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Convertibles look for next wave to surf

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The convertible bond market proved a crucial source of finance during the coronavirus outbreak, for star companies and struggling ones. But the market sputtered in late 2021, as deals dried up. Going into 2022, there are plenty of reasons why new sources of business should soon appear. Aidan Gregory reports

Convertible bonds thrived during the pandemic. Specialist equity-linked investors showed an extraordinary willingness to lend money to all kinds of borrowers, from high growth US technology companies to some of the hardest hit industries, such as airlines.

The recovery phase from Covid has caused CB issuance to subside. But the resumption of economic growth should bring fresh opportunities, just as long as the Omicron variant does not set the world back 18 months.

“The convertible market has always been a provider of growth capital and restructuring capital,” says Venu Krishna, head of equity-linked strategies at Barclays in New York. “As the world normalises, and as some of these businesses which got hit go back to normal, their capital needs will be different. We saw a burst of issuance because the convertible market was one of the few capital markets open to these companies, which desperately needed to raise capital. It was specific to that period.”

In 2020, over $194bn was raised globally in the equity-linked market, the busiest year since 2007, according to Dealogic.

The momentum continued into 2021, with more than $156bn issued, up to November 17. Most dealflow was in the US, but EMEA also produced a strong output. However, despite these large volumes, the market has slowed in recent months.

“2020 was incredibly busy and beat lots of records globally,” says the head of EMEA equity-linked at a US house. “The first half of 2021 was a continuation of the same trend, then we had a quiet period following the summer. That is globally, not just regionally. We will finish the second half at a very low number versus what our expectations were at the beginning of the year.”

Why have the wheels come off for convertibles? The primary answer is that it is not CBs themselves, but their issuers that have gone out of style.

David Hulme

There is a large overlap between the companies that have funded themselves with CBs in the past two years and the hot growth stocks that caught investors’ imaginations as the big winners from the pandemic.

But this category of companies has tanked in the stockmarket as 2021 wore on, as investors repositioned into sectors that had been hobbled by the pandemic, but now stand to benefit from the recovery.

Shares in internet-savvy exercise bike maker Peloton, for example, which issued a $1bn convertible bond in April, have fallen more than 62% in 2021.

Asos and Global Fashion Group, the online clothes retailers, crashed more than 41% and 28% respectively during 2021 as a result of the equity market rotation. Meanwhile, the S&P 500 has climbed 24%.

Issuers of that kind have contributed the bulk of CB deals in 2021 — more than half in the US, while the European market has become increasingly weighted towards technology too.

Convertibles suit technology companies that are growing fast — so have high prospects for share price growth — but have short track records and low profitability, making them weak credit risks.

“October was one of the quietest months on record globally,” says Juan Rodriguez Andrade, head of EMEA equity-linked at Bank of America in London. “There has clearly been a slowdown. Part of it was driven by many companies being in blackout but it goes beyond that. A lot of companies have pre-financed in advance, so they have less need to fund now than a year ago, as they took the chance at the start of the year. On top of that, in the technology sector, which is one of the sectors we have seen a lot of issuance from, with rates going up and the re-opening happening, it has impacted their equity valuations, so it will take a while for them to think about issuing convertibles again.”

No more distress


The second big reason why CB issuance has dwindled is the easing of distress in the economy.

With the rollout of Covid-19 vaccines, few expect a return to the widespread and severe lockdowns of 2020-21 — even though countries such as the Netherlands and Austria were tightening controls, and a worryingly infectious variant was discovered in South Africa, as this review went to press.

The airline industry is the best example. Many of the world’s major carriers, including Cathay Pacific, British Airways’ parent IAG and Singapore Airlines, have issued convertibles over the past two years, as part of wider financing packages to obtain much needed cash after passenger numbers collapsed.

With the resumption of global travel, including the re-opening of the US to European visitors in November, the outlook for these businesses is rosier.

“If you think about who was issuing convertibles over the last 12-18 months, on the one hand we had lots of heavily impacted companies like airlines and travel and leisure firms,” says Ilyas Amlani, head of EMEA equity-linked at HSBC in London. “Many of those companies have already raised capital and their operational performance has improved dramatically. Their businesses are performing much better and their need for additional liquidity has drained away. It is unlikely they will all go back to equity-linked so soon.”

Blue chip drought


While growth tech companies and struggling consumer businesses have visited CB-land in droves, investment grade issuers, which make up the bulk of the European corporate bond market, have continued to avert their gaze.

The rates outlook perking up has not yet fed through into a rise in funding costs for European investment grade companies. They can still issue straight bonds extremely cheaply, so they remain only rare visitors to the equity-linked market.

“Alternative options in the debt market also continue to be strong,” says the US head. “Many issuers have these options and have chosen to go down the debt route. That explains why we have had such a quiet period over the last few months.”

Despite these explanations, the slowdown in issuance still puzzles equity-linked bankers, as share prices continue to set new all-time highs almost every week. High equity valuations mean CBs can be issued extra-cheaply, with less risk of the company having to place equity at a dilutive price.

“We all agree that it is a bit odd and not what we expected at the start of the year,” adds the US head.

The bull run in global equities shows little sign of slowing, even if rates do rise in 2022, as expected.

The resumption of economic growth may have caused sharp adjustments and repositioning in equity markets as investors tried to ride the fastest rising stocks, but ultimately the sector rotation will peter out. Growth should bring rising earnings and corporate investment, and with it, new needs for financing.

“Do I think this quiet period will last?” asks the US head. “No. With macroeconomic conditions and the rise in rates, along with equity valuations remaining attractive, there could be some issuers who are tempted to revisit convertible bonds.”

That will include the recently out-of-favour tech companies, much given to CB issuance.

While the end of social distancing is welcome for many firms, the swerve towards digitalisation brought by the pandemic is not going to be reversed.

“Software has been a very active area of issuance,” says David Hulme, managing director at Advent Capital Management in New York. “We are seeing an extremely fast digitalisation of the economy. Software companies generally are booming and we have seen them raise capital to take advantage of that opportunity.”

Hulme adds: “Covid accelerated that transition. Companies realised they have to be able to deal with distributed workforces, which has cybersecurity implications, and their staff need to communicate effectively in that kind of environment.”

When growth share prices are re-rated upwards again, it is likely to spur them to return to the equity-linked market for funding — particularly since investor appetite for CBs remains strong.

“Companies tend to be more sensitive to their equity valuations,” says Krishna. “Typically, when equity valuations correct [downwards], you can see companies becoming more reluctant to issue convertibles. Right now, the market is still very attractive because of speed of access and pricing, which remains very favourable.”

Tie-ups to finance


In 2022, as well as resuming financing tech companies, equity-linked investors expect to provide more debt to firms embarking on mergers and acquisitions to exploit the recovery.

“M&A has been subdued this year and was much stronger on the private equity side and less so on the listed company side,” says Stephanie Zwick, head of convertible bonds at Fisch Asset Management in Zurich. “As we head into next year, we should see some more M&A activity, and consolidation, which should lead to some convertible bond financing.”

Financing M&A has historically been a classic purpose of issuing convertible bonds.

“I think there is going to be a lot more M&A,” says Rodriguez. “Clients are talking about the full toolkit of financing solutions and are looking across capital markets, including convertibles. That will also be a driver in 2022, in addition to tech.”

Another source of optimism is that 2021 was the busiest year in history for IPOs globally, with $558bn raised, Dealogic data show. Many of these firms will need to return to equity markets for financing, and convertibles are likely to suit some.

“We have seen a lot of newcomers to the convertible market and there has been a lot of IPO activity,” says Hulme. “It may not continue at that frenetic pace. Some of those companies, a couple of years after their IPOs, will come to the convertible market. It is often a first stop for them in credit markets.” GC

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Aidan Gregory
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