Why so many convertibles?
There are times when
market just goes crazy for one product. It was the case in 2002 for convertibles.
Just in the month of April Pechiney, Agache, Vinci, CGIP, Club Méditerranée,
Anglo-American and Accor raised more than €4bn in convertible or exchangeable
bonds, while Penauille withdrew its capital increase for lack of demand.
How can we explain this attractiveness from time to time for convertibles? There are three possible explanations:
1. Convertibles and exchangeables are relatively easy to sell
The bank often "sells" the convertible to
the issuer pointing out that it carries a lower interest rate than a conventional
loan in the event of non-conversion and the opportunity to issue new equity
at a premium to the current share price in the event of conversion. It's a miracle
By now you readers know us and know that there is no such thing as a miracle product. The bond will be converted if the share price is higher than the strike price, and existing shareholders will be diluted under unfavourable price terms, since the company will issue new shares to pay off its bond debt at a price lower than the current share price. Meanwhile, the CB investor pays for the conversion option via the interest rate, which is lower than justified by the issuer's credit risk. So CBs are not miracle products. At best, they are mirages!
In practical terms, the placement can be done very rapidly, which is a plus when markets are volatile. It can also be done without taking up management time for road shows or meetings with investors and requires no financial rating. The reason for this is the relative lack of asymmetry in information between managers and investors, who are protected by the bond component.
One more thing: convertibles are often said to be a cheap form of financing. How many times have we heard it said that it is equivalent to the interest rate of the bond component! In fact, it is theoretically equal to the average of the cost of debt and the cost of equity, an average that is weighted for the likelihood of conversion. We also often hear that convertibles lower the cost of capital. If this was true, companies would have long ago decided to raise financing only through convertibles. But this is far from the truth! Only a reduction in the risk of capital employed can reduce the cost of capital.
2. Simple supply and demand
Healthy markets require both vigorous supply and vigorous
demand. This was the case in 2002.
On the supply side, new equity issues have almost vanished. Companies that want to issue equity must turn to convertible bonds, hoping that the bonds will end up being converted. Moreover, issuing a convertible is tantamount to selling volatility, and volatility has been very high for some time now. So now is the time to issue, especially as volatility has tended to decline in recent weeks.
On the demand side, given the sharp rise and fall in equity prices over the previous 18 months, there are relatively few true convertibles currently listed. More than half of them have become debt-like, with little hope of conversion, 13% have become almost equity-like and only 35% of are still true convertibles. Hence, the demand for new issues of convertibles.
For investors wary of uncertainties in stocks, convertibles
look like an ideal product, providing downside protection, along with some of
the upside benefit.
3. Structural reasons (at least for the moment )
In 2000 most convertibles were bought by conventional or specialised bond funds. Today more than half are bought by hedge funds, which then sell the underlying shares they have borrowed. The funds therefore do not take a position on the stock but rather on the volatility of the stock, which they naturally hope will increase. As is often the case for these hedge funds, the deal is not a hedge at all but speculation. Such funds are currently very popular. Last month even a large retailer began distributing them to its shoppers!
As a result, the underlying stock often falls by 3 to 5% when the convertible is issued, as it is sold by hedge funds. Whoever said that convertibles were not expensive?