After 2018, which was one of the quietest years for new equity-linked issuance since the financial crisis, Europe’s convertible bond market bounced back in 2019.
Sustained low interest rates had held back the market for some time. However, equity markets worldwide hit new highs in 2019, prompting many companies to re-examine the terms that can be achieved on convertible and exchangeable bonds. This led to more new issuance, which Armin Heuberger, head of equity-linked debt at UBS in London, says has been driven by a couple of factors: “Share price levels have recovered strongly and have provided a strong base to strike premiums off,” he says. “Secondly, the market has continued to be starved of new paper, hence the investor bid remains extremely strong, both from hedge funds and outrights, allowing issues to price very successfully.”
There was €16.4bn of new issuance in EMEA in 2019 (up to November 25), according to Dealogic, up from €11.6bn in the whole of 2018. But these volumes are still not large. A £3.4bn mandatorily convertible bond from Vodafone, the UK telecoms firm, formed a quarter of the volume and one from Swiss building materials company Sika another 7%.
“It is coming off a low bar and around €5.2bn is mandos, which have a more limited audience in Europe, but it is still helpful,” says Jon Murray, head of EMEA equity-linked origination at Mizuho in London.
New issuance in the US — $53bn this year — still puts Europe in the shade.
“The US [stock] market has outperformed Europe and most of the other global markets,” says David Hulme, managing director at Advent Capital Management in New York. “Strong equity performance tends to beget issuance because companies are more likely to sell convertibles when their stock prices are high. The interest rate profile in the US is a bit different to the rest of the world. Extremely low interest rates in Europe mean companies are more inclined to borrow in the straight debt market.”
European equities underperformed during 2016-2019, up only 22% against 42% for the US. However, in 2019, Europe has been running almost as fast: as of November 25, the S&P 500 had risen by 25% and the EuroStoxx 50 by 24%.
A persistent structural reason why convertible bond issuance in Europe lags the US, is that Europe has fewer fast-growing tech companies, which are the biggest source of supply in the US. Some 47% of US equity-linked issuance in 2019 came from computer and electronics companies, according to Dealogic, but only 16% of European issuance.
How low can you go?
If there is one thing that market participants agree has been holding Europe’s convertible bond market back, it is ultra-low interest rates.
There is an interest cost saving for companies when issuing convertible bonds. Equity-linked investors are willing to accept much lower coupons than those on straight bonds, in exchange for an option to convert the bonds into cheap shares if an issuer’s share price rises above the strike price for conversion. However, the bull market for credit and low government bond interest rates have enabled European companies to raise large amounts of capital at extremely cheap costs with ordinary bonds, which do not risk diluting their shareholders.
“In the absence of M&A or refinancing of existing convertibles to drive new issuance, corporates have sometimes struggled to get to grips with potential dilution, given where rates and spreads are currently,” says Murray.
Many have therefore shunned convertible bonds.
“European issuance has been better than last year but it is still not looking fantastic,” says Tareen Carmichael, head of convertible bond sales at UniCredit in London. “The negative yield environment isn’t going away. We are talking about years now. It is the new normal.”
2019 will be remembered as the year when euro government bond yields hit record lows, amid small spikes in equity volatility, as a result of trade tensions between the US and China and fears of a slowdown in global growth.
The European Central Bank restarted quantitative easing in the autumn, depressing the region’s bond yields still further. It now has a new president, former IMF managing director Christine Lagarde, but there is unlikely to be any substantial hardening of monetary policy in the near future. Few expect a rate rise in Europe in 2020 or even the following year.
Getting tomorrow’s share price today
Despite the ready availability of cheap money in the conventional bond market, a good range of issuers, both investment grade and unrated or high yield companies, did come to the equity-linked market in 2019, particularly in France.
While convertibles issued for conventional financing purposes have not been common in 2019, there was a rash of European firms issuing bonds exchangeable into shares of companies they own. At its simplest, this technique monetises a stake, obtaining a higher price for the shares than the market price. This form of issuance is likely to continue or increase in 2020.
“Considering the solid performance of stock markets and low rates, it makes sense for exchangeable bonds to be compelling instruments,” says Xavier Lagache, head of EMEA equity-linked debt at Deutsche Bank in London. “Convertible bonds will more rarely be seen as the most attractive debt financing alternative by CFOs, especially for investment grade issuers, but exchangeable bonds are a different story.”
Issuers such as Group Bruxelles Lambert, LVMH and Atos issued large exchangeable bonds in 2019 with aggressive terms. In October, Atos, the French IT services company, issued a €544m five year bond exchangeable into some of its non-core stake in payments group Worldline at a negative yield of minus 1.68%. It struck a conversion premium of 35% above the price achieved in a concurrent block trade, which was 27% above where the stock began the year.
When investors buy exchangeable bonds, they take credit risk on the issuer, but are exposed to the share price volatility and performance of the underlying. This mix is often highly attractive for investors, particularly if the underlying is from a sector under-represented in the convertible bond benchmark indices. Issuers, meanwhile, secure extremely cheap financing on a stake that may be non-core.
“Exchangeables make a lot of sense and will continue to do so for a while,” says Murray. “The redemption schedule [of equity-linked bonds] remains high and as long as fund flows hold, it is clear we are going to have a supportive landscape for these trades, especially when there is a strong credit, coupled with an interesting underlying. Whether as part of a disposal strategy or purely for opportunistic financing, it is probably the best time ever to be proactive and think about making your stakes work for you.”
Investors see this kind of activity continuing into 2020, as long as stock markets remain buoyant.
“The convertible market is a unique way for a company to monetise a strategic stake,” says Hulme. “If they wanted to unload that type of stake into the equity market they would generally have to sell it at a discount. By issuing a convertible they can effectively sell the stake at a premium. I would anticipate more of that kind of activity as companies try to simplify themselves.”
Seller’s market
The prolonged shortage of new issues in Europe and a steady flow of redemptions has created a seller’s market, in which issuers can achieve stellar terms on convertible bond offerings. This is unlikely to change going into 2020.
More money is expected to flow into the asset class because many investors are conscious that the cycle is old, with stock markets at record highs but still rising further, even though there are fears that an economic downturn is approaching. This is creating an even stronger bid for convertible bonds, which offer the combination of equity upside and debt-like downside protection.
“The equity-linked market has been consistently a very friendly issuer’s market, a seller’s market, whereas if you compare it across to equities via IPOs and blocks, on balance that is probably more a buyer’s market,” says Heuberger. “Good performance of the asset class, coupled with defensive characteristics into a more uncertain and more volatile environment going forward, has helped with fundraising.”
2020 promises to be just as volatile than 2019, with the Brexit deadline, the continuing trade war between the US and China, US elections, and more tensions in the Middle East. This dynamic is fuelling interest in convertibles, even though many believe a correction is coming.
“A lot of people are coming round to the idea that equities will be more volatile going forward, so convertible bonds make sense as an alternative,” says Tarek Saber, head of convertible bond strategies at NN Investment Partners in London. “In our sphere there are good returns to be made. If equities sell off, you don’t lose as much and then you will be better placed for a recovery.” GC