Outlook 2015: Cheaper pricing, strong issuance eyed after convertibles pull back from 2014 levels

By Rebecca Melvin

New York, Jan. 2 – U.S. convertibles are seen somewhat cheap heading into 2015, reversing a trend of several years, after having endured a midyear pricing slump and several market-rattling events, including the oil price shocks of this past fall.

Convertible valuations are about 0.5% to 0.6% cheap heading into the new year after being fair to a little rich at this time last year, sources say.

The cheapening occurred in the second half of the year as strong new issuance, rich pricing, a pullback in equities, and the beginning of oil shocks sparked 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, a New York-based trader said. “It’s just a function of an illiquid market.”

A second New York-based trader said that valuations that began dropping in August represented something of a small bubble bursting. “Earlier in the year, paper was priced as tightly as it possibly could be,” the trader said. Those assets lose value very quickly when the bubble pops.

Meanwhile, collapsing energy convertibles and issuer-specific events like GT Advanced Technologies Inc.’s unexpected bankruptcy filing Oct. 6, contributed to air coming out of the market.

Looking ahead, market players that take advantage of currently cheaper convertible paper in January will be met by a more balanced convertibles universe, with a higher percentage of issues in that mid-range, sweet spot of pricing, where more optionality and potential value exists. Prices of balanced convertibles are generally between 90 and 110 and up to 130.

The balanced portion of the convertible universe has increased to about 32% at the end of 2014 from 28% at the end of 2013, according to Barclays’ convertibles research.

ServiceNow Inc.’s 0% convertibles due 2018 is a balanced issue that was 113 bid, 114 offered on Dec. 19 against shares at $69.00 for the San Diego-based cloud IT services company. RBC Capital Markets upgraded ServiceNow to a top pick from “outperform” and raised its share price target to $80.00 from $70.00 on Dec. 16.

Pace of supply to stay strong

In addition to a cheaper universe of more balanced convertible paper, strong new issuance, which has rebounded for the last two years, is expected to remain strong in 2015. New issuance is expected to reach more than $50 billion and up to $60 billion in 2015, according to several sources. That comes on top of $50.73 billion of new issuance in 2014 – a post-credit-crisis high, and $48.19 billion of new issuance in 2013.

“I always welcome more new issues, whether high-quality or low-quality, large-cap or small-cap. The more, the merrier. If pricing of new issues seems unattractive, that’s a problem that will eventually be corrected in the secondary market. As a convertible investor, I'm an obvious beneficiary of a growing market,” a former portfolio manager and convertibles expert told Prospect News.

Notwithstanding the headwinds of a potentially worsening oil market situation and slowing economic growth in parts of the world, the outlook for convertibles, given its internals, seems bright.

Mixed results for 2014

The market for convertibles was mixed in 2014, however. Convertible returns were “decent” for outright, or fundamental, players, Barclays’ convertibles analysts said in their convertibles outlook report for 2015, entitled, “Setting the Sail.”

Barclays’ convertibles total composite index outperformed the Barclays U.S. High Yield, Barclays U.S. credit and Russell 1000 in 2014, but it underperformed the S&P 500 stock index, the Nasdaq and Russell 2000.

Barclays’ total composite return for convertibles was 7.6% as of mid-November, versus the S&P, which was up 12.3% at the time. That result was down sharply from 2013, when the total composite return was 24.4% compared to the S&P, which sported a 32.4% return.

As for hedged returns for convertible arbitrageurs, Barclays said results were disappointing, with some funds slightly negative for returns and some slightly positive.

As tracked by the CSFB/Tremont hedge fund index, the convertible arb strategy was down 0.85% for 2014 as of Dec. 19, which underperformed the S&P 500, which was up nearly 14%. But it outdid the S&P Goldman Sachs Commodities index, which was down a whopping 22.5% year to date.

Among HFR’s relative value indexes, convertible arbitrage was the worst performer, down 8.47% for the year to date as of Dec. 19. For November alone, the HFR convertible arb index was down 4.65%, and for December, the index was down 2.4%, all as of Dec. 19.

“There was a dispersion of funds; some did well and some did badly,” Barclays’ convertibles analyst Piyush Anchliya said.

Looking ahead, the return for Barclays’ total composite index for 2015 is expected to be 6.1% under base case variables, including a 7.5% gain in equities. The total composite return will be 8.4% if equities gain 12.5%, and it will be 2.7% if equities end flat for 2015, according to Barclays research.

Benefits of lower oil?

Convert arb is difficult to judge these days because there are few hedge funds that practice the art in the traditional way that simply goes long a convertible and short the underlying stock, market sources point out.

In its pure form, convertible arbitrage attempts to lock in a fixed interest rate from the debt portion of convertibles while reaping the benefit of equity moves from the equity portion of the hybrid securities.

Even this form of arb can sour: a recent example occurred in 2005, when many arbitrageurs had long positions in General Motors convertible bonds and short positions in GM stock. They suffered losses when a billionaire investor tried to buy GM stock at the same time its debt was being downgraded by credit-ratings agencies.

Today’s sophisticated managers of convert arb strategies overlay options and other derivatives to express various views, and such overlays probably carry more risk than traditional convert arb, a former portfolio manager and convertibles expert told Prospect News.

Unwinds of these derivatives precipitated by highly unlikely and/or surprising events can be devastating and quick. The oil shocks this past fall “may have been a Black Swan that understandably frightened the market,” the former portfolio manager said.

The obvious effect of the drop was rapid widening of credit spreads in oil-related convertibles, which by their inherently high leverage makes the credits susceptible to deterioration when exogenous events turn negative, he said.

“There have apparently been some collateral effects on credit spreads of convertibles of lower quality that are not energy related. This sort of change in spreads makes it appear over the short term that the affected convertibles are not providing appropriate downside protection. And, for classic convertible arbitrageurs, these situations may create losses based on deltas that were assumed before the drop in the oil price,” the expert said.

“When a convertible begins to trade stressed, delta becomes difficult to estimate...and delta gets suddenly much higher regardless of the conversion premium,” he said.

“For 2015, if the oil price stays low, I should think the benefits of low oil prices will be noticed, and there will be a lot more benefits than negatives. The initial reaction to the drop in oil prices reflects those who are hurt like the companies with specific exposures,” the expert said.

“The broad economy that will benefit has no such concentration of payoffs – except, perhaps, for some obvious beneficiaries in industries like airlines and autos. “It's curious to observe that multiple airlines have suffered huge losses because of bets on a stable or rising price of fuel. Anyway, I wonder why the auto companies don’t hedge fuel since it certainly affects their sales and margins.” he said.

E&P collapses

The oil and natural gas exploration and production sector started to crack in early October with the shares of many of those names drooping to 52-week lows.

Energy XXI (Bermuda) Ltd.’s 3% convertibles due 2018 traded down 4.5 points to 5 points amid a 20% slump in the underlying shares on Oct. 8. The bonds had been around 80 previously. Shares of the Bermuda-based oil and gas E&P company fell to $10.05. When shares bounced back some intraday, the convertibles didn’t improve. On Dec. 19, the Energy XXI 3% convertibles were at 29 and the shares closed at $3.43.

Cobalt International Energy Inc. and Goodrich Petroleum Corp. were also notably weak E&P names in convertibles. On Dec. 19, Cobalt’s 2.625% convertibles were at 63, which represented a little bit of an improvement from lows notched in the mid to upper 50s. Cobalt shares closed Dec. 19 at $9.37. These bonds had been more than par in early summer.

Goodrich Petroleum’s 5% convertible due 2029 were at 54 on Dec. 19, which was close to their lows from a price level of 100 as recently as September. The Goodrich shares, under ticker symbol GDP, were at $5.37 at the end of Dec. 19.

The E&P sector was the first to feel the effects of a glut of natural gas and crude oil. But at the end of November, when the Organization of the Petroleum Exporting Countries said that it would not curb its crude production but keep pumping at its rate of about 30 million barrels a day, the E&P sector tanked again, this time bringing much of the rest of the market with it.

Oil pricing is close to an inflection point in which companies are not making enough to compensate for the cost of production. But whether this will bring meaningful consolidation that corrects the market in the short term isn’t known.

West Texas Intermediate crude fell below $55 per barrel during the week ended Dec. 19, ending at $57.77 per barrel that day.

Deutsche Bank expect energy profits to take a hit of about 30% on $65 billion to $70 billion per year average. That and a strengthening dollar will present stiff headwinds in 2015, Deutsche Bank strategists believe.

‘Flash bankruptcy’

GT Advanced’s convertibles collapsed on Oct. 6 after the Merrimack, N.H.-based solar and LED equipment company filed for Chapter 11 bankruptcy protection.

GT Advanced bonds immediately fell to around 33, which was down from about 115 for the GT Advanced 3% convertible due 2020, of which $190 million priced in December 2013, and down from 155 for the older GT Advanced 3% convertible due 2017, of which $220 million priced in September 2012.

They slid further to 29, then recovered some to the 40 mark, before heading even lower, down to 20 as shares collapsed to $0.39.

Aside from some rumblings of trouble starting in August, traders said that the GT Advanced bankruptcy filing was unexpected.

“There wasn’t a lot of warning; it was a flash bankruptcy. It is name specific,” said a New York-based trader, who added that the bankruptcy didn’t reverberate among solar convertible names or other names in the renewable energy sector on a sector level.

The GT Advanced 3% convertibles due 2017 were the ones that were mostly held on a hedged basis, according to one trader.

But both the older 2012 bonds and the 2020 convertibles, which were mostly held on an outright basis, were said to have come in 10 points to 15 points on a dollar-neutral basis, sources said.

After the bankruptcy announcement, GT shares dropped 93% to $0.80. Earlier in the year, the shares had reached $20.54, which was its 52-week high mark.

GT Advanced said that it expects to continue to conduct business as usual after it and certain of its direct and indirect subsidiaries filed for Chapter 11 bankruptcy protection in the U.S. Bankruptcy Court for the District of New Hampshire.

As of Sept. 29, the company had about $85 million in cash, and it now seeks debtor-in-possession financing.

Dendreon files

Dendreon Corp. also filed for Chapter 11 late in the year, and convertibles players were hurt. But the pain was not close to the degree that the GT Advanced bankruptcy caused.

Dendreon’s 2.875% convertibles due January 2016 dropped more than 15 points to 49 on the day of the filing on Nov. 10. Shares slumped to $0.18 from $0.94. But later the convertibles were trading in the 50 to 55 range.

The $620 million issue of bonds had traded prior to the bankruptcy at 66, but it had been offered lower in the weeks leading up to the filing with no trades, a trader said. It had started the year at about 70.

The Seattle-based maker of the Provenge prostate cancer drug said it has enough cash to support operations during its restructuring.

Under the company’s restructuring plan, which was negotiated with approval from the majority of convertible noteholders, holders will get either equity in the reorganized company or cash, if there is a buyer of the company.

Dendreon had warned in August that its debt load was unsustainable and that it was looking at alternatives, so the filing was not a big surprise, but “the timing was a little bit of a surprise,” a trader said.

Solazyme hurts

Solazyme Inc. was another pitfall for convertibles players this past fall as their fortunes followed those of the equity after the San Francisco-based developer of renewable oils from algae reported a third-quarter earnings miss and warned on revenue going forward due to production issues at its Moema, Brazil, plant.

Solazyme shares started 2014 at $10.98. They rose to about $12.00 per share by midyear and then slid down in pretty much a straight line to $7.74 on Nov. 3. That’s when they collapsed on the earnings report.

On Dec.19, Solazyme’s 5% convertibles due 2019 were at 45, and Solazyme shares were at $2.53.

December sell-off

Convertibles experienced another strong wave of selling during the first two weeks of December in tandem with a sell-off in equities. This time the selling spread beyond energy to more liquid issues in the space as portfolio managers attempted to reduce absolute risk going into year-end and shore up capital.

With year-end staring portfolio managers in the face, many didn’t want to rebalance holdings per se, but they began selling, traders said.

“A client sold something, and we asked him why he was selling, and he said ‘Because I can,’” a New York-based trader said.

Because there were few buyers, traders were forced to lower prices to make trades work.

“Nobody wants to buy, so you are forced to move the market down, a second trader said at the time the market was in a tailspin.

In one session, Priceline Group Inc.’s 0.9% convertibles moved down to the 92.75 bid, 93.125 offered level, down 0.5 point on the day, and while weaker, it was holding up, or “holding in,” OK relative to many other issues.

Red Hat Inc. also fell during the sell-off, but the issue snapped back when markets turned around Dec. 17. Markets started to rally after the Federal Reserve said its stance remains “patient” when it comes to raising rates.

There was also a resurgence of volume in convertibles after the policy statement following Federal Open Market Committee’s regularly scheduled, two-day meeting.

Rates seen benign

Deutsche Bank called this past year’s persistent decline in Treasury yields “astonishing.” This occurred despite improved U.S. growth trends, a stronger labor market and arguably lesser geopolitical risk, Deutsche Bank Market Research said in its U.S. Equity Insights report published Dec. 15.

The only thing behind the low rates that can be pointed to is Europe’s inability to sustain growth and falling European yields, the bank’s research arm said.

Many had projected a rise in rates in 2014, and insofar as this wrong call affected credit markets, it also affected convertibles to a degree. But rates at this point have been relatively benign for convertibles and are expected to remain so going forward.

Many believe the new year promises to be something similar to 2014, especially after the Federal Reserve’s last regular policy setting meeting on Dec. 17 when it voted to be patient about raising rates.

But if the economy doesn't hold up, and rates go higher in 2015, it could mean a difficult environment for equities, and therefore, for convertibles.

Some say the 10-year Treasury bond will yield above 3% by the end of the year. But not everyone is convinced.

“2015 is going to be interesting; we will see if we get full scale purchase from the ECB,” a New York-based convertibles trader said, referring to the European Central Bank.

“Central banks outside of the Fed will continue to enlarge their balance sheet. I have a hard time seeing rates going any higher, especially in the long end,” the trader said.

U.S. growth and equities

With U.S. convertibles having turned slightly cheap, equity returns will play a key role in returns for U.S. convertibles going forward, according to Barclays.

“If an economic slowdown or technical correction negatively impacts the equity markets, U.S. converts will be negatively impacted as well,” Barclays said in its Setting the Sail convertibles report.

Meanwhile equities will depend on the U.S. economy and monetary policy.

“We think the key issue for 2015 is how the U.S. economy, its labor market and its monetary policy compares to the world,” Deutsche Bank strategists David Bianco, Ju Wang and Winnie Nip wrote in their equity report.

Many expect a relatively healthy U.S. economic growth amid a supply glut in global oil markets and weak oil demand from parts of the world including China and Europe.

U.S. gross domestic product growth is expected to be 3.15%, according to Goldman Sachs & Co.’s chief economist of global investment research, Jan Hatzius. That is up from 2.2% in 2014, the Goldman Sachs economist said.

That estimate compares to 2.9% U.S. GDP growth in 2015 projected by Barclays economist, who cited improving labor market conditions and eyeing the benefit U.S. consumers will reap from lower oil.

Barclays said slower-than-expected U.S. growth appears limited, equity returns should be solid in the mid-single digits range, and the Fed seems on track for midyear interest rate increases.

Such rate increases should have a salutary effect on convertibles unless the impact generates disorder among the broader equity and credit markets, Barclays said.

S&P earnings per share should grow in the low single digits, based on the view that oil prices remain weak and the U.S. dollar strengthens, many believe.

Credit concerns

But Deutsche Bank pointed out in a recent credit report that without a rebound in energy, the broader market indices will be pulled lower, credit spreads will widen and defaults will rise.

“We are marking our spread targets to 575 basis points in high yield, which is higher by 95 bps, and 150 bps in investment grade, which is 25 bps higher,” the bank’s credit report said.

“Returns could be negative over the next few months,” it said. In addition, high-yield defaults, which have seen their lows for this cycle at 1.7% in September, are now heading toward 3.5% next year, Deutsche said.

With the August pullback in convertible pricing, the universe is slightly less equity sensitive with credit sensitively little changed. The profile has shifted to 55% equity sensitive, 32% balanced and 12% credit-sensitive at the end of this year, compared to 59% equity sensitive, 28% balanced and 12.2% credit sensitive at the end of last year, according to Barclays.

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