Convertible bond issuance is expected to rise amid improvement in the U.S. equities markets and from increased demand from institutions looking for steady cash flows.
And brokers are ready to capitalize on this, as a number of firms have recently jumped into the business. Firms like Nomura Securities International and BTIG have opened convertible trading desks, while Keefe, Bruyette & Woods is expanding its operations in this hybrid security. Why?
The one-two punch of projected growth in mergers and acquisitions and a shrinking outstanding supply for convertibles is expected to generate new revenue for the firms in this niche market. Convertibles offer companies a cheap source of financing and are an attractive alternative to an equity offering.
By definition, convertible bonds are debt securities in which the buyers get a coupon payment and the option to exchange the bonds for common or preferred shares if a company’s stock climbs past a given price. Investors benefit as the bonds pay a fixed coupon cash stream and can appreciate if the underlying stock increases in value.
Issuing companies also benefit because convertible bonds do not dilute outstanding shares and usually pay investors a smaller coupon than other bonds, lowering their funding costs. Also, the rating agencies often treat them as equity, less of a burden than other debt.
However, convertible bonds are also riskier than other bonds as they are not in the first loss position in the case of default, so if a company goes under, holders will likely take a larger loss.
Convertible bonds fell out of favor in late 2007 when hedge funds, always big investors in the instrument, sold them when banks required the funds to put up more assets as collateral on credit lines as a result of the financial crisis. The plunging equities markets also made the bonds’ embedded equity options worthless.
During 2006 and 2007, bond funds put on trades where they purchased convertible bonds and then shorted the underlying company’s stock. This trading strategy was stymied and halted in 2008 when the Securities and Exchange Commission banned the short selling of financial companies for several months, also hurting the sector.
Last year was not kind to convertibles either, as investors viewed the securities as derivatives, giving them the same stigma as other esoteric securities such as credit default swaps and collateralized debt obligations. This was the final straw that broke the proverbial camel’s back.
But as the equity markets are rebounding from their March 9, 2009 low–6547.05 for the Dow Jones Industrial Average–interest in convertible bonds has also increased as the value of the embedded stock call option has increased.
According to market estimates, the convertible bond market globally is $500 billion in bonds outstanding with 50 percent in the U.S., up from $325 billion globally in 2007. In 2010,
U.S. issuance is projected to reach $50 billion.
"The market definitely has a number of compelling reasons to get to $50 billion and north, but it’s dependent on M&A transactions," said Prasanth Burri Rao-Kathi, head of equity-linked capital markets at Bank of America Merrill Lynch.
Fifteen to 20 percent of all M&A activity historically has been financed by convertible bonds, Rao-Kathi said. So if the economy continues to rebound and M&A activity increases, so will convertible bond issuance, the thinking goes.
Another supporting argument for convertible bond market growth is the imbalance of new issuance to roll off–the amount that comes out of the market through either bond calls or paydowns. Rao-Kathi said $37.5 billion convertibles were issued in 2009 and $67.5 billion came out of the market that same year. In 2008, $62 billion convertibles were issued and $77 billion left the market. And in 2007, new issuance totaled $97 billion and $77 billion came out. So net outflows have exceeded issuance.
"In this market, redemptions have outpaced new issues for four of the last five years," Rao-Kathi said. "Investors are looking to replenish their portfolios. And companies that are coming to market are being greeted with heavy over subscriptions."
In 2009, half of new issue U.S. convertible offerings were upsized considerably due to investor demand and by an average of 40 percent, according to Rao-Kathi’s data. Given that backdrop of demand, more growth and issuance is likely, he said.
And to handle this expected market growth, firms are expanding or creating convertible bond desks. Nomura Securities International recruited five people from JonesTrading to staff its recently formed U.S. convertible bond desk. A sixth person was hired from CIBC World Markets.
Keefe, Bruyette & Woods, a wholly-owned subsidiary of KBW, Inc., also announced plans to bolster its presence in the convertible securities market by appointing industry veteran Rick Jeffrey as senior vice president and head of the business.
BTIG went all in and launched a U.S. convertible securities business and hired six sales and trading pros. Robert Langer, previously a partner at hedge fund Stanfield Capital Group, runs the desk. Bill Feingold, Chris Roller and Greg Sullivan join him as sales traders.
At stake are millions of dollars. Underwriters can stand to rake in millions in placement and advisory fees on initial offerings, said George Douglas, chief investment officer at SSI Investment Management. Not to mention, convertible bonds are quoted in the secondary markets in spreads ranging from one-quarter point to one point, allowing for plenty of trading profits.
"That’s a very decent spread and profit for market makers," Douglas said.
According to Douglas, convertible bonds due to their structure–part bond, part stock–attract investors because they promise the security of a bond’s fixed payment cash stream and the option to convert to equity should the company’s market valuation rise. It’s a win-win for investors. Companies that issue convertibles benefit also as these securities require lower interest payments than do most ordinary bonds or in some cases, no interest at all.
"There is good institutional demand for convertibles, more so from long-only investors than arbitrage investors," Douglas said. "The reason is simple; the bonds offer a steady fixed income stream that common stock does not. Investors are looking to buy convexity."
By definition, convexity is a measure of the sensitivity of the duration of a bond to changes in interest rates. In general, the higher the convexity, the less sensitive the bond price is to interest rate shifts, the lower the convexity, the more sensitive it is.
And in the current investment environment where income stream preservation is king, convertible bonds, which make their fixed coupon interest payments regardless of an up or down market, satisfies holders’ needs for convexity. Even in a declining equity market, convertibles still pay holders coupon income preserving cash flow–positive convexity.
"It’s the downside protection institutions want after taking a battering in stocks the last few years," Douglas said. "Convertibles are a good defensive investment."
Douglas said on average, five-year Double B rated convertible bonds offer coupons in the 3-to-4-percent range with a default rate of less than 1 percent. Comparable high-yield bonds pay 5 to 6 percent but have an average 3 percent default rate. New issue Treasury five-year notes were recently auctioned at 2.065 percent.
"I’m seeing and hearing about more interest in fixed income and convertibles, as a sub set, are getting more attention," said a portfolio manager. "While this is more or less a fringe business, there is money to be made for those who get in."
