Outlook 2016: Convertibles primary market seen in line to higher after disappointing 2015

By Rebecca Melvin

New York, Dec. 31 – Barring a repeat of last year’s third quarter when extremely light issuance cut into full-year volume, the U.S. convertibles primary market is expected to trend flat to better in 2016 amid moderate economic growth and positive stocks.

Estimates on how many convertibles will be issued were not widely available, but one New York-based banker put the range at about $45 billion to $55 billion, which is higher compared to a disappointing $39.5 billion in total for 2015.

Demand should remain strong with an estimated absorption capacity of about $50 billion to $55 billion through 2016, outstripping the projected $36 billion of redemptions, according to Barclays’ convertibles research team.

But there are those who think 2016’s tally will be only in line with 2015’s total as equity markets are expected to continue “to hold convertible issuance back,” a second New York-based banker said.

“It didn’t seem like investors were willing to take the risk this year,” he said.

Total U.S. convertible issuance in 2015 was $39.51 billion in 91 deals, which was down 22% compared to $50.8 billion in 139 deals for 2014, according to Prospect News’ data.

Around the world, non-U.S. deals were down 12% to $34.6 billion in 93 deals, from $39.2 billion in 134 deals in 2014.

4Q issuance improves

But U.S. issuance improved in the fourth quarter from the third quarter. Only $4.2 billion in 12 deals priced in the July-September time period. But for December alone, there was $5.4 billion of issuance in 11 deals. That was up 29% sequentially and up 20% compared to $4.5 billion in seven deals for December 2014, according to Prospect News.

October 2015 was also a strong month for new issuance, but November was a washout.

Volume and deal strength in 2016 are expected to be generated by the same trends as last year, namely robust mergers and acquisitions activity, refinancing, and capital raises to grow businesses.

Mandatory convertible issuance in the form of preferred shares and equity units accounted for nearly 50% of overall issuance in 2015, which was much higher than the under 20% for which it accounted in 2014. This form of issuance is not preferable for many convertible arbitrage investors, but given that it’s favored for use in M&A, it is likely to remain a more prominent form of convertibles this year.

Meanwhile, bond-structure convertibles fell in 2015, so without the higher level of mandatory issuance, the overall level of convertible issuance would have been even weaker compared to 2014.

“Strong M&A volumes bode well for convertibles; and more volatility in debt markets and the need to shore up balance sheets with equity alternatives like mandatories especially for companies underlying M&A or companies in stressed sectors like materials and energy will also encourage the use of convertibles,” a New York-based syndicate source said.

Analysts eye catalysts

Barclays analysts looking at the question of issuance for 2016 said that catalysts will include broader market features such as rising interest rates, ongoing strength in equity valuations, wider high-yield credit spreads and all-in yields, and higher nominal growth in gross domestic product.

“We expect issuer interest in tapping the convertible market to remain healthy due to the asset class’s structural flexibility, subordination levels, competitive pricing especially versus high yield, speed to market, and accounting treatment,” Barclays’ analysts Venu Krishna, Manoj Shivdasani and Piyush Anchliya wrote in their 2016 convertibles outlook: Driving in the Right Lane.

The first rate increase by the Federal Reserve since the 2008 financial crisis came in December and was viewed as positive for convertibles. In December, 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.

During a press conference following the FOMC’s policy statement, Fed chairman Janet Yellen said that the rate raise “reflects the committee’s confidence that the economy will continue to strengthen.” But policy remains accommodative as “economic recovery has come a long way, but it is not yet complete,” she said.

“There was a decent reaction in the markets,” a New York-based convertibles trader said. “It is a pretty rational reaction to what is essentially good news. Some of the tension has been relieved and people look forward to moving forward on a more rational basis.”

As for the quality of issuance, one source said that origination had been relatively strong credit-wise with companies coming to market with good levels of stock borrow. He expected that trend to continue even if there is the likelihood of more distressed energy companies coming to market to refinance in 2016 due to ongoing low oil prices.

The market finished off on a high note, with good terms for the last few deals in December, the source said regarding 2015’s convertibles primary market.

In early December, Pandora Media Inc. priced $300 million of five-year convertible notes at the tight end of coupon talk, and the notes expanded upon release for secondary dealings.

The Pandora deal continued to perform well despite an overhang of uncertainty tied to a decision on copyright fees that was announced later in the month. When the ruling of the copyright royalty board was announced Dec. 17, it was viewed as positive for the internet radio company and the convertibles expanded further on a dollar-neutral, or swap, basis.

The fact that convertibles structured as bonds dwindled in 2016 to about $16.5 billion even as mandatories increased was not viewed as overly concerning to some market players. Convertibles are a derivative product that is specifically equity-linked, one source pointed out, and it has typically been used for M&A, where the companies don’t want to raise too much debt for acquisitions.

M&A drives manadatories

M&A had an unprecedented year, so it is not surprising that there was a lot of mandatory issuance, he said. At the same time, in the current low-rate environment, high yield has been favored for bond issuance because it has been so inexpensive and liquid. As this point, “the high-yield market is still open so we have not had the flow through to convertibles,” he said.

No one knows how long that will continue as rates are expected to continue to rise, albeit gradually. There are some wildcards related to 2016, and how rate moves will impact the markets is one of them.

“We’ll see. The market may not reopen again until February. But the rate move helps hopefully,” a source said regarding the primary convertible market. The convertibles market went silent by mid-December as 2015 business wound down ahead of year-end.

Higher rates will make high yield more expensive and could return the markets to an older dynamic in which issuers looked to the convertibles market for low coupon and lower cost financing. But higher rates could hurt stocks, and if that happens, then that will create a lid for convertible issuance.

Given the cross currents at work in the markets, one syndicate source said about 2016 convertible new issuance: “In line is the general consensus.”

The energy sector will be “very interesting,” the syndicate source said. These companies have completed cutting capital expenditures to preserve their balance sheets and they will have to figure out other ways to raise capital, he said.

“As these companies face more challenges, we will have to be more creative in how deals are structured, but in terms of pricing, I think they will be similar to how they have been priced in 2015,” he said.

Pre-IPO trend

One source suggested that there will be more pre-initial public offering convertibles that will help the underwriters’ deal numbers, but which will not be added to league tables because of the private nature of such deals.

There were a few pre-IPO deals in 2015, and that uptick is expected to continue as the private market for straight preferred shares has cratered on the heels of some downgrades from the likes of Fidelity Investments and Black Rock.

In November, Fidelity wrote down its SnapChat Inc. investment by about 25%. BlackRock has also downgraded investments of so called “unicorns,” or private companies valued at more than $1 billion. Some of these companies are facing a potential down round, or financing procured at a valuation that is lower than the last financing, a syndicate source said, so they may opt to raise capital via pre-IPO convertibles instead.

Such financing “provides the private companies with a way to have valuation and to continue to grow until they can become public,” the syndicate source said. “It is also good for investors who want to invest in pre-IPO companies because they get the defensiveness of the convertible in tandem with the potential for higher equity valuation. Convertibles are a nice hybrid instrument.”

There were a couple of pre-IPO issues this year and not all were publicly disclosed, he said.

“Fidelity marking down its investment got people thinking the market had turned,” the source said.

Things got more risky, and facing a down round makes investors get more diluted. A pre-IPO convertible as opposed to a straight preferred adds debt to it and makes it secured debt on the downside.

Given valuations investors were more downside focused.

Diverging from straights

Also, the convertibles market experienced a divergence in the fourth quarter from the straight debt market, in which high yield weakened considerably on the back of more energy and commodity sector shocks and following the Sprint Corp. downgrade to CCC, which caused a considerable amount of dislocation in the high-yield market, a New York-based syndicate source said.

But this weakening didn’t immediately spill over into the convertibles market, and that resilience tells the banker that convertibles have the underpinning necessary for a decently strong upcoming year.

A lack of supply and money on the sidelines earmarked for the convertible product were a good part of why the convertibles market held up, the syndicate source said.

In addition there are potential high-yield and term loan cross-over buyers.

Still the high-yield market continues to play a role in the outcomes in convertibles. “A lot will depend on how the straight high-yield market does. That will set the tone for financings in the first half,” the syndicate source said of how convertibles will perform and how much issuance there will be in 2016.

Third-quarter hiccup

Total new issue volume for 2015 was $39.5 billion in 89 deals as of Dec. 18, which is down 22% from the $50.8 billion in 123 deals total for 2014, according to data compiled by Prospect News.

In contrast, 2014 volume was $51.3 billion in 140 deals, which just edged 2013’s total $49.3 billion in 157 deals, according to data compiled by Prospect News.

Of 2015’s $39.5 billion, about $15 billion of new issuance priced in the first quarter, $10 billion in the second quarter, $4 billion in the third quarter and nearly $8 billion in the fourth quarter, a syndicate source pointed out.

He pointed out that the market requires about $12.5 billion of new paper per quarter to reach the $50 billion mark, and the only quarter last year that was well off of that was the third quarter.

“At the end of the day, the hiccup in the market in Q3 was really what did it to our market,” the New York-based syndicate source.

There were several reasons behind that hiccup, but primarily it was fears about slowing growth in China and what that says about global GDP that was the main problem. The late summer equity market started to weaken. And there were many convertible issues that were delayed or didn’t price at all.

Looking ahead, key risks for the asset class are growth and policy related, according to Barclays. Expectations for modest growth in the U.S. could get negatively impacted by slower overseas growth, namely in China and Europe, and the continuing strength in the dollar. Also the uncertain impact of the start of the long-awaited rate hiking cycle could cause market gyrations, according to Barclays.

Risks specific to the convert market include a potential increase in defaults, challenging liquidity, secondary market valuation pressure as issuance ramps up and a potential correction in the underlying equities, Barclays said.

Mandatories bolster 2015

Barclays expects issuance to rebound in 2016 after a surge in mandatory convertible issues saved 2015 and represented the “highlight of the year.” Robust M&A and the need to shore up balance sheets in stressed sectors like energy were behind the higher level of issuance. The rise masked a sharp drop in bond structure issuance in 2015, which was down about 55% year over year to $16.7 billion, according to Barclays.

Accounting for about 50% of total issuance, mandatory issuance was up from a “meaningful” amount in 2014, or 19%, according to Barclays U.S. Convertibles Outlook 2015 report.

Sources think that the current rebound will continue as issuers tap a market with strong investor demand, lower yields compared to the straight bond markets and premiums that remain high, albeit generally lower than at the beginning of the year.

Actavis plc’s $5.06 billion of mandatory convertible preferred stock, which priced in February with a 5.5% dividend, was the largest new deal in 2015. On its own it accounted for 7% to 8% of the entire new issue market.

Other large mandatory deals included American Tower Corp.’s $1.375 billion of convertible preferred stock, which also priced in February; Southwestern Energy Co.’s $1.725 billion in mandatory convertible preferred stock in January; Anthem Inc.’s $1.25 billion of convertible equity units in May, Anadarko Petroleum Corp.’s 7.5% tangible equity units and Frontier Communications Corp.’s 11.125% mandatory convertible preferred stock priced in June; Stericycle Inc.’s $770 million of mandatory convertible preferreds in September; and Kinder Morgan Inc.’s $1.57 billion of mandatory convertible preferreds in October.

Health care dominates supply

The most active business sectors issuing convertibles were health care and technology, which accounted for more than half of issuance for 2015, followed by energy as the third biggest sector, contributing 18%. Just 6% of issuance was investment gradek, and almost 85% was non-rated.

In terms of market capitalization, about 53% of last year’s deals was issued by large cap companies and mid and small-cap accounted for about 47%. That profile tilted just slightly to large cap issuers, which accounted for 50% of issuance in 2014.

Upcoming maturities spurred investor demand as did coupon income. Also risk-controlled equity alternatives, a diversified fundamental buyer base including both equity and credit buyers and a benign funding rate environment contributed to primary activity.

The biggest months for issuance were February and June. While issuance hit the skids in the summer months, net supply was still positive for a second straight year. It was $10 billion positive for 2015 compared to $7.3 billion positive in 2014 and $21.9 billion negative in 2011, according to Barclays.

Pricing favors investors

Despite the slowdown in overall volume, which made for tight supply, new issue pricing was favorable for investors. Average cheapness was 1.9% versus 0.9% last year and 1.2% in 2013, according to Barclays. Initial conversion premiums to stocks were down. Last year there were several deals with premiums of 50%, but this year premiums were lower.

One of highest premiums of the year was ON Semiconductor Corp.’s 1% convertibles due 2020 that priced with a 42.5% premium on June 2. Coupon data was skewed to reflect the typically higher coupon range of mandatory issuance, so fully 36% of new issuance saw coupons in the 5.5% to 6.5% range. Reflecting typical bond coupons, 22% of total issuance came with a coupon of 1% to 1.99%. Thirteen percent of convertibles had a coupon in the 2% to 2.99% range, according to Prospect News’ data.

Compared to initial talk, 15 deals, or 40% of the total, came at the rich end of talked terms. Six percent of deals came beyond the rich end of talk. Twenty-two percent of deals came within talk, and 19% of deals came at the cheap end, while only 2% came beyond the cheap end of pricing, according to Prospect News.

About 46% of deals were upsized and only one deal representing 0.4% of the total was downsized.

Endologix Inc.’s 3.25% convertibles due 2020 were downsized to $125 million from $150 million. The Irvine, Calif.-based company develops and makes aortic disorder treatments.

Nuance Communications Inc.’s 1% convertibles due 2035 were upsized to $588 million from $550 million. The Burlington, Mass.-based provider of voice and language software came at mixed terms compared to talk.

Fifty-four percent of deals came at the initially talked size.

Best deals of 2015

In October. Kinder Morgan Inc., a Houston-based energy pipeline company, priced $1.57 billion of mandatory convertible preferred stock at $49.00, a $1.00 discount to par, with a 9.75% dividend and 17.5% initial conversion premium. One trader said it was one of the best new deals and trades of the year.

On its debut the mandatory traded down to about $48.00 from its $49.00 issue price and was called a point lower on swap, as shares slipped. Traders said at the time that the action in Kinder Morgan was sloppy.

Strikes against the deal included the fact that Kinder Morgan was a very large new issue and that it is in the energy sector, which was also weak amid lower crude and natural gas prices. In addition, other energy-related mandatories had already priced such as those of Southwestern Energy Co. and WPX Energy Inc.

But Kinder Morgan was the first significant new deal to hit the convertible market in more than a month. But after the deal priced, the company cut its dividend by 75%, so the mandatories vastly outperformed the underlying stock on a swap basis. The players who called that right and got into the mandatory just before the dividend was cut made about 8 points on a dollar-neutral, or hedged, basis, a New York-based trader said.

As of Dec. 18, the Kinder Morgan mandatory was at $39.30, which was down 21% since issue, but Kinder Morgan’s common shares were down 45% at $15.60.

In September, Extra Space Storage Inc.’s $500 million of 3.125% exchangeables was also called one of the year’s winners. The Salt Lake City-based real estate investment trust’s September deal came at the cheap end of talked terms, and on first day trading the convertibles slipped along with the underlying stock. But subsequently they strengthened.

Also in September, Dycom Industries Inc.’s $420 million of 0.75% convertibles priced at the midpoint of talked terms, and expanded about 1.5 points in the week subsequent to pricing.

The specialty contracting services company’s deal was also a favorite of outright players.

“We expect issuer interest in tapping the convertible market to remain healthy due to the asset class’s structural flexibility, subordination levels, competitive pricing especially versus high yield, speed to market, and accounting treatment.” – Barclays analysts, in a note

“The market may not reopen again until February.” – A New York-based convertibles trader

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