Outlook 2010: U.S. convertible primary market could track higher after 2009 new issue volume lags

By Rebecca Melvin

New York, Dec. 31 - New issuance in the U.S. convertible bond market in 2010 will probably reach between $50 billion to $65 billion, market sources suggest.

If stocks return around 10%, the market could see $50 billion to $55 billion of new issuance, a New York-based sellside analyst predicted. And if the market gets a 15% return in equities, then the convertibles primary market will probably get $60 billion to $65 billion.

According to a Barclays Capital calculation, the convertibles market could absorb $66.6 billion in new issuance based on certain assumptions, like $40 billion leaving the market this year due to puts, calls, maturities and coupon cash flows. But the total will most likely be well below that, a Barclays Capital analyst told Prospect News.

2009's tally

New issuance in the U.S. convertible bond market in 2009 totaled $59.4 billion, including Bank of America Corp.'s controversial $19.3 billion of common equivalent securities, for total volume that was only slightly below 2008 total new issuance of $61.8 billion, according to data compiled by Prospect News.

Bank of America's Dec. 3 deal was controversial because many players didn't see it as a true convertible. Without the Bank of America securities, new convertible issuance would have totaled $40.2 billion, which is 35% below 2008's volume total, according to Prospect News data.

Barclays Capital put total new issue volume for 2009 at $34.6 billion, which it termed "lackluster." By way of comparison, both investment-grade and high-yield straight debt had record issuances of $853.2 billion and $134.5 billion, respectively, Barclays said.

The tally of new convertible deals in 2009 also included Citigroup Inc.'s mega $3.5 billion of three-year mandatory convertibles, known as tangible equity units. Even with the Citi deal, Bank of America Merrill Lynch put the new issue total in 2009 at $37.1 billion.

It was the worst year of new issuance in 11 years, Bank of America Merrill Lynch said in its outlook report dated Dec. 22.

Citi versus B of A

The Citi deal was counted toward totals and the B of A equity units weren't because B of A's deal was "just a roundabout way to issue true common stock," Bank of America Merrill Lynch equity-linked analyst Tatyana Hube said.

"They are nothing like the mandatory structure that convert issuers have done historically. Citi was a true mandatory with three-year life, and minimum and maximum ratios. The B of A units were pseudo equity," Hube told Prospect News.

"If B of A had authorization from shareholders, they would have issued equity. And if shareholders don't approve, there are a few things that kick in, like extra interest, to strong arm shareholders into voting positively," Hube said.

Another source said the Citi mandatories have optionality like a true convertible, but the B of A securities don't.

New issuance needed

What most players agree with is that a healthy dose of new issuance is vital to the overall performance of the convertible bond market.

"It's all going to be about the new issue calendar" in 2010, a New York-based sellside analyst said in late December.

The secondary market is expensive, and stock performance last fall was minimal, and may remain so in 2010, so convertible market performance is going to boil down to new issuance, sources said.

If stocks rally, there is a better chance of higher new issuance volume. But even if stocks stall, one sellsider said, he still didn't think it would deter issuers from bringing deals.

Refinancings are likely to continue. And issuance may pick up as corporate managements begin to raise capital to fund future growth and/or to pay for acquisitions.

Convertibles will also be helped vis a vis high yield, if borrowing costs in the high-yield bond market go up and if there are rising interest rates in 2010.

With some stocks running as far as they have there could be a continuance of new issuance in January and February if stocks don't have some kind of correction, another sellsider said.

"New issuance is a platform that we're aggressively building out here at Wedbush. We expect to see a robust new issuance market through 2010 as companies seek relatively low cost, customizable capital raising solutions to refinance existing debt and fund future growth opportunities," Wedbush Morgan Securities managing director Thomas Murphy said.

Deltas need to be higher

It is difficult to predict the pace of convertible new issuance. New issuance is generally highly correlated to equity performance. Currently the market is also highly correlated to the bond market due to high premiums and low deltas, one sellside analyst said.

Deltas finished November at 53%, compared to 47% at the beginning of 2009, he said.

Deltas would have to be around 65% to achieve more equity sensitivity, the sellsider said, and historically that has driven the new issue calendar.

In 2009, many companies issued straight debt even if they had issued convertibles in the past. There was also a concerted effort to retire paper. "I suspect those retiring won't be running back to re-issue," the sellsider said.

For issuers there are plenty of question marks around whether to issue. Some issuers issue because their business is growing, which raises the question, will there be enough growth? the sellsider said.

Some companies raise money to finance acquisitions, which begs the question what will that market be like? Then there's raising funds for general corporate purposes. Those issuers are probably more sensitive to terms because it's discretionary capital that they're raising, so the question is will terms suit them? the sellsider said.

Barclays Capital convertible analysts suggested that convertible issuance is likely to be a more attractive option going forward than in 2009 from an issuer's perspective since equities have already rallied significantly.

"Any potential spread widening and vol spiking event would make the convert asset class even more attractive from an issuer's perspective," Barclays Capital analysts Venu Krishna, Manoj Shivdasani, and Peng Cheng wrote.

Best issues of 2009

The best new issues of 2009 were the first block of new issuance in the March-May time frame. The equity markets were bottoming and the terms on that first chunk of issuance were attractive because no one knew what level of cheapness it would take to clear the market.

No one wanted to bring a deal to market and have to revise the terms against the issuer, or worse, be forced to pull the offering completely.

Johnson Controls Inc. is a prime example of one of the market's most successful deals from the investors' perspective.

The Johnson Controls 6.5% convertible bonds of 2012 were issued at par on March 9, 2009. One month later, they were trading at 160. By August, the bonds were trading in the range of 230 to 240 before the company announced and completed a tender offer.

A buysider also counted Johnson Controls' 11.5% mandatory preferred as one of the year's best issues.

Some of the early-in-the-year cyclical issues also soared as the market began to discount recovery, among other things, the buysider said. ArcelorMittal SA priced $700 million of 5% convertibles due 2014 on April 30.

Following a season of robust issuance in the spring, the summer was weaker, but players expected it to be followed by an active autumn calendar. Unfortunately once September arrived, the high-yield calendar was red hot and "nobody even thought of converts," a New York-based sellside analyst said.

There was also a quick flurry of issues in December; but overall the year's volume was disappointing.

New deal terms

The market was seen as too rich later in the year after a positive first half. By October, there were higher premiums on a couple of deals. There was a rash of deals with lower premiums of under 30%, then investors got smart and pushed back on the higher premium, another sellsider said.

The yield-premium trend in convert new issuance for 2009 was for paper on average yielding 4.8%, up 24.3%, compared to an average 6.1%, up 27.8%, in 2008 and an average 3.2%, up 30.9%, in 2007. Meanwhile, 2006 saw some of the lowest yields, with an average yield of 2.4%, up 25%, according to Barclays Capital research.

Many players said that new deal terms will need to be cheap to continue to attract investors. But a New York-based convertibles analyst said, "I suspect we get a series of deals with worse terms for investors because demand will, in my opinion, exceed supply."

Coupons have been fine, another sellsider said, but premiums need to stay low, especially given that stock markets have climbed.

Theoretical cheapness and one-day delta hedged performance attest to both attractive valuation and strong demand of convertsible.

Such cheapness allowed many deals to get done successfully and then expand upon release to the secondary market.

A look at issuers

Credit quality was shifting in 2009 as well: 27% of new issues were rated investment grade in 2009, compared to 45% in 2008 and 35% in 2007.

Cyclical sectors, including materials and consumer discretionary, accounted for 47% of total new issue volume in 2009. There were Alcoa Inc.'s $500 million of 5.25% convertibles due 2014 and Ford Motor Co.'s $2.5 billion of $4.25% convertibles. But in addition, there was Newmont Mining Corp., which priced $450 million of 3% three-year convertibles that came early in the year.

In addition to a few large financial deals in 2009, plenty of airline convertible deals got done.

Deals from builders would also be very welcome, a sellside analyst said, since the buyside would love to have the ability to gain more exposure to that sector.

There were a few steel company issues in 2009, too, but that is unlikely to continue given the high-yield CDS spreads at 300 to 400 bps for steel right now, and there will "definitely be no converts in that case," the sellsider pointed out.

In airlines, last fall brought UAL Corp.'s 6% convertibles due 2029, AMR Corp.'s 6.25% convertibles due 2014 and AirTran Holdings Inc.'s. 5.25% convertibles due 2016. JetBlue Airways Corp. also priced a deal in June.

"Issuing enough coupon and low premium, like 6s, up 20% when you have a bond with a five-year put, you can put a spread of 1,000 basis points over Libor on it and the black box will kick out a pretty cheap piece of paper," a Connecticut-based sellside analyst said regarding the airline deals.

Another analyst pointed out that UAL paid 11% to 12.5% on its secured senior notes, so with low double digits, they started thinking about unsecured convertible deals.

"People generally don't want unsecured paper because if they ever get into financial trouble, unsecured recovery is going to be so low, especially since the industry is so collateralized. Secured recovery would be 70 to 80, but unsecured guys are going to go away with single digits recovery," the analyst said.

Even though air travel demand picked up, there's the big uncertainty over fuel prices and the emerging market's demand for oil.

"Look at 2007, demand for air travel was pretty strong, but these guys lost money. It's a special sector compared to others. Versus unsecured straight bonds, which pay 15% to 16% to get the deal done, converts were done at 4% to 6%, that's a huge savings for the issuers. You don't see that in other sectors like energy, commodities," the analyst said.

Mentioned in this article:

AirTran Holdings Inc. NYSE: AAI

Alcoa Inc. NYSE: AA

AMR Corp. NYSE: AMR

ArcelorMittal SA NYSE: MT

Bank of America Corp. NYSE: BAC

Citigroup Inc. NYSE: C

Ford Motor Co. NYSE: F

JetBlue Airways Corp. Nasdaq: JBLU

Johnson Controls Inc. NYSE: JCI

Newmont Mining Corp. NYSE: NEM

UAL Corp. Nasdaq: UAUA

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