Ratings analysis snubs convertibles issuers

  • 01 Feb 2001
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One of the key consideration for issuers in the convertibles market is clearly the impact that an issue will have on the balance sheet. Although convertibles will usually be regarded by the ratings agencies as debt, the possibility (or probability) of ultimate conversion into equity will also mean that a convertible bond is less likely to exert downward pressure on a borrower than an issue of straight debt. "We start out from the position that convertibles look like debt," says Chris Legg, senior corporate analyst at Standard & Poor's in London. "Although the coupon is lower than on a straight bond there is still the obligation to service coupon repayments, as well as the possibility of cash repayment at some stage in the future."

Legg says that he doubts whether any downgrades or upgrades made by his agency will have been in direct response to the impact on a company's balance sheet of issuing convertibles rather than other securities, but he points out that a well-performing convertible can certainly do no harm to an issuer's rating.

"In our internal discussions we may well say that a company with a convertible with, say, a year to run which is in the money might mean that it is less likely to be downgraded than a company with pure debt."

Bankers say that the approach of the ratings agencies is inevitably a highly conservative one, but that companies financing themselves through the convertibles market should of course have a rosier ratings outlook than those opting for straight gearing.

"In a way the whole ratings question is a bearish point for issuers of convertibles," says one analyst, "because they are financing themselves in a way that is good news for their balance sheet without necessarily being given the credit for it from the ratings agencies."

Inevitably, gearing levels and the response of ratings agencies to these levels will be much more important for companies in certain sectors than in others. One obvious example of a sector that needs to pay more attention to its ratings than others is the insurance industry, which, say some analysts, is one explanation as to why an issuer such as Axa has been so prolific in the convertibles market in recent years.

Even if the number of visits that Axa has made to the market has left some investors totally saturated with paper from the issuer - and therefore demanding more generous pricing - analysts say that the insurer is likely to continue to tap the convertibles market. "Axa's convertible bonds are subordinated in status," says Mark Conway, from the convertibles research department at Credit Suisse First Boston in London. "Therefore the convertible has a twofold benefit to the company. It pays a lower coupon than a conventional straight bond, but also the subordinated status supports its senior status and claims-paying credit ratings."

All these considerations, say bankers, have not been lost on the corporate sector. Firouz Momeni, director of equity capital markets at Dresdner Kleinwort Wasserstein says that the attractions of the convertibles market are now so well understood and appreciated by finance directors that bankers no longer have to adopt a hard-sell approach to promoting the concept of equity-linked financing. But that is not to say that the convertible is a panacea for finance directors exploring the full range of funding options.

"Companies are becoming a lot more receptive to the concept of financing through convertibles," says Momeni. "But one of the biggest problems finance directors still have with the product is the uncertainty as to whether it will convert or not."

Irrespective of how confident a company is about its conversion prospects, therefore, Momeni says that a sensible rule of thumb for any issuer is to make certain that conversion will not have a significant impact on a company's total gearing level. "We would usually advise companies that they shouldn't have more than 15% or 20% of their capital in the form of convertibles," he says.

Uncertainty about the future environment for share prices is especially hazardous, say bankers, for issuers contemplating the pre-IPO convertibles market. Recent practice in the US market, for example, has been for pre-IPO deals to be structured with a compensating pick up in the coupon or reduction in the conversion premium if the IPO into which bonds can be exchanged does not materialise as planned.

Pre-IPO convertibles work fine in a healthy and prolonged bull market, but would leave would be issuers highly exposed in a lengthy bear phase in which the environment for IPOs is hostile. At least one recent pre-IPO convertible in the US was structured in such a way that if the flotation is delayed by two years, the conversion premium reverts to zero.

While uncertainty over the future impact on the balance sheet may be one reason for issuers to be wary about using the convertibles market, another will inevitably be the knock-on effect on a company's share price. "Generally when companies announce plans for a convertible issue the stock price falls," says one analyst. "That is partly a reflection of the market's assumption that hedge funds will be shorting the stock, and partly because straight equity investors will obviously step out of the market if they expect an equity-linked instrument to be launched at attractive terms."

Others say that although capital markets practitioners are inevitably keen to play down the impact of a convertible on a share price, the truth of the matter is that the increased involvement in the market of hedge funds is inevitably having a profound influence in this respect.

"If you bring out a convertible for Eu1bn, and sell half of it to hedge funds, and they in turn short the stock, the maths suggest that somebody somewhere is going to be selling a quarter of a billion worth of your stock," says one analyst.

Again, however, bankers point out that it is up to the company to assess the value of the trade-off between the attractions of a convertible issue and the short term impact that an equity-linked offering will have on its share price. *

  • 01 Feb 2001

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