Convertibles: Hitting the Headlines

07-May-2020

Convertible markets have been experiencing a surge in activity, and interest from the broader market, if recent headlines are anything to go by. We highlight some of the reasons this niche market is receiving so much mainstream attention.

With convertibles potentially transforming from niche to “must-have” asset class for many issuers and investors alike, Monis provides market-leading analytics for all convertible and equity hybrid instruments that is fully supported by the Monis Data Service (MDS for short), an in-house convertibles data service managed by a global team of convertibles market professionals, all of which may be accessed through a comprehensive suite of products and managed services capable of delivering the various requirements of diverse market participants.

What is a Convertible?

For those unfamiliar with the asset class, convertible bonds are hybrid instruments that have characteristics of both bonds and equities. In their simplest form, they consist of a corporate bond with an embedded equity call option.

Typically ranking as senior debt in an issuer's capital structure, the bond provides holders with an income stream through interest payments over the life of the instrument. A predetermined strike, or conversion price, determines the number of shares the instrument will convert into. Investors will choose when and whether to exercise their option to convert their bonds into the company's ordinary shares or, alternatively if the shares have not performed as expected, to have the issuer redeem their bonds in cash at their face value.

This results in a valuation / pay-off profile Monis refers to as the convertible “fingerprint” graph, exemplified by Carnival's recent convertible bond issue below.

With the equity share price on the x-axis and the convertible bond value in percent on the y-axis, the horizontal line (in teal) illustrates the fixed income value, or “bond floor” of the instrument, the diagonal (in blue) illustrates the equity component, which is the conversion value or “parity”. The curve (in green) illustrates the value of the convertible, the value of the embedded call option being the area bounded by the curve, the bond floor and parity value.

As the equity price of the underlying shares into which the bond can convert increases above the conversion price, the more that the instrument exhibits equity-like performance characteristics – moving in line with the equity to the far right of the graph. Conversely, as the equity price decreases below the conversion price, ie looking towards the left of the graph, the less sensitive the convertible bond value becomes to changes in the share price and the more sensitive it becomes to any changes in the fixed income value (ie bond floor).

Convertibles are therefore often marketed as a way to gain defensive exposure to equity market upside. This might be more emphatically described as “positive asymmetry”, whereby bondholders benefit from capturing the majority of the equity upside, whilst simultaneously being protected on the downside by the fixed income element. Furthermore, the value of the embedded option component is enhanced by increased volatility.

At their more complex, convertibles will often be structured to include early redemption and / or conversion features such as calls and puts, dividend protection features to compensate holders in the event of larger than expected payouts to shareholders and takeover protection to compensate for early termination in the event of an acquisition of the company. Terms may even include conversion price reset features, designed to reduce the strike to a new lower level in the event the underlying shares fail to perform, and therefore increase the likelihood of conversion. Issuers of Convertible instruments, working with capital markets origination teams, will look to use a combination of these, and other features, to tailor the investment profile of their particular convertible so as to entice investors.

The Monis suite of products is designed to satisfy the needs presented by the range of market participants, be they the issuers and origination teams, buy side investors looking to value investments at both an individual and a portfolio level, or trading desks seeking to hedge exposure and manage their risk.

The hybrid performance characteristics and, often seen to be, complex structures have led to convertibles being somewhat of a niche asset class, both for investors and for issuers. However, it is these very characteristics that have let to convertibles being somewhat “counter-cyclical” in nature both in terms of performance for investors and attractiveness for issuers.

Uncertain times - the best of times?

These are without doubt unprecedented and uncertain times. At the time of compiling this report (at the end of April), whilst it remains early days in terms of understanding the full, long-term implications of the global “lockdown”, thus far it appears that convertibles’ hybrid performance could prove invaluable.

In recent weeks we have observed equity market volatility spiking to all-time highs, as major indices have declined more than 20% in many cases. Broad market convertible indices, by contrast, are down “only” single digit percentages since the beginning of the year, clearly demonstrating the more defensive nature of the asset class. It is also worth making the point that, while we have already observed many companies slashing or completely cancelling dividend payouts to their shareholders, convertible investors continue to accrue interest on their investments.

Using Monis's own long-only convertible indices to examine this performance in more detail, we observe that convertibles reached a peak around 19-Feb, roughly in-line with equity indices; global broad market convertibles were up 5.8% at this point. The sharp equity-led decline that followed, hit a low around 23-Mar, by which point convertibles were down 17.4% since the start of the year. Since then, a remarkable rally has seen global convertibles recover to -5.9% YTD (30-Apr).

The diverse nature of convertibles and significant presence of non-mainstream issuers, while offering diversification benefits for traditional asset managers, makes identifying truly comparable equity index benchmarks for direct comparison problematic; this is perhaps most accute at the global level. With that said, if we look at the performance of the individual regional markets, then some comparison with equity market performance can be more readily drawn

The most dramatic swings in performance have been observed in convertibles in the US market. This should not be surprising; the broad characteristics of this market make it the most sensitive to equity market moves. The US market is the largest, and most liquid, market for convertibles with a market value of roughly $ 250bn and nearly 550 convertibles. It also comprises the greatest proportion of equity-like convertibles, which we define as those with a Delta greater than 70%. Deltais a measure of an instrument's equity sensitivity, the percentage of the underlying equity move we expect to observe in the convertible price. We calculate the market value-weighted average Delta for the US market at just over 55%; for every 1% increase in the underlying equities, we expect a 0.55% increase in the value of the convertibles.

At the worst point of the sell off, the S&P500 had declined 30.8% since the beginning of the year, while the Russell 2000 (arguably the more comparable to convertibles' underlying equities) had fallen by 40.6%. By comparison, US broad market convertibles relative "outperformance" saw them down "only" 20.8%. As markets recovered through April, S&P equities pared back losses to down 9.0%, while those in the Russell remain down 18.4%. US Convertibles have now returned -5.7% since the beginning of the year, as at 30-Apr.

In Europe, convertibles currently exhibit a lower sensitivity to their underlying equities with a market value-weighted Delta of 30%. This helped protect holders from the equity decline to a slightly greater extent than observed in the US. Returns from our EMEA convertibles index fell to -13.4% at their March low. Major European equity indices, in sharp contrast, were reporting declines of between 33 and 37% (returns from these blue-chip benchmarks which may even understate the true performance of convertibles' often more speculative underlying equities.) Having recovered somewhat since, these major indices are still down between 16 and 22% year-to-date. However we have seen convertibles recovering to -7.6% by the end of April.

In Asia, convertible performance and volatility have been relatively less dramatic. Japan in particular, as the market with the lowest equity sensitivity - market value-weighted Delta is just 22% - appears to have experienced the lowest volatility of any of the regions. The market peak was much lower than in other markets, and was experienced earlier in the year, on 20-Jan. The ensuing decline was also much shallower and more drawn out - the trough was only achieved on 3-Apr with a -5.4% return from convertibles, which subsequently recovered to -4.2% by the end of April. Japanese equities were no less hit by the recent sell-off; the Nikkei and TOPIX were down 30.0% and 25.5% at their recent lows respectively, recovering somewhat to -14.6% and -15.0% by end of April. Asia-ex Japan, with a market Delta of almost 30%, fell by only -8.9% to the trough in late March, allowing the convertibles in this region to recover to produce the "best" performance year-to-date with an index return of -3.5% to 30-Apr.

NB - compiling this note has been somewhat of a moving target - at the time of publishing global convertibles are now -3.2% year-to-date and have even returned to positive territory, +1.2% on a rolling 12-month basis.

Secondary market - outperformance

Anecdotal evidence suggests that during the initial sell off, and very much in line with other asset classes, it was the most liquid convertibles that saw the sharpest declines, as investors simply sought to sell whatever there were firm bids for. As the situation stabilized, it appears that those convertibles with greater equity sensitivity saw the biggest declines, whilst those with a greater fixed income component fared slightly better, with their more modest declines being primarily driven by widening credit spreads. However, the relative outperformers have been those convertibles with the most “balanced” profile. This is very much in line with expected behaviour, because the deteriorating credit situation and declining equity markets have been partially offset by uncertainty stoking volatility and thus increasing the value of the conversion option component.

“Outperformance” is a highly relative term, especially against a backdrop of twenty percent plus declines in major indices; however, it has not gone unnoticed, even by some retail investors.

Issuance by Region /$bn

click individual regions in the legend to include/exclude

A vibrant domestic market for convertible bonds has emerged in China over the last decade, depicted by the increasing presence of the bright green band in our issuance chart, and as reported by the Monis Data Service team earlier this year, 2019 saw the greatest annual issuance total thus far – just under 41 billion US dollars equivalent – more than Europe, Japan and the rest of Asia could muster combined, and second only to the US. After a brief hiatus during the height of the pandemic, issuance has again picked up in late Q1/early Q2 and, citing a large increase in trading volumes, a Reuters article from mid-April concluded that: “Chinese Mom-and-Pop investors are rushing into the convertible bond market to avoid the pandemic-led swings in equities”.

The last decade has been characterized by low interest rates and forever tightening credit spreads accompanied by buoyant equity markets and low volatility, none of which are particularly conducive to convertible issuance. The lower coupon advantage of convertibles was completely negated by the zero-rate and low volatility world. The result was years of relatively low issuance in comparison to 2007’s 160 billion Dollars’ worth. There were of course other post financial crisis factors at play here too, such as the Volker rule and Frank-Dodd reforms leading to the demise of large bank proprietary trading books, and declining Hedge fund “convertible arbitrage” assets as a result of financial crisis drawdowns and subsequent deleveraging.

Global Issuance /$bn

Nevertheless, this tradeoff of lower coupons in return for higher volatility has naturally lent convertible markets a concentration in precisely those issuers and sectors that might otherwise find accessing capital markets prohibitively expensive – those with higher risk, higher equity volatility, higher growth – such as healthcare and technology companies. Many such companies become “serial issuers” of convertible bonds.

A perfect example is Tesla. The company, best known for its electric vehicles, currently has three issues outstanding, maturing in 2021, 2022 and 2024, with a total combined face value in excess of 4 billion dollars. The parity, or conversion values, of all three bonds are well in excess of 200 percent of their face value, i.e. their combined current market value is well in excess of 8 billion dollars and hence are all likely to be converted into equity. Contrast this with their bond that matured in March 2019; the Conversion Price was just under 400 Dollars per share, yet on the maturity date the share price was just below 300 Dollars per share – in other words the conversion value was only around 75% of face value. Therefore, rather than convert to equity, bondholders redeemed their bonds for their face value plus accrued interest, which perfectly illustrates the opposite ends of the performance spectrum for convertibles, from the one issuer.

Primary market - buoyant issuance

Although the last decade was characterized by low interest rates, low volatility and hence low convertible issuance, that started to change towards the end of the decade as interest rates began to rise and volatility started to pick up. This resulted in total global issuance of just under 130 billion dollars for 2019, the highest since 2007.

The first quarter of 2020 was also shaping up quite nicely, and then the coronavirus pandemic hit. Initially, only Chinese domestic issuance was impacted as they were first hit, but as other countries around the world quickly followed into lockdown, markets plummeted during March, and global convertible issuance inevitably ground to a halt. Despite this unprecedented and unparalleled demand shock, the first quarter of 2020 still saw aggregate global convertible issuance of almost 30 billion dollars, spread across a total of 66 issues. Whilst that represents a decline relative to the 40 billion of issuance during the same period last year, it does not look disastrous – in fact, it is still more than any first quarter between 2012 and 2016.

Issuance by Region /$bn

It quickly became apparent that there would be immediate winners and losers from the rapidly evolving crisis. While the likes of online retailers and sections of the healthcare industry would benefit, other sections of the economy, such as travel, tourism and high street retail would face immediate and total shut down of operations. This created an immediate need to raise capital, with, on the one hand, companies looking to fund the rapid expansion of their operations and, on the other, companies whose turnover had suddenly dropped to zero needing to raise cash quickly in order to tide them over until operations can resume.

Whereas the secondary market performance profile of converts can provide a relatively safe haven for investors, convertible primary markets provide an effective way for companies to raise capital in such turbulent times. Equity placings and rights issues may be difficult to achieve in such volatile periods, while widening credit spreads may make straight bond issues unpalatably expensive. However, it is under precisely such conditions that convertible debt can prove to be an attractive alternative. High levels of volatility typically allow issuing companies to structure instruments with visibly cheaper call options, while the value of the call option itself allows the issuer the ability to pay a lower coupon than they would on a comparable straight bond.

Issuance by Region /$bn

It is therefore not entirely surprising that issuance of convertible bonds has witnessed a rapid rebound, particularly in the US, in the early days of the second quarter. April has witnessed a quite remarkable 41 new deals globally, totalling just over 17.1 billion dollars, of which 12.2 billion was from the US. To put that into context, the US has already issued approximately 28.2 billion dollars' worth of convertibles during the first four months of 2020, which is more than the first half of 2019 at 27 billion, which itself was the best year since the financial crisis. As we publish, a further 9.4bn Dollars of convertibles has been issued in the first week or so of May.

Post-lockdown, convertible issuance appears to be bifurcated along the lines of those either looking to finance growth or those looking to raise the necessary cash to survive the crisis.

Convertibles - funding growth and survival

A good example of a company that has recently tapped the convertible market to fund expansion is the Dutch listed Just Eat Takeaway.com, which operates online food ordering and delivery services throughout Europe. The company managed to raise 300 million Euros, with repayment due in six years’ time. They managed to “strike” the option to convert into equity at a healthy 40 percent premium to the current share price, which was the top of the indicated range given to prospective investors at inception. Furthermore, they managed to keep the coupon, or interest payments, down to a mere 1.25% per annum, despite rapidly widening credit spreads, precisely because of the enhanced value of the embedded option with increased market volatility. The bonds were announced on the 22nd of April, yet by the 30th they had already traded up to around 107%.

Equally, there are numerous examples of companies whose income and operations have been decimated or halted entirely by the pandemic, who have managed to raise capital using convertibles at much lower rates than would be achievable by any other routes. The likes of clothing retailers American Eagle Outfitters and Burlington Stores, golf club manufacturer Callaway Golf, travel site Booking.com and Dufry, the Swiss duty free retailer have all recently raised capital in the convertible markets.

One company that came to the market relatively soon after lockdowns took hold across the West and which perfectly exemplifies the benefits of convertibles – both for issuers and investors alike, is Carnival, the world’s largest cruise ship operator.

With the complete shutdown of global tourism and the negative press surrounding cruises, Carnival’s stock price plunged by over 80%, from around 50 dollars per share to below 10. Facing a complete collapse in revenue, they quickly sought to raise cash, which they managed to achieve with the help of a 3-year convertible bond that raised over 2 billion dollars. We understand the convert displaced a potential high yield loan from some hedge funds, and furthermore a concurrent equity raising was downsized due to a lack of demand, whereas the convertible size was increased with a fully utilized Greenshoe option.

The benefits of the deal for investors are immediately apparent - they get a chance to participate in any potential rebound in the equity upon a return to any semblance of normality, whilst simultaneously having the benefits of receiving the coupon payments and being a senior creditor in the capital structure. One of the potential benefits for the issuer, aside from the lower interest rates achievable, is the very fact that the bond can be converted to equity. If the equity does rebound and the bond is converted, then the issuer will avoid having to repay the principal at maturity, instead swapping the repayment for dilution as the debt converts into equity. One month on and the parity value of the issue is already an astonishing 165% and bonds are trading north of 175.

Demand appears undiminished

A recent Dow Jones article on the current popularity of convertibles cited that, historically, they only account for around 15 percent of equity financing; however, since the beginning of April that has surged to over 60% and the “bankers say they expect to see many more convertible deals in the coming weeks”. So far, despite the surge in issuance, demand from investors appears to remain strong, judging by the number of issuers able to both upsize the initial offer and to price the deal at either the worst/rich end of the indicative terms, or indeed on occasion outside of the initial indications. Bonds typically come to market with an indicated annual coupon range and a conversion price premium range over the current share price. This is perhaps best exemplified by Southwest Airlines recent deal pricing at a coupon of 1.25%, which was well below the initially indicated 2 to 2.5% coupon range, and yet also achieved the top of the indicated 30-35% premium range. The deal was also upsized from 1 billion dollars to an astonishing 2 billion.

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