Outlook 2017: Convertibles issuance in 2016 lackluster, but hope exists for 2017’s deal flow

By Stephanie N. Rotondo

Seattle, Dec. 30 – New convertible bond issuance in 2016 failed to impress the market, but there was some hope for 2017.

One trader said he was “bullish” about 2017’s new issue prospects.

“With rates rising in this [strong equity market] environment, it’s going to be good for converts,” he said.

As of Dec. 16, issuance stood at $34.08 billion raised from 86 transactions. By comparison, there were 93 convertible debt deals done in all of 2015, for proceeds of $39.98 billion.

One New York-based sellside source was disappointed in the deal flow and went so far as to opine that issuance was even less than league tables show.

“I think it’s skewed with all of these mandatory deals,” he said, referring to issues like Hess Corp.’s $500 million offering of 8% series A mandatory convertible preferred stock.

That deal came Feb. 5 at par of $50.00 with a 17.5% initial conversion premium.

Early 2016 was tough for convertibles as well as the broader markets. Sizable declines in crude oil prices pressured the energy sector and pulled anything linked to that space down with it. The end result was a massive high-yield sell-off that spilled into the broader markets.

That decline then resulted in concerns about interest rates – that is, given the overall weakness, would the Federal Reserve see enough evidence of growth to move forward with interest rate increases?

Things started to look up, though, when Donald Trump won the presidential election. His pro-business remarks made companies feel more secure and investors more willing to take risk.

Additionally, Trump has often decried the Fed’s slowness to increase rates, causing some to wonder if the president-elect would have enough influence to push the central bank to move at a quicker clip.

“I think our new president-elect has repeatedly stated he is unhappy with Fed policy,” one convertibles trader said. “I would think that means higher rates so companies should issue ahead of that.”

The expectation of higher rates – as well as the Fed’s decision to hike rates on Dec. 14 – did bring about a flurry of deals in the final weeks of the year. Market sources speculated that the good times were just beginning.

“The big potential in 2017 that would be an added feature of the convertibles market is if there is resumed optimism among corporations,” said F. Barry Nelson, a partner at Advent Capital Management, in a Nov. 30 video posted on Asset TV. “If there is greater capital spending, greater anticipation of growth, this could lead to a lot more new issues of convertible securities.”

Rich vs. cheap

In terms of rich versus cheap, pricing was fairly mixed in 2016.

“Every deal is different,” said one trader. Especially in January and February, new issues were coming cheaply so as to attract investors.

“The deals that will trade have to come above fair value, making them inherently cheap,” the trader said.

However, the “relative cheapness” of paper was “not as great as in previous years.”

In fact, there was no shortage to deals that came rich – usually because “there was no paper, so issuers took advantage,” the trader said.

“Anytime I see [1% yields], up 40%, I say it’s rich,” said another trader.

Based on data compiled by Prospect News, it was quite nearly even between cheap and rich deals.

As of Dec. 16, 31.04% of new convertible deals came with a yield in the 5% range. A majority of those deals came with a low conversion premium – as low as 14.4%. Those deals were considered cheap.

But another 31.33% of deals came with coupons with 2% or 3% handles and conversion premiums on the high end, resulting in the “rich” classification.

The role of rising rates

Come 2017, convertible debt players will be keeping an eye on the Fed and how it moves on interest rates.

“Maybe this election means we are through with this sort of permanent panic condition in which the Fed keeps interest rates as low as they can and is still in control,” Nelson said in the Nov. 30 video. “Rising interest rates are usually a feature of good stock markets. If the stock market goes up, it’s going to take convertibles with it. If we get more new issues, they are going to come at higher yields.

“The whole environment could very well improve,” he said.

On Dec. 14, the Fed’s Federal Open Market Committee increased interest rates for the first time since December 2015.

The new target rate was upped to 0.5% to 0.75%, from 0.25% to 0.5%.

Assuming the economy continues to show signs of growth, the FOMC also projected more-than-expected increases in the coming years. For 2017, three increases were forecast, another two to three in 2018 and yet another three in 2019.

The coming year brings several unknowns: How will the new administration help businesses prosper? Will the Fed follow through on its plans to continue to raise rates? There are no clear answers going into 2017, but Nelson points out that there is one thing that is known: change is coming.

“There is a definite impetus, a greater-than-usual impetus, for convertibles in the wake of the election,” he said in the Asset TV interview. “We don’t know what is coming with the new administration, but love or hate the president-elect, it means change. It probably means market volatility, it means risk and it is going to mean opportunity.”

“With rates rising in this [strong equity market] environment, it’s going to be good for converts.” – A trader

“The big potential in 2017 that would be an added feature of the convertibles market is if there is resumed optimism among corporations.” – F. Barry Nelson, a partner at Advent Capital Management, in a statement

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