On the road again
The convertible bond market finally woke up in September. But Martin Steward finds that there is a long way to go before portfolio managers are out of the woods
There is no shortage of people recommending convertible bonds for these times of binary risk. Bet on equities and you risk the euro-zone, China or US ‘fiscal cliff’ blowing up in your face. Head for bonds and you risk missing the rally should these problems be resolved – or even from the response of central banks should they get worse.
With convertibles, you don’t have to make the choice: the embedded option gives you equity participation; and the bond floor rests on pristine corporate balance sheets. The only problem is that the convertibles market is worth less than $400bn (€309bn). Convertible bond portfolio managers are notorious for worrying that supply is about to run dry. But over the early summer of 2012, those worries seemed more justified than they had for a long time.
Each year from 2006 through to 2010, global issuance topped $100bn, peaking at $200bn in 2007. Then, in 2011, it slumped to about $80bn. But even that looked bounteous by the end of August 2012, when new issuance was struggling to break the $30bn mark for the year to date; in Europe, almost nothing was seen besides one $3bn issue from Siemens. Meanwhile, some $200bn is due for redemption during 2013 and 2014 alone, according to UBS.
Then, in September, things sprang back to life at a speed not seen since 2003. In the first two weeks alone, $6.3bn-worth of bonds came to market, with more than half of that value issuing from Europe.
“We’ve seen a dramatic turnaround,” says Nathalia Barazal, a senior convertibles portfolio manager at Lombard Odier Investment Managers.
“These issuers probably wanted to come to market before the summer, but the market conditions simply were not there,” reasons Emmanuel Martin, CIO at Parisian convertibles specialist Acropole Asset Management.
Since the 2009-10 equity rally ran out of steam, issuing convertibles has been tough for company CFOs, many of whom were able to tap straight debt markets for super-low rates instead. Now that it feels like a floor sits under risk assets – the ‘Draghi put’ – appetite has returned for the equity-option side of the deal and convertible implied volatility has been selling at around 35% under the weight of demand.
“A lot of investors are desperate for big, investment-grade issues because they have to deploy new inflows,” says Martin.
This is symptomatic of a primary market rebound – as are the issuers that have come to market: financials (exemplified by a BNP Paribas bond convertible into Pargesa equity) and real estate (exemplified by British Land and Capital Shopping Centres). “These issuers have historically been very opportunistic – they come out only when the conditions are very favourable to them,” says Martin.
Unsurprisingly, of the 10 issues Martin saw in September, eight were not interesting at all, while Subsea 7 and Faurecia were rejected because of their sector risk.
“Investors should avoid the first issuers,” says Martin. “We look for pure corporates issuing to increase capex or to improve growth organically or through acquisition. These are usually non-rated mid-caps rather than financials or large-caps.”
Léonard Vinville, a convertibles portfolio manager at M&G Investments, agrees that September was perfect for “opportunistic” issuers.
“I say bravo to them,” he says. “But broadly speaking, we didn’t see much that was appealing. Out of 28 new [global] issues, we’ve been involved only in three. I know that some of our competitors were desperate for new issuance over the summer, but that’s because their funds are four times bigger than mine.”
Lombard Odier, with €6bn in convertibles, was certainly more upbeat about recent issuance. “All the issues from the last few weeks went well and pricing has been good for both parties,” says Barazal. “When we’ve seen deals struck at the wrong price they have quickly corrected.”
Some deals were not attractive, she adds – BNP Paribas and GDF Suez were “a bit boring”, with low coupons and not enough equity sensitivity – but the real estate issuers were on the menu alongside Subsea 7, Russian steel producer Severstal and the South African furniture manufacturer Steinhoff International.
Does this reflect a greater need for new issues to balance a big portfolio? As equity markets trundle along or decline, the delta, or equity sensitivity of convertible portfolios will also decline – reducing the convexity, the upside capture and downside protection, for which they are so prized. New issues help to refresh that convexity.
“Without new issuance I knew I’d be facing problems 12-18 months ahead,” Barazal concedes. “We buy with strong conviction, so the last thing I want is to be forced to buy stuff I don’t like.”
As a result, both Lombard Odier and (the much smaller) Acropole have turned to synthetic positions – call options paired with straight debt – to help maintain delta. At M&G, Vinville tends to focus solely on convertibles as a package. For him, the key is being able to tilt regionally towards the markets where equity sensitivity is being offered most reasonably.
“The Asian market has the lowest delta – often they are busted equities,” he says. “In Europe, the delta is also quite low, perhaps a 0.35 weighted average. But in the US you get about 0.45.”
The US market did not experience the precipitous fall-off in issuance before the summer of 2012 that Europe did, and there hasn’t been the same flood of multi-billion dollar issues since; 12 bonds came to market in September, valued at about $2.5bn.
“That doesn’t sound a lot, as there has been some massive issuance in Europe, but we like the number of new issues and the fact that it is smaller companies using new capital to grow,” says Justin Kass, a leading US-only convertibles manager with Allianz Global Investors Capital.
He contrasts today with 2005-06, when huge issues were sold to hedge funds to finance stock buybacks. “It’s set up much better for outright managers such as ourselves,” he says. “In almost every instance they have deltas and conversion premiums that are balanced, giving us 60-80% of the equity upside and less than 50% of the downside.”
But he hesitates to describe the US market as “healthy”. Like Europe’s, it faces a stark-looking redemption calendar with the effect being felt more obviously among large-cap, investment-grade issuers. “Citigroup goes away at the end of the year, EMC goes away in 2013, Medtronics goes away in 2013,” says Kass.
They are staying away because they can get low rates in straight debt without any danger of diluting their shareholders – leaving a primary market of small issues from non-rated companies. Even high-yield issuers who sold 8-9% coupons three years ago can get away with 5-6% today. “We need that to become 7-8%, so that a 3% convertible becomes an attractive alternative,” Kass explains.
The only real exception was a bond from Priceline.com, which looks similar to the recent ‘opportunistic’ deals in Europe – an ultra-low coupon with a pricey conversion premium financing a stock buyback.
Of course, this doesn’t mean catastrophe for the existing positions in US portfolios, which still deliver convexity.
“Everyone loves to talk about the timing of their entry into convertibles or high-yield, and yet they’re not in the least worried about their 50% allocation to equity,” Kass says. “The reason you own a convertible is not because you think implied volatility is down and credit spreads are tight and now’s a good time to buy – it’s because, over the long term, you are going to capture more of the upside and less of the downside.
We just celebrated 20 years with one of our clients – we were not only their best-performing convertibles manager, we were their best-performing manager.”
However, it could become challenging to maintain that convexity if the low-rates, sideways equities environment of 2011-02 persists for too many more months. The non-rated mid-caps could retreat again as their options cheapen, while continuing low rates keep investment grade large-caps away, too. It is a strange irony: the very environment that best favours convertible bonds for investors could sour the asset class for issuers.