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EquityEquity-Linked

Convertible market looks to kick on after coming of age

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Convertible bonds have thrived during the pandemic, as companies rushed to raise capital to shore up their damaged balance sheets or to take advantage of the opportunities for growth that the crisis has unexpectedly created. Meanwhile, investors who bought in have been rewarded with strong returns. More of the same is expected in 2021. Aidan Gregory reports

After a stellar 2020, which saw record issuance volumes in the primary market, equity-linked is expected to remain one of the hottest areas of the equity capital markets for the foreseeable future. 

Going into 2021, market participants are confident that the flow of deals will continue, as hard-hit companies seek to refinance themselves to get through what is expected to be a long and difficult winter and even spring, with many countries enduring fresh lockdowns, such as Germany, France and the UK. 

“The pandemic is likely to continue into next year so I don’t see why not,” says Ilyas Amlani, head of EMEA equity-linked at HSBC in London. “A lot of companies out there still need to repair their balance sheets which have been further impacted from second lockdowns across Europe. I wouldn’t be surprised if we see a continuation of the strong issuance that we have seen.”

In November, Pfizer and BioNTech, as well as Moderna, announced that their Covid-19 vaccines had been more than 90% successful in late stage clinical trials. Trials of the Oxford University/AstraZeneca vaccine also showed it to be highly effective. The news prompted stocks around the world to surge, particularly companies from some of the worst-hit sectors, such as the airlines. 

With working vaccines expected to be widely available by spring 2021, fund managers have been shifting their portfolios from growth stocks, which have been winners during the pandemic, into value stocks that stand to be the biggest gainers as an economic recovery materialises. 

“The vaccine news is good for the world but it is also good for our portfolios’ positioning, so we are pleased about that,” says David Hulme, a managing director at Advent Capital Management in New York. “The more levered the company the bigger the improvement generally is as you get a mix of short covering and fundamental buyers who take it as a sign that the worst over for these companies.

“The companies that have generally been holding up better, whose businesses have improved with people being shut at home, are seeing some pressure on their stock prices on the flipside of that.”

This shift is likely to prompt more companies from hard-hit industries to issue convertible bonds to shore up their balance sheets with cheap debt until the economy improves. Lufthansa and Singapore Airlines both sold large convertible bonds in November in the wake of the vaccine news. They are likely to be joined by many other companies in the months ahead, now that their share prices have rebounded from their lows earlier in the year. 

“This year has been one of the best years ever for issuance,” says Damien Regnier, a portfolio manager at Tyrus Capital in London. “Can we top it? I don’t know. After 2007, we had a very bad year. Let’s hope next year is also a great year for our market. I think because of the damage in the macroeconomic baseline, a lot of companies will still need financial support, even if there is a working vaccine. That is going to take a while. In the UK we are in lockdown and it is the same situation across Europe in France and Germany for example. This is going to create lasting damage and we need to be careful.”

Many companies, particularly those in Europe, have taken advantage of generous state support schemes during the pandemic, and have had less of a need to tap the capital markets for financing as a result. 

State support often comes with conditions, such as being unable to pay dividends or lay off staff as part of a restructuring — stipulations that could hinder businesses in an improving economic climate.

More companies are expected to refinance themselves via the capital markets as a way of exiting these lending schemes and preparing for the future when the pandemic subsides. The convertible bond market is likely to continue to offer a cheap and flexible way for issuers to achieve this. 

“Next year we should still see good flow from issuers because there is a lot of refinancing of loans that needs to be done that many companies have taken from banks or government schemes.” says Jose-Antonio Gagliardi, head of equity-linked origination at Société Générale in Paris. “As long as there are no shocks, we should see a relatively spread-out issuance calendar with a lot of refinancing. 

“There should still be a great deal of money in the financial system with more stimulus in Europe and the US coming up.”

Investors are expecting a pick-up in M&A activity, one of the traditional activities that convertible bonds are issued to finance, as companies seek to either consolidate by buying weaker rivals, or scale up to survive the severe economic downturn.

“Convertibles are often issued in conjunction with M&A activity and we do see that picking up,” says Advent’s Hulme. “We have seen quite a lot of it recently, some of which has involved convertible issuers buying or being bought. That will drive further capital raises in the convertible market to help finance some of those purchases.”

Tried and tested

The old adage that the convertible bond asset class comes into its own in periods of crisis has proven true. This is due to the ability of the primary market to stay open even in volatile markets, and the natural convexity of convertible bonds, which deliver bond-like protections on the downside while retaining equity-like returns if stocks rise. 

The pandemic left many companies scrambling for funding at a time when government-imposed lockdowns forced their businesses to close temporarily. These included businesses from sectors such as airlines, cruise lines and energy.

With many facing downgrades, issuing bonds or raising loans was no longer such an attractive option. The equity-linked market, where ratings are optional and not required, provided a lifeline. 

At the same time, a raft of growth companies, eager to capitalise on the trends the pandemic has accelerated, have rushed to raise capital to finance their faster than expected growth. 

“We have seen a surge of issuance this year since the outbreak of the pandemic,” says Virginie de Grivel Nigam, head of equity-linked at JP Morgan in London. “There were rescue deals from companies facing liquidity crises and who needed to raise capital very quickly and the investors in the equity-linked market were there for them. 

“That was a big part of the spring, but since the beginning of the summer, many transactions have been opportunistic capital raises to finance growth, with a lot of high growth companies coming to market.” 

Companies can issue convertible bonds at a much lower cost of financing than straight debt, as equity-linked investors are willing to accept lower coupons, in exchange for an option to convert the bonds into cheap stock if an issuer’s share price rises. Volatile markets also make it more attractive for companies to monetize volatility as the value of the embedded options within convertible bonds increases. 

The result has been an extraordinary year for issuance. Globally, more than $176bn of new convertible bonds have been sold this year, as of November 22, up 34% from the same period in 2019, according to Dealogic data.

US companies have been at the forefront of the surge. The Americas region is on track to finish this year with over $100bn of issuance — a post-financial crisis record. Over half the volume in the US originated from technology and healthcare companies. 

In EMEA, the size of the market is still small compared to the US, with volumes of $33bn, but has still enjoyed a strong year nevertheless. 

“This year has been a good year for the market in terms of volumes,” says Gagliardi. “It is amazing what the US market has done this year. Europe is nowhere near that, but it has been a good year in Europe.”

Investors who piled in have been rewarded, aided by a sharp rally in global stocks since March fuelled by unprecedented economic and fiscal interventions by governments and central banks around the world, and recent news that working vaccines for Covid-19 will soon be available. 

The Refinitiv Global Qualified Convertible Index, one of the key global benchmarks used by equity-linked investors, is up 25.6% in US dollars this year, as of November 23, outperforming the S&P 500 and the EuroStoxx 50. 

This notable outperformance is fuelling greater interest in the asset class, which has begun to capture more mainstream attention and attract more inflows. 

“A lot of investors first survived the crisis then started to look at the asset class in the summer,” says Stephanie Zwick, head of convertible bonds at Fisch Asset Management in Zurich. “We have a lot of talks right now with prospective clients about the asset class.”   GC

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