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EquityEquity-Linked

Convertibles thrill with windfall terms: will issuers take notice?

Investors see equity-linked debt as combining safety with upside in a happy medium. But for issuers, the product is offering happy extremes: super-high premiums, ultra-low coupons and even no equity risk. Jon Hay reports.

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Convertible bonds are a market of enthusiasts, and right now, the enthusiasm level is at fever pitch.

“The whole convertible universe is as expensive for investors as I’ve ever seen it,” says Xavier Lagache, head of EMEA equity-linked debt at Deutsche Bank in London. “The terms investment grade issuers can achieve these days are utterly exceptional. Are we going to remain quite at the same level? I wouldn’t bet on it, but I still think the conditions will be very attractive to issuers for some months, or maybe a year to come. Issuers will be able to mould the product a little bit so that they meet their very specific corporate finance purpose.” 

In many financial markets, the eagerness of demand from investors seems to lead issuance. Demand grows, and issuance follows. Not so with convertibles. Appetite has been strong for years, with impressive consistency since the fall of Lehman Brothers — but the pattern of issuers tapping into that demand remains sporadic and unpredictable.

“Since 2008, if you are a CFO, the entrepreneur in you is dead,” says Tarek Saber, head of convertible bond strategies at NN Investment Partners (NNIP) in London. “You just leave things alone and fail conventionally. It makes me so angry.”

For several years, the European convertible market has been undersupplied, with issuance flat or falling, while the money allocated to it has increased. The result is valuations twisting ever tighter, so that what issuers can achieve in the market has become extraordinary.

“There are very interesting developments which bode well for the market going into 2016,” says Frank Heitmann, head of EMEA convertible origination at Credit Suisse in London.

Several of these concern innovative structures, but another is the size of deals. “It’s clear that €1bn, €2bn, even €3bn are very much doable — there is enough depth in the market,” says Heitmann. América Móvil’s €3bn bond in May 2015, exchangeable into shares of Dutch telecoms group KPN, proved that point decisively.

 

The high premium convertible

Telecom Italia brought out a remarkable deal in March, exploiting convertible investors’ hunger for paper. The bond gave TI seven year debt at 1.125%, by one estimate 163bp cheaper than it could have issued straight debt — and with a conversion premium of 70%, higher than had been seen for many years on a major European deal. This enabled TI to send a strong message about the potential for its share price.

Size: €2bn (top of €1.5bn-€2bn range)

Maturity: seven years

Launched: March 19, priced March 20

Leads: BNP Paribas, JP Morgan

Ratings: Ba1/BB+/BBB-

Coupon: 1.125% (midpoint of 0.875% to 1.375% range)

Conversion premium: fixed 70%

Implied volatility: 25.5%

Historic volatility: 30%

“To do a €2bn convertible with a 70% premium and end up with close to a 1% coupon, you need the market conditions of 2015” — Andrea Balzarini, Telecom Italia head of finance


Outer reaches

The remarkably receptive market conditions are enabling convertible bond structurers to go where they have never been before. “The trend to high conversion or exchange premiums is likely to remain an important element of traction for corporates in 2016,” says Karim Makki, head of international equity capital markets and equity-linked at Banca IMI in London. “Not only have issuers achieved some extremely high premiums, but there is the sheer number of these deals. More than a third of all issues in the first half of 2015 had a premium above 40%.”

In June, Ingenico, the French payment devices maker, raised €500m with a conversion premium of 55%. International Airlines Group, owner of British Airways, borrowed €1bn over five and seven years in November to finance its takeover of Aer Lingus, at a 62.5% premium. 

Most remarkably, Telecom Italia — hardly a stockmarket darling, and rated only Ba1/BB+ — raised €2bn in March with a 70% premium. 

Andrea Balzarini, head of finance at Telecom Italia in Milan, admitted that when it started developing the deal with BNP Paribas and JP Morgan, the 70% premium had felt like “a slightly crazy idea”. But he says: “We wanted to convey a strong message about what we feel is the potential for our share price.”

Win-win

That investors are willing to buy Telecom Italia debt at a 1.125% coupon — 160bp less than on its normal bonds — in return for an option to buy its stock 70% above today’s price, is something most financial experts still find baffling.

But for aficionados, CBs offer the best of both worlds. Saber at NNIP thinks of them as a vehicle to gain exposure to a stock — but an “all terrain vehicle”, rugged in all market conditions, with capital protection and equity upside.

In 2015, for example, the year began with “a massive rally in equities, especially in Europe, because of QE,” Saber says. “Then in the second quarter there was all the talk of interest rate rises, and US Treasuries got clipped. In the third quarter it was a bloodbath in equities.”

Convertibles, he says, outperformed equities during the bull phase — a rare feat — and fell about half as much as stocks in the bearish market, achieving a total return of about 5.5%.

This attraction explains why, despite the paucity of issuance, “there’s been a very strong flow into European investment grade convertibles, as investors seek the perceived safety of investment grade, but also try and benefit from QE in Europe,” says Mike Reed, partner at BlueBay Asset Management in London. “Due to the very low bond yields available generally, new investors are coming in, looking for alternatives that give them the potential to stay in fixed income.”

Pay me to issue

The flip side of high premium deals are those with exceptionally low yields. In May, Haniel, the German family holding company, issued a €500m bond exchangeable into shares of Metro, the supermarket chain. The deal’s whole marketed yield range was negative, and Haniel ended up at minus 0.54%.

But the deals capturing most attention seem to defy the rules of equity-linked issuance: the issuer does not have to bear any risk of giving equity upside to the investors.

Equity-neutral CBs, like those issued by National Grid, Iberdrola and Vodafone in the autumn, are to the investor quite normal convertibles, with conversion settled in cash. But markets now are offering blue chip issuers a rare arbitrage: they can buy an option from a bank that fully hedges their exposure to that cash settlement, if their share price should rise and trigger conversion. 

After paying for the option, Iberdrola still saved 50bp-60bp with its €500m CB in November, compared with a straight bond. These deals are making CBs an option, even for companies dead set against issuing equity.

“The fact that an issuer like Vodafone is seeing value in such a structure is a sign that more will follow,” says Banca IMI’s Makki.

Investors like the deals, too. “It will bring more issuers to the market,” says Reed. “It supplies genuine paper to the market, with liquidity, which is what CB investors want.” 

Banks are pitching the deals as hard as they can. “The pool of potential issuers is relatively limited,” says Lagache, “but if you can issue straight debt at a lower cost, why wouldn’t you?”

 

The equity-neutral convertible
Vodafone’s was one of a string of deals in the autumn where the issuer is fully hedged with an option against having to settle conversion. That suits companies, like Vodafone, with no interest in issuing equity. It was the issuer’s first CB and won extremely strong demand.

Size: £600m, increased from £500m

Maturity: five years

Launched: November 19

Leads: Morgan Stanley (gc), HSBC

Ratings: Baa1/BBB+

Coupon: 0% (below original range of 0.4% to   1.2%)

Conversion premium: fixed 30%

Implied volatility: 33%

Historic volatility: 25%

“just vanilla debt that’s cheaper” — Neil Garrod, Vodafone treasury director


Mando down

A year ago, the product bankers were most excited about was mandatory convertibles, but the past year has not been kind to them. One of the most prominent issuers was Volkswagen. Just seven weeks before its €3.77bn mando, issued in 2012 and 2013, was due to mature on November 9 last year, VW was hit by the emissions cheating scandal that knocked 43% off its share price in a fortnight. 

Suddenly, investors knew they were going to be issued shares, at a price of about €180, now far above what they were worth. The bonds fell almost as much as the shares. “It repriced the whole mando market for a few weeks, though it’s now mostly back to the sort of valuations seen before this event,” says Lagache. 

But mandos remain possible. “For anyone who wants to raise equity or sell with certainty it’s an attractive alternative,” says Credit Suisse’s Heitmann.

Like other markets, convertibles are affected by the tides of central bank monetary policy. But while specialists agree that depressed yields have encouraged investors to turn to CBs, they are also convinced that when interest rates do start to rise, “the great winner will be equity-linked”, as Makki puts it. “In the past year, the average cash cost saving for equity-linked issuers in Europe, compared with plain vanilla bonds, has been about 200bp. As rates go up, that cost saving will get greater — and if you’re a high yield issuer, it can be double that.”

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