it is bounded — convertibles have never become a mass market. Issuance in EMEA has bumped along at an average of about $30bn a year for two decades.
“It’s a perennial challenge,” says Martin Haycock, partner at Fisch Asset Management in Zurich. “Why does issuance in Europe remain stubbornly at the same levels? Why isn’t it triple that?”
There are lots of explanations. But living with this frustration has taught equity-linked specialists not to fret.
“I have been doing equity-linked for 15 years and every few years people are scared the market will disappear — then it comes back,” says Xavier Lagache, head of equity-linked at Deutsche Bank in London. “Talking to the key investors, there is no worry at all as to the survival of this market. There were concerns in the US, and now they’ve just had their best start of the year for a long time, with over $20bn of issuance.”
Liquidity good, could be better
Being so used to the unexpected, and to taking what comes, equity-linked experts are loath to predict the market’s evolution.
Asked to identify secular trends, however, they home in on one tangled knot of inter-related issues, which most keenly affect the secondary market — regulation, trading, liquidity and benchmarks.
On January 1 next year, the Markets in Financial Instruments Directive II will be introduced in the European Union. It will compel convertible investors to have access to an electronic trading platform, so they can prove they are trading at the best prices.
While systems like Tradeweb have offered CB trading for some time, investors have not flocked to them, and most rely on traditional over-the-counter trading with investment banks. Once investors are forced to hook up to platforms, these habits and the availability of liquidity may change.
Investors in all markets gripe that liquidity has declined since the financial crisis, but CB buyers are not the loudest complainers. “For a reasonable number of names there is fairly good liquidity and competition, so it’s usually not difficult to do what needs to get done,” says Luke Olsen, investment manager at Aberdeen Asset Management in London. “The limited depth and breadth in the market can result in some one-sided or gappy price movements, but I do not feel that has changed a lot in the last few years.”
Comparing the bid/offer spread and number of market makers for a typical €400m five year CB with those for a similar high yield bond, Olsen reckons, “there’s probably not much difference, or maybe even favouring the CB”.
The non-bond part of a CB — the embedded equity option — is usually much more liquid than the equivalent standalone option. “This is an enduring attractiveness of the convertible asset class,” says Olsen. Trying to build a naked portfolio of long term options would mean accepting either a very restricted range of underlying stocks or serious illiquidity.
Liquidity is thus a virtue of the CB market. It is also particularly important to CB investors, most of which do not want to hold a bond to the end of its life. Investors specialise in owning bonds at different stages of their evolution.
Any threat to liquidity is a worry, therefore. “Trading volumes have been a historic concern for investors,” says Lagache, “but activity is up this year, driven by the US and EMEA, although it’s getting very concentrated with a few houses.”
Firms such as BNP Paribas, Deutsche and JP Morgan have remained active, participants say, while others — including some that regularly lead new issues — trade much less, constrained by tougher regulation and capital requirements.
Even the biggest traders do a fraction of what they used to. While the larger firms ran books of $2bn of more in Europe pre-crisis — not counting purely proprietary money — they might now hold more like $150m-$500m of inventory.
Investors’ widespread adoption over the past few years of index benchmarks, against which to measure their performance, has contributed to illiquidity, Lagache believes. “Once you buy a newly issued convert and it enters the indices, if you sell it to realise some value, you might not be able to come back later, because no one might be willing to sell it,” he says. “There are too many investors who need to own it to remain indexed.” He detects a new swing away from indexation, as investors tire of owning too narrow a range of similar, expensive bonds.
Into this ruffled pool, MiFID II is about to flop like a stone. Some think it could have drastic effects on banks’ sales and trading businesses.
Automation could further shrink the already thinned company of CB traders and salespeople. If investors can see a list of traders’ quotes for a bond on Tradeweb, will they need to speak to — or message — salespeople at all? This might lead to an even greater concentration of trading, as investors cease to do banks favours and go rigorously for the best terms.
However, banks are likely to keep at least a skeleton sales force for new issues and to keep in touch with investors’ thinking. “There are remarkably few salespeople anyway,” Haycock points out — recalling that when he moved to the secondary side of UBS’s business in 2001, “we were 65 globally in sales, trading and research”.
“What are banks going to do, go from one salesperson to none?” he asks. “To my mind, the real adjustment in headcount has already occurred.”
The result is what Haycock calls “a thriftier market — people make do with less”. Issuance, trading, staffing and profits are below their peaks, but the market continues, perhaps more efficiently.
Hairy issuers welcome
For the primary market, the foreseeable future is that it will remain an issuer’s market. Investors like the product: some $4bn has flowed into listed CB funds globally this year and a typical strategy has returned 4.8%, Lagache says.
The battle remains convincing issuers to bring deals. Here, there is hope. “We have not seen, in the last few years, what happens when against a positive economic and corporate backdrop, you start to see rising rates,” says Olsen. “When that happens, it could be an attractive environment for CB investing and issuing, particularly for issuers that can get in early.”
Considering how low bond yields have been for years, the CB market has arguably done very well to maintain or increase its size. When companies start to feel the pinch of having to refinance debt at 3% instead of 1.5%, CBs that can offer close to zero coupons may sound very interesting.
This will be music to the ears of investors, whose portfolios are now, Lagache says, more defensive than ever before.
The equity-neutral CB for blue chip, investment grade issuers — the phenomenon of the past two years — will continue to appear from time to time, whenever the CB market is so hungry for paper it will price the option much more aggressively than the options market. Structural innovation is going on to make these deals more palatable to investors.
But what investors and banks alike hope for and expect is a wave of deals from the CB market’s ideal kind of issuer: a rare and probably high yield credit, with an exciting midcap equity growth story.
It will probably always be a minority of such companies that can be tempted into the equity-linked market, but specialists are not worried. “Sometimes these deals are incredibly clever and structured, sometimes they meet a straightforward aim,” says Haycock. “But companies that have done CBs seem to keep coming back. There’s a particularly rich seam of happy customers.”