Question: You are the corporate treasurer of a multi-billion market capitalisation investment grade firm with Eu500m-Eu1bn to raise in your next capital markets transaction.
Do you a) tap the bond market with a quick drive-by, paying what is probably the lowest coupon ever achieved at your firm and take the rest of the week off; or b) make a detailed proposal for an equity-linked transaction for your CFO to present to your board of directors, threaten your shareholders with potential dilution for the first time and deal with unfounded worries about hedge funds shorting your stock blood, sweat and perhaps tears, unleavened even by any favourable accounting treatment?
Its hardly a dilemma, is it? But the answer supplies the reason as to why issuance in the convertible bond market is running at a $20bn annual rate, on course for perhaps the lowest annual total since 2005 recorded just $17bn and a far cry from the $49bn record of 2007.
With interest rates still close to rock-bottom levels, the differential between CB and straight bond coupons are just not high enough to be tempting to treasury teams.
"Being in a very low interest rate environment, and frankly one in which spreads are compressed given the amount of liquidity we have, investment grade issuers do not see a big difference between the coupon on a CB and the coupon on a straight bond," says Alain Dib, global head of equity-linked at BNP Paribas in London. "The main selling point is the cash coupon and right now it is not that striking."
And for many, indeed most, large-cap European corporates, its not even as if there is a funding choice to make in the first place, says Philippe Dischamps, global head of equity-linked origination at HSBC in London.
"Right now the lack of issuance is also driven by the fact that a lot of corporates have solid balance sheets with a lot of cash," he says. "They have not started an acquisition spree and they have turned the capex tap down for three years while they still keep on generating decent levels of cashflows. Plus, a lot of corporates prefunded their 2011 and 2012 requirements in 2009 and 2010 because they were concerned that their ability to raise capital could be under severe stress given the extent of the financial crisis. The environment is proving much more benign than that."
Three Rs in equity-linked
What issuance there has been since the end of 2010 and through the start of 2011 has been characterised by three types of borrowers: repeat issuers, real estate issuers and un-rated or sub-investment grade issuers.
The latter have dominated sales so far this year, accounting for 80%-85% of the $10bn sold in Europe a fact explained by the higher coupons on straight debt and therefore greater differential achieved on CBs.
It also helps that on the demand side, conditions have never, at least recently, been so good. "Investors in this environment like the product," says Dib. "It gives them the bond protection and the equity upside in an environment in which there is a lot of uncertainty."
That has helped some of this years issuers unusually extract premium pricing for their deals, with several CBs priced at levels of implied volatility below levels of realised volatility and for others to price at implied vol levels through their existing CBs.
Books heavily skewed towards long-only funds or hedge funds buying on an outright basis have become the norm, the reverse of the situation before the financial crisis when arbitrage-driven buying was the cornerstone of the market. Two-thirds/one-third splits have become the average, with some deals achieving even more long-only distribution.
"Investors now are buying less on technicals like hedge funds and more on fundamentals," says Dib. He points to a recent Eu84m CB for French firm Econocom, a small company for which the underlying stock represented around 225 trading days volume. "That really shows that investors are buying deals on a fundamental basis."
And when investment grade deals do come to market, there is a clamour to get hold of bonds, he says. "Long-only investors want to have, and sometimes need to have, a balanced portfolio in terms of credit diversification and industry diversification. Given the level of primary issuance over the last few years this is also translating into a very expensive secondary market."
Repeat issuance has also featured heavily in 2011 with few first-time CB issuers in the market.
"Weve seen as share prices have increased since their trough in 2009 after the financial crisis, and further to a steady flow of issuance on the back of it, that issuers are considering the merits of having a new CB out there on the basis of a different and often much higher conversion price," says Dischamps. "So just like you build your credit curve, you build your conversion price curve. It gives an issuer additional flexibility because a CB has an unknown outcome and depending on the circumstances you can steer it one way or another with differing conversion price."
Keyvan Zolfaghari, head of EMEA equity-linked origination at Deutsche Bank in London says that repeat issuers are also attracted back to the market having experienced first-hand its benefits. "Companies that have issued before frequently re-issue having seen that there is so little downside to the market for an issuer but for those that havent with the current rate and credit environment it can be hard for them to make that initial step."
And the third issuance trend of the year has been the steady supply from property companies for which the product makes more sense, due to its accounting treatment and economics, than for other types of companies.
"A lot of real estate companies are trading at a premium to NAV or very close to NAV, so a convertible secures funds at a price that would be at an additional premium to NAV," explains Dischamps, pointing to a recent deal from Derwent London which priced a CB with a conversion price 55% above its net asset value. "Real estate companies are also comfortable with the net share settle structure which allows them to account for the coupon on the basis of the cash coupon instead of the normalised cost of financing. For a REIT, which tends to be assessed on recurring income and which tends to do a mark-to-market on assets, having to mark the convertible to market as well is not such a big issue."
Convertibles and exchangeables are not, though, only about transaction economics. Cultural factors still play a big part in company decisions to issue with those pesky questions about dilution and arbitrage cropping up in boardrooms, though less frequently than in the past.
"Old-fashioned prejudice on boards is fading away, though it has been a slow process," says Dischamps. "Companies understand it now as a mainstream source of funding. It shouldnt be seen as raising equity because it is not it is accounted for as debt and whether it is going to become equity is unknown at the outset. However, as an issuer you have various tools to steer the outcome. If you want it to become equity you can do so; if you want to offset the conversion it is also manageable."
Dib says that some of his clients are just refinancing debt when they issue, even though in theory they are potentially calling on some form of equity.
"They see that its a good time, its opportunistic, the share price is healthy and, by the way, sometimes the fact that you might be converted is not seen as a bad thing. Sometimes conversion can be used as nice way to create equity in high growth companies. It is not a sin that there is conversion."
French company managers have a reputation for being more open to CB issuance than their Anglo-Saxon peers a strange phenomenon given that large and mid-cap stocks across Europe tend to have almost identical shareholder registers.
"It is not so much the attitude of the shareholders towards convertibles but maybe the attitude of the management as to how they will manage the shareholders," says Dib. "Its down to cultural factors in seeing success and wanting to replicate success with no taboos and no preconceptions"
The UK, however, is a different story.
"Generally UK boards are quite conservative and issuing a CB is a decision that, unlike with a bond, goes up to the board," says one banks equity-linked specialist. "There are a number of reasonably large cap UK companies which have treasury teams that think it would be a good idea to issue a convertible but its hard for them to guarantee absolutely 100% that it will work. Theres not a lot of point of them taking that risk, however small, until you get to the point where the straight bond is more expensive than it is now."
And Zolfaghari reckons that a small part of the UK reluctance to issue is a hang-up from nearly two decades ago. "There is still some corporate memory in the UK of deals done in the early 1990s that ended up looking very expensive," he says. "What people forget about those deals is that sterling interest rates at that time were massively high and the convertibles coupons were actually at much lower levels than straight bonds."
Unlocking the deal
Back to our crash-test dummy corporate treasurer again, only this time, its not just a benchmark-sized deal hes after. Its time to get in a huddle with senior management to solve a more complicated problem how to finance an equity stake, put treasury shares to work, or provide the firepower for a buyback programme, for example.
Now, using the equity-linked market becomes a more obvious choice.
Zolfaghari cites Decembers $1.5bn deal for Lukoil as an example of a structured solution unlocking a convertible bond issue. The company had exposure to its own treasury stock, having bought back a stake held by ConocoPhillips. "They got the financing benefit, and they also got the benefit of recycling the stock," he notes.
Likewise, Abu Dhabi investment firm Aabar used a structured format to raise cheap debt while using a call-spread overlay to push up the effective exchange price on the Daimler stock underlying its Eu1.25bn exchangeable in May this year. "It was a large deal but with the convenience of coming to the equity-linked market, the ease of execution with the liquid underlying shares and a exchange price significantly above the share price with the overlay, it made sense," explains Zolfaghari.
"Thats how you unlock a very large transaction. Theres a requirement to be more creative, to solve problems for companies and to help them to understand that its worth doing the deal. If it is just vanilla and the company has never done one before, it can be difficult for them to get over the line particularly if they have access to financing at very low headline levels elsewhere."
And if they dont? Well, given a fair wind and a pick-up in the global economy, interest rates are likely to start rising and so will convertible issuance, say equity-linked bankers.
"If interest rates were to increase then big investment grade names should come back and volumes could suddenly, easily treble," says Dib.And maybe you, Mr Treasurer, should be practicing that presentation to the board, after all.