US convertible boom gives Europe something to hope for: rate rises

Rising interest rates in the US have created a roaring market for convertible bonds. Europe’s barren market has been put to shame — it risks being the driest year for two decades. Going into 2019, Europe is likely to remain in the shade of the US, but there are hopes of an issuance rebound — that is if interest rates ever start to rise. Aidan Gregory reports.

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The global convertible bond market is heading into 2019 in great shape, with lively activity and decent secondary performance amid plunging stockmarkets. But this is no thanks to Europe, where issuance is becalmed.

The lopsided nature of the equity-linked debt market supports the claim that much in the world of convertibles comes down to interest rates. 

In the US, repeated rate rises by the Federal Reserve, striving to rein in a booming economy, have driven the 10 year Treasury yield past 3%. Along with the tax reform of December 2017, which may have sharpened the incentive for US companies to issue low coupon debt, this has led to a bumper year for equity-linked issuance by companies in the US. One of the archetypal reasons for companies to issue CBs is to raise cheaper funding than they could with a straight bond. 

The over $45bn of paper placed by US issuers by late November is more than in any of the last three years. If another $3bn comes out by year end, it will be the busiest year since 2008.

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“Global equity-linked issuance as of November 19, 2018, stands at over $90bn, with US and Asia leading, and with European issuance remaining low,” says Tareen Carmichael, head of convertible bond sales at UniCredit in London. “There is a chance, if issuance continues at this pace right up to Christmas, that it could be the biggest issuance year for a decade.”

More than half the US issuance has been from companies in the technology sector, which typically issue CBs to raise growth capital at far better terms than they can achieve in the high yield bond market.

Annus horribilis

Europe, on the other hand, has had a dreadful year. By November 20 just €10.6bn had been issued, down 48% from the same period in 2017, according to Dealogic. If no more deals are issued, it will be the quietest year since 1996.

“The key is rising interest rates at the moment,” says Martin Haycock, senior partner at Fisch Asset Management in Zurich. “We also need stock prices to behave themselves and we need companies to need money. So in that context, we have seen the US have a brilliant year in relative terms, and it has been driven by growth stocks, while Europe has been the laggard.”

There are other reasons why US equity-linked issuance has left Europe in the dust this year. 

Europe does not have anywhere near as many fast-growing tech and biotech companies, of the kind that have powered US dealflow. The European market is far more heavily investment grade.

“The US market has had a healthier year, from both a primary and secondary perspective, and primary is the lifeblood of the product,” says Satnam Sohal, principal consultant at Greenwich Associates, the capital markets-focused management consultancy, in London. “Europe has been a very different story. The difference in the mix of underlying issuers has always been there and that is why the US market is so much bigger.”

At the end of 2018, the European Central Bank is expected to cease expanding its €2.4tr stash of quantitative easing bonds. But it is still in ultra-dovish mode, and even after QE ends it will continue to reinvest coupons and maturing principal.

The result is that the gap between US and European interest rates is extremely wide — 3.07% for the 10 year Treasury and 0.36% for the equivalent Bund, as of November 26.

“What will drive the closing of that gap in Europe is likely to be fears that the European economy is close to reaching capacity,” says Chris Sim, managing director, investment banking at Investec in London. “However, it is a disparate market, with southern European countries like Italy facing major structural challenges, while in northern Europe the picture is very different. Therefore, it is difficult to see how the rate environment can change quickly, in the absence of a real pick-up in growth which would give the ECB concerns about capacity issues and inflation. The structural challenges that have long been talked about in Europe, such as labour markets, don’t seem to be rapidly changing.”

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The only way is up

Nevertheless, the end of QE, and the prospect of the ECB rate hikes that will eventually follow it, are generating cautious optimism in the European equity-linked market, after a disappointing 2018.

On paper, higher rates should push more European companies to issue equity-linked debt, to reduce their funding costs. Enthusiasts believe this could be the catalyst the market needs to get back to the higher levels of issuance of years gone by.

However, nobody expects European issuance to catch up with that in the US any time soon. Any uplift in 2019 will be very gradual, and many features of the market in 2018, such as the high volume of synthetic and equity-neutral deals, will prevail for some time.

“As far as the primary market is concerned, 2019 will definitely be better than 2018 — that isn’t too difficult,” says Thierry Petit, head of EMEA equity-linked debt at BNP Paribas in London. “There is a combination of factors that should help boost primary activity. The first one is the end of the quantitative easing policy from the ECB. And although we should not expect a hike before the summer of 2019, a first hike will probably happen at the end of next year.

“If you add to that a more volatile equity market, I think you set the grounds for a pick-up in primary market activity,” Petit adds. “The fixed income market is still functioning quite well, but we are seeing some volatility towards certain sectors like real estate.”


Arb is not dead

In 2018, an important driver of the little issuance there was in European equity-linked was highly structured, synthetic deals such as equity-neutral convertibles and bank-issued exchangeable bonds.

Equity-neutral CBs are a way for investment grade companies to raise capital at virtually no cost, while avoiding the risk of diluting their shareholders.

The CB is cash-settled, and the issuer buys call options from banks to hedge its exposure to having to deliver the cash equivalent of shares to investors if the bonds convert into equity. 

Investors often dislike the structure, as it has to be priced aggressively so that the issuer can still save money compared with issuing straight debt, even after paying for the hedge. Nevertheless, equity-neutral deals are likely to persist. “There remains a gap between the number of European companies wanting to launch convertible bonds and the strong demand for investment grade paper among investors,” says Haycock. “Demand is greater than supply for IG paper and therefore there will still be a market for alternative structures, be they equity-neutral or other forms of structured paper.”

While thin volumes are likely to persist for a while, some expect equity-neutral deals to dwindle in 2019. Their reasoning is that rates will rise, making investors less tolerant of ultra-tight deals and tempting other, higher yielding issuers into the market.

“I personally think there is embedded inflation in Europe which will pop up as a surprise, and for that we will get a bit of what we have seen in the States, but nothing on the same scale,” says Tarek Saber, head of convertible bond strategies at NN Investment Partners in London. “The good news is companies in Europe will have to pay up a bit more and a lot of the equity-neutral deals will not be able to get done. That kind of structure may persist with some companies but it isn’t going to be the norm, so that is good news.”


Vol gives converts time to shine

After several years of mainly benign equity markets, and in the US, the longest bull run in history, volatility returned to US and European equities in 2018.

Escalating trade war tensions between the US and China spooked investors in October, sparking a global market sell-off, particularly in the Faang stocks. By late November, the S&P 500 and the Nasdaq had given up all their gains in 2018.

European stocks have fared much worse. As of November 26, the Dax 30 had dropped 12% in the year, the CAC 40 5.5% and the FTSE 100 8%.

The Vix, the US index that measures volatility, has more than doubled over the past 12 months.

Higher volatility is bad news for equity investors, but it presents the equity-linked asset class with a chance to show its value.

“Putting money into CBs in the current climate seems a very sensible way to go, as a method of partly offsetting increased risk in equities,” says Haycock. “We are optimistic that we will see some good flows into the asset class in 2019. CBs in principle provide a cushioning effect when volatility increases, but it is about absolute performance relative to equities. CBs give equity exposure, albeit at a lower delta, and importantly provide a bond floor. There are many good reasons why investors are and should be looking at CBs at the moment.”

Over the past 12 months, just over half of investors had net inflows into their European convertible bond portfolios, according to Greenwich Associates.

Before and after the onset of the market correction in the autumn, more institutional investors have been considering CBs as a method of generating alpha during a prolonged market downturn.

“You have pension funds who want to own CBs as a diversifier and insurance companies looking at it from a solvency perspective,” Saber says. “What we have seen is a huge amount of interest in the asset class. It isn’t the enigma it once was and a lot of people are coming in.”