Outlook 2016: Modest convertible returns expected, but vol. should boost valuations; rates eyed

By Rebecca Melvin

New York, Dec. 31 – Mild returns are expected for convertibles in 2016 as limited gains for U.S. equities look likely to keep a lid on performance. But well-played bouts of volatility will bolster valuations even as the high-yield straight market sets the tone for strength or weakness in financings in the first half, market players said.

The stock market’s role in the performance of convertibles will be prominent as usual, but tepid performance in stocks doesn’t necessarily dictate the same for convertibles. If the year brings choppy stock markets as many predict, it could mean opportunity for convertible arbitrage players.

“Tepid stock performance isn’t how convert arb sees this market – ups and downs equal opportunity. It’s about how the stock market got its returns. You may look back in five years and say the Dow was off 1% in 2015, but it’s how it got to down 1%,” a New York-based convertibles trader said.

Stocks face potential headwinds, including higher rates, company fundamentals and stock index behaviors, but most forecasters are predicting continued gains.

Morgan Stanley’s chief U.S. stock strategist, Adam Parker, expects the S&P 500 stock index will rise to 2175 by the end of 2016, an 8% increase over its close on Dec. 18. Barclays expects stocks to return 5% as a base case and convertibles to return 4.1% on an outright basis in 2016.

Overall, most institutions predict a 4% to 14% price gain for U.S. equities in 2016 even as Goldman Sachs is calling for growth of 2.2% gross domestic product for the next two years.

Rate move offers opportunity

But at least one of the headwinds for stocks is intrinsically favorable to convertibles, namely the changing rate picture.

Convertibles responded favorably to the lift off in December from the Federal Reserve’s zero-rate policy, which had been in effect since the 2008 financial crisis. Higher rates mean convertibles can compete better with their big sister asset class, high yield, for issuance. But again, much depends on how the rates get higher. If the change brings too much turbulence to financial markets, then it won’t be good for convertibles.

Members of the Federal Open Market Committee decided unanimously to raise the target rate for the Federal Funds rate by 25 basis points to 0.25% to 0.5%. The FOMC also said rates would continue to rise gradually, with incremental raises expected in 2016.

In the zero-rate environment, convertibles were always losing out to high yield, which had 6.5 times the amount of new issuance in 2015 than convertibles did. There was $262.86 billion in U.S. dollar-denominated junk-rated paper in 2015, which was down 16% from the year-earlier tally, but nevertheless dwarfed convertibles, which had about $39.51 billion in new U.S. issuance on 2015, according to Prospect News’ data. When rates were higher, high yield was more expensive, and convertibles had a larger share of the pie, with an occasional $80 billion to $100 billion a year in issuance.

But even a convertibles player admitted that rates remain a wildcard. If inflation picks up, it could force the Federal Reserve to raise interest rates faster than expected, and that could have a negative impact on the markets.

Mostly flat 2015 returns

The Barclays’ convertibles total composite index, which measures convertibles on an outright basis, underperformed the S&P 500 stock index, with a negative 0.4% return as of Dec. 4. The result was particularly disappointing since there had been a gain of better than 6% for convertibles notched through June.

Convertibles on swap were slightly positive for 2015, at positive 0.3% according to HFR’s convertible arbitrage relative value index. It was about in the middle of the pack in terms of performance among strategies for the year, and it was better than 2014, when convertible arbitrage was a worst performer, down 9.4% for the year after two years of solid gains in 2012 and 2013, according to HFR.

As tracked by the Credit Suisse hedge fund indexes, the convertible arb strategy was up 1.6% for 2015 as of Dec. 18, compared to negative 0.85% for 2014 and compared to the average annual return of 6.75% going back to 1994.

That compares with a 3% gain for the S&P and a disastrously negative 26.5% for the Goldman Sachs commodities index and negative 30% for the Dow Jones Latin America index. The Credit Suisse high yield II index was flat for the year. (The S&P was down 2% for the year as of Dec. 18.)

The U.S. market had also seen some fundamental deterioration in credit quality: leverage rose, partly as a result of share buybacks and mergers & acquisitions funded by borrowing. In fact, 2015 M&A was unprecedented with more than $3.7 trillion spent by company marriages.

U.S. high yield was the underperformer of 2015, as the damage started at the end of 2014 by energy-related bonds, including rigs, pipelines, exploration and refining, spread beyond those issues amid a prolonged fall in oil prices.

Meanwhile other commodity prices, including copper and iron, ore hit their lowest levels for years, and bonds exposed to metals and mining also sold off.

Outside of energy and commodity names, however, defaults were very low, and they are expected to remain low. Among convertible issuers, the default rate was lower in 2015 than it was in 2014, according to Barclays’ convertibles research.

The swings in convertible arbitrage from year to year are sizable. In 2010, convert arb was up about 10%; in 2011, it was down 4.9%; in 2012 and 2013, it was up again; but in 2014, it fell; and for 2015, it was just about flat.

For November alone, the HFR convertible arb index was up 1.6% for the year, compared to a negative return of 4.65% in 2014.

2014 brought a pullback in equities, and the beginning of oil shocks, sparking several bouts of pronounced selling. The rout that began in August continued into October, and was followed by a nice snapback, but due to the generally illiquid character of the convertibles market, not all players were able to participate in the recovery as fully as they may have wanted.

There was a similar pattern in 2015 with a prolonged summer sell-off in equities that damaged convertibles. But this time, convertibles were able to recover, by and large, as “blow ups” didn’t seem to be as damaging as the defaults at the end of 2014, including that of GT Advanced Technologies Inc.

The meltdown of SunEdison Inc., which brought four new issues in 2015 alone for about $2 billion in issuance, was a big drag on the convertibles space, and perhaps it was the biggest drag of the year.

Most energy and commodity names also suffered, however. In 2014 West Texas Intermediate crude fell below $55 per barrel during the week ended Dec. 19. In December 2015, the WTI front month contract fell to a handle of $34 per barrel with only 10 days left in the year.

Going forward it is difficult to predict where things shake out. The quality of issues and sectors represented make a difference, and at this point some of the internals of the market are strong. For example, the size of the market has expanded for two years in a row with new issuance outpacing redemptions, maturities and buybacks.

According to Barclays’ convertibles research, the convertibles market was set-supply positive by $7.3 billion in 2014 and net-supply positive by $10.1 billion in 2015.

Signs of strength

The convert market started out strong in 2015 with a January deal from Brocade Communications Systems Inc., which priced $575 million of 1.375% five-year convertible senior notes with an initial conversion premium of 35%.

The Rule 144A paper came at the rich end of talk but still performed admirably in the aftermarket. At the time it was viewed as a good sign for convertibles.

The California-based tech company could have used the high-yield market but instead chose the convertibles market, employing a call spread overlay for the deal to help protect its stock price when the bonds converted to shares, market sources pointed out.

The overlay boosts the initial conversion premium from the issuer’s perspective, and makes the deal more equivalent to a straight high-yield deal.

Many bond deals came with a call spread, capped call or similar variant during 2015.

The market was called robust at that point with attractive terms vis a vis relative value. Brocade got priced at the tight end of what could be called very aggressive terms, a market source said.

Health care space eyed

The health of the convertibles space is intact from that time even though issuance lagged in the second half of 2015 amid broader market concerns. But if the high-yield market continues to experience some of the difficulties it has had recently, then convertibles may be used even more, market players expect.

Typically the convert space doesn’t jump out of the gate immediately at the new year, but it did in 2015, and other than the waters of energy names, it should not be too daunting for market players to dip their toe back in.

Figuring out how to structure deals for energy issuers in 2016 is going to be a challenge for the origination and syndication side, one banker confessed. Pitching the deal in conjunction with stock buybacks was prevalent in 2016, but expect more innovations in 2016, he said. And he felt demand for such paper would hold up.

Brocade’s 1.375% convertibles due 2020 traded up to 103 on their debut on an outright basis and added 2.5 points on a dollar-neutral basis, against a share price of $11.98, which was up 18 cents that day.

Brocade is a well-respected high-yield company that could have tapped that market. But it opted for a convertible likely due to a combination of factors, including stocks that are near their highs, a recent stumble in the high-yield market, and due to the fact that having access to and using multiple debt markets is a way of prudently managing capital structure, a source said. Those factors remain in place heading into 2016.

The strike on the warrants transacted at part of the call spread for Brocade was $20.65, which boosted the initial conversion premium from the issuer’s perspective to 75%. About $30.4 million of the proceeds was used to pay the net cost of the call spread.

Joint bookrunners of the Brocade deal were Wells Fargo Securities LLC and BofA Merrill Lynch, with co-manager Deutsche Bank Securities Inc.

Medicines deal in focus

Even earlier in 2015 the Medicines Co. priced an upsized $400 million of 2.5% seven-year convertible bonds on Jan. 7.

The bond appealed to market players because it is a health care name, the vol. was good and it had a decent coupon.

The two dominant sectors of convertibles new issuance were health care and technology, or more specifically information technology. Energy was in third place with 18%, according to Barclays’ convertibles research.

Given Medicines’ hot market sector and stock volatility, there was significant interest among investors. Deals are typically placed with both hedged players and outright investors, and the desired allocation profile is about 50-50. Even if a deal is significantly oversubscribed, and can be allocated 100% to hedged players, the underwriters won’t do this as it is not conducive to the health of the bond.

The Medicines paper went to about 102 with the underlying shares at about $24.90 on its debut. Medicines’ older convertible bonds also held their own after coming in a little bit. The share reference price was $24.79.

The Rule 144A Medicines deal priced with a 35% premium and was initially talked at $300 million in size.

Joint bookrunners were Goldman Sachs & Co., Citigroup Global Markets Inc. and J.P. Morgan Securities LLC.

Subsequently, the Medicines deal continued to outperform. On Aug. 31, when most of the market was selling off, Medicines’ 1.375% convertibles due 2017 traded up 15 points to 146.50 and was up 2 points on swap, ending the session even better at 151 to 152 after positive drug trial news.

Medicines’ 2.5% convertibles due 2022 were up 14.5 points on an outright basis to 135 bid, 136 offered versus an underlying share price of $40.00 and were seen up as much as 3 points on swap, sources said.

Medicines shares surged $7.36, or 22% to $41.00.

Medicines’ drug development partner, Alnylam Pharmaceuticals Inc., announced that its investigational RNAi therapeutic lowered cholesterol up to 83% with a mean maximum reduction of up to 64%, plus or minus 5%, in an early stage study.

Parsippany, N.J.-based Medicines develops products that improve specialized care.

Credit spreads used to value that new paper ranged from 550 bps to 600 bps over Libor, and vol. was nailed down at 35%. A lower spread and vol. could be used given the seven-year tenor of the bonds and concerns over a patent litigation suit for its Angiomax therapy, a thrombin inhibitor approved for use as an anticoagulant, and accounting for 87% of the company’s total revenue for the quarter ended Sept. 30.

FireEye in focus

In May, FireEye Inc.’s upsized $800 million of 20-year convertible senior notes traded actively, and both tranches moved up to about 104.5 immediately after the deals priced at the rich end of revised coupon talk and at the rich end of premium talk. Pricing for the coupon was revised during marketing.

But FireEye’s stock price was at $21.55 as of Dec. 18, down by almost half from the $45.01 stock reference price when the convertible priced May 27. That huge drop in the underlying shares caused by concerns about the company’s ability to sustain high growth rates also made the bonds drop. But the paper is still of interest to convertibles players.

FireEye’s 1% series A convertibles fell to 83.375 when shares dropped to $22.10. They had been 87.75 bid, 88.5 offered versus a share price of $29.00 before the November earnings report. On their debut they had traded up to 104.5.

The FireEye 1.625% B series convertibles traded down to 80 to 80.5 when shares were at $22.00. They had been at 86.25 to 97 with shares at $29.00. The Bs also traded up to 104.5 on their debut.

“The FEYE bonds are flying,” a New York-based trader said on their debut. And a syndicate source said they richened on a swap basis.

Morgan Stanley & Co. LLC, JPMorgan and Nomura Securities Co. Ltd. were joint bookrunners of the deal.

Even though the two FireEye bonds mature in 2035 they can be looked at as five-year and seven-year paper from the investors’ perspective, a syndicate source said.

There was an economic benefit to structuring the deal like this rather than to do simply five-year and seven-year bullets, the source said.

In addition to structuring the two tranches as 20-year paper officially, the company also did a forward stock purchase deal rather than a call spread, which has been favored by many issuers lately.

The deal was very successful from the perspective of both the issuer and the investors, a syndicate source said. It was many times oversubscribed with good participation from both outrights and hedged players.

“You would do well owning this growth story,” he said.

Late summer slump

In late August, a lot of people were just trading their deltas, referring to stock held in tandem with the convertible’s long position. Regarding the majority of trades, nothing expanded.

Trading of U.S. convertibles was muted on Sept. 1 as summer doldrums continued amid a steep sell-off in equities. But convertibles were remarkably quiet given what is happening in the broader markets, a New York-based trader said. Convertibles held in and many higher-grade credit names actually expanded in a flight-to-quality trade.

U.S. stock markets dropped straight down at the open and closed near their session lows for the first session of September. The S&P 500 stock index closed down 58 points, or 3%, at 1,913.85.

The sell-off – which hit international stock markets as well – came on the heels of economic data out of China that showed weaker manufacturing activity than expected.

China’s official manufacturing purchasing managers’ index for August fell to 49.7 from 50.0 in July, its lowest level since August 2012, and marking a contraction.

The CBOE volatility index surged to as high as 33.82 and settled up at 31.40. The VIX has averaged in the low teens for much of the last several years.

The bulk of late August’s wild market swings didn’t end up amounting to much in the convertibles space as the volatility was a little too wild to capitalize on. The energy sector suffered, however. Convertible bellwethers Chesapeake Energy Corp. and Whiting Petroleum Corp. are now severely distressed after sliding since about mid-year. The Whiting bond was down to 66.25 at the end of 2015. But a lot of the pain was felt in only a few beaten down names, including Ctrip.com International Ltd. and SunEdison Inc.

Continuing strength

Pandora Media Inc.’s convertibles expanded on swap by 1.5 points to 2 points on Dec. 17 after a ruling by the copyright royalty board that was more favorable for Pandora than some had feared.

The internet radio company, along with others of its ilk, will pay more for music played but not as much as record companies and artists had hoped.

Pandora’s 1.75% convertibles due 2020 were last seen up at about 114 with shares of the Oakland, Calif.-based internet radio service at $15.25. Shares had jumped $1.82, or nearly 13.5%, that day.

The bond has been a blockbuster since it priced at the rich end of coupon talk on Dec. 4. The positive pricing was notable given the overhang of the Copyright Royalty Board decision. The bond expanded upon release for secondary action and has moved up ever since.

The deal shows that the convertible bond market is open for business even though the high-yield market has been weaker, especially in early December, a syndicate source said.

Under the federal Copyright Royalty Board’s ruling, Pandora will pay 17 cents for every 100 times their free radio users listen to a song and 22 cents per 100 times for paying subscribers.

“It’s a business that people know, and a lot of the largest investors liked the company and the product,” a market source said. Before the Dec. 17 decision, songs could be played for 0.5 cent and the music industry wanted to double that. The decision had implications for the company’s margin structure. Valuing is normally difficult to do at the time of financing, and with a near-term event such as the copyright charge it could be impossible to do in other asset classes.

“The fact that we could do a convertible shows that the convertibles market can understand and digest specific fact patterns, and it allows issuers to raise money when they couldn’t do it in another market,” a market source said.

The advantages are not only on the issuer side, the source noted. Convertibles allow 70% of the upside, and on the downside there is the protection of a bond and coupon income. These features appeal to investors who are more risk averse.

Nevertheless, given where the markets are currently, new convertibles deals in January – and possibly the rest of 2016 – will have to come at more attractive terms compared to where they have been pricing, a New York-based trader said.

Single B is pricing in 9% on the high-yield side, and single B rated or equivalently rated is what much of convertible paper is, the trader said. “Given where high yield is guiding, 0.5% [coupon], up 35% [premium] is not going to fly until things settle. The bonds have to come cheaper, otherwise people will say we can just buy in the secondary.”

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