Convertible Securities Set for Comeback Amid Swinging Marketsby
Companies can attract new investors with equity-linked debt
Investors could absorb `$55 billion to $65 billion' in 2016
With both debt and equity markets plagued by volatility, one asset class offers a cash-raising alternative: Convertible securities.
Convertibles, as they’re known, are a type of hybrid security that pay interest like bonds, and can be swapped for stock when shares rise above a fixed price. In turbulent markets, they’re an attractive proposition to investors keen on a stake in a specific company: collect a coupon or dividend now, while also getting an embedded call option -- the right to shares in the future, often at a much higher price than they’re currently trading.
Finding a way to lure investors is crucial at a time when raising capital has been tougher across asset classes, especially for companies with lower credit ratings. Stocks have been on a roller-coaster ride, at the same time as wary credit market investors have driven up the cost of issuing debt for some firms.
About $7.4 billion in convertible securities have been issued in the U.S. this year, according to data compiled by Bloomberg. While that’s down 31 percent from this time in 2015, convertible issuance has been relatively healthy compared to other asset classes. Junk bond issuance plunged 57 percent so far in 2016, the worst start to a year since the recession in 2009, according to the data.
The Standard & Poor’s 500 Index has only recently turned positive for 2016, after the worst start to a year ever. Meanwhile the Chicago Board Options Volatility Index, which gauges investor nervousness, has averaged an unsettling level of 20 this year. That’s 24 percent higher than the same period in 2015.
“With heightened volatility, the embedded call option has more value,” said Liz Myers, global head of equity capital markets at JPMorgan Chase & Co. who said that interest from clients in converts has been very strong this year.
In the past, quarterly increases in convertible issuance have coincided or immediately followed periods with average elevated volatility, according to data compiled by Bloomberg.
The second quarter of 2014 saw the VIX rise 35 percent to an average of about 20, alongside a 30 percent rise in convertible issuance. In the last three months of last year, the VIX average was up 31 percent, and convertible issuance climbed 134 percent, according to data compiled by Bloomberg.
Investors could absorb about $55 billion to $65 billion in new issuance in 2016, according to Venu Krishna, head of equity-linked strategies at Barclays Plc. The demand from investors is there, Krishna said, but there hasn’t been enough supply to satiate it -- yet.
Across North America, firms’ debt ratings are being downgraded below investment grade, marking their debt as riskier than before. Average high-yield borrowing costs have risen over the past 12 months from 6.6 percent to 8.58 percent after touching as high as 10.17 percent last month, according to Bank of America Merrill Lynch Indexes.
That makes the 5-to-9 percent coupon that’s typically applied to convertible securities look like less of an immediate burden, helping make them an alternative cash-raising opportunity, Myers said.
They can also be flexible. Convertible securities come in several forms, including debt that pays a coupon and later converts to equity, as well as preferred stock, which pays a dividend. Both typically have a set redemption value when the bond matures. Mandatory convertibles, meanwhile, don’t have a fixed conversion amount. Instead they automatically give the investor a certain number of shares depended on the underlying stock price.
The most obvious advantage, though, is the potential uptick in value. Medical-device company NuVasive Inc. raised $650 million in convertible senior notes to pay down debt, and for general corporate purposes. The price at which they convert to equity is $59.82 -- NuVasive shares closed at $36.50 on March 10, the day before the company priced the securities.
Also in March, software and services company CSG Systems International Inc. raised $230 million with a $57.26 conversion price. The shares closed at $38.40 on March 8, the day before the convertible senior notes were issued.
The energy industry is facing a slump in crude prices not seen since the early 2000s. To keep operations running, and fund drilling or pay dividends, these companies are scrambling to reach a wider array of investors. Depressed share prices and a rash of credit downgrades are making new shares tough to market. Convertibles can be added to the mix to offer investors something different.
Oil producer Hess Corp. tapped both equity investors and those who want converts in February when it sold 25 million shares of common stock and 10 million depository shares -- each representing a stake in mandatory convertible stock. The share sale came as Standard and Poor’s credit rating was lowered to BBB- from BBB, and after it reported its first annual loss in 13 years.
Smaller oil and gas exploration company Gran Tierra Energy Inc. raised $100 million last week in a security with a $3.21-a-share conversion price, above the $2.65 where the stock closed a day before the issuance.
Consumer, financial and industrial companies are also attracting interest, and would get a good reception in this market, said JPMorgan’s Myers, who spoke in an interview on Bloomberg Radio.
Public companies aren’t the only ones taking advantage of convertibles. Privately-held music streaming service Spotify Ltd. raised $1 billion in convertible debt from investors including private equity firm TPG Capital and hedge fund Dragoneer Investment Group, according to people familiar with the matter.
For the Swedish company, the rationale for issuing a convertible instead of debt or equity is similar to listed entities: The cost of capital was attractive and management believes its share price will be higher down the road when it goes public, one of the people said.
Still, convertibles aren’t a catch-all solution. With interest rates remaining low, debt is relatively inexpensive -- and companies aim to raise capital where it’s cheapest. Also, if investors aren’t convinced that a company’s stock will reach the conversion price, they’re unlikely to pile in.
Despite the risks, above all, convertible give companies a chance to bring more potential investors to the table, according to Michael Cippoletti, managing director and head of U.S. equity capital markets at Bank of Montreal.
While conditions are looking better for stocks, with the Standard & Poor’s 500 Index ending the first quarter virtually where it began and high-yield bonds on the rebound, the stability may not be sustained. Equity strategists forecast more turmoil, while debt strategists at Morgan Stanley expect the high-yield market to move out of its current “sweet spot.”
“Volatility and dislocations in credit markets could increase convertible issuance,” Cippoletti said.