Outlook 2019: Convertibles see ‘phenomenal’ year for issuance; views mixed for 2019

By Abigail W. Adams

Portland, Me., Dec. 31 – It was an active year for new deal activity in the convertibles primary market with new issue volume increasing more than 40% to hit on a post-financial crisis high.

There was a pause in activity into the fourth quarter as volatility roiled markets, but the new deal volume up to that point had been robust and driven predominately by a single sector – tech.

Pricing terms were aggressive and rich for the first half of the year, but the trend reversed with deals coming cheap in the latter part of the third quarter and into the fourth.

There was investor pushback as supply increased and new paper struggled in the secondary space under heavy market conditions, sources said.

Sources were mixed on the year ahead with some seeing a pullback in new deal activity and a return to more balanced issuance from the sectors in the universe.

Others are projecting a continued uptick in new deal volume with the convertibles universe continuing to attract first-time issuers – many that may be looking to refinance their high-yield debt.

A ‘phenomenal’ year

It was a “phenomenal year,” for the convertibles primary market with new issue activity hitting on a post-financial crisis high, sources said.

Rising interest rates, greater volatility in the market, and tax reform that capped deductions on interest payments all supported an increase in overall convertible issuance, sources said.

The convertibles primary marked priced $50.32 billion over 149 deals as of Dec. 18, according to Prospect News data, a 40% increase over the $35.96 billion that priced by that time in 2017.

It was the heaviest volume for new deal activity since 2014 when $50.8 billion priced, according to Prospect News data.

New deal volume was $52.4 billion, according to Barclays’ “US Convertibles Outlook 2019: In the Wheelhouse,” setting a new post-financial crisis record for new deal activity.

The deal volume hit its peak in the second quarter with more than $20 billion pricing – most deals came in May and June.

However, there was a marked slowdown in primary market activity late in the third quarter and into the fourth with potential issuers withdrawing offerings due to market conditions.

Three deals withdrew from the market in November and December – Post Holdings, Inc.’s $400 million offering of series D cumulative perpetual convertible preferred stock, Ribbon Communications Inc.’s $150 million offering of five-year convertible notes and RH’s, formerly Restoration Hardware’s, opportunistic offering of $300 million 0% five-year convertible notes.

Several other deals that were in the pipeline will most likely appear as first-quarter business in 2019 due to the choppiness in the market, a market source said.

While the new deal volume would have been even greater had it not been for deteriorating conditions in the third and fourth quarters, it was a good year, sources said.

Supply outstripped redemptions and the convertibles universe, which has been contracted since the financial crisis, showed signs of sustainable growth, sources said.

The deals of 2018 were notable for several reasons, such as the large average deal size and issuer friendly pricing terms.

However, most notable of all was the concentration of new paper from a singular sector – the tech sector.

The tech effect

Technology issuance was the theme of the year with the sector, at one point, accounting for almost 50% of new deal volume, according to market sources.

“That was very unique,” a source said.

The sector has always been a dominant force in the convertibles market, which is largely tapped for growth or restructuring capital, said Venu Krishna, co-author of the Barclays report.

The trend continued with tech and health care accounting for 52% of the total issuance.

However, tech issuance outpaced biotech almost 2 to 1 with the sector pricing $18.8 billion compared to the $8.4 billion priced by health care.

Relatively low interest rates and tight credit spreads helped drive new issue activity with companies unable to raise straight debt due to their cash flow or short credit history turning to the convertibles market.

However, equity valuations were the dominant force behind the surge.

Valuations in the tech sector, particularly in some of the software names, “were at an absolute record” for much of the year with names trading at 7x their revenue, market source said.

“That’s a good time to consider equity-linked financing,” the source said.

The financing was largely opportunistic with companies raising funds for dry powder M&A activity, a market source said.

More than 50% of the new issue activity was from first time convertible issuers, according to the BofA Merrill Lynch report “Global Convertibles: 2019 – the year ahead.”

Competing companies in the tech sector noticed the trend of convertibles financing and many hopped on the bandwagon to raise capital at attractive rates, sources said.

However, many of the deals that came were large, robust deals from household names – a huge boon to the convertibles universe.

“You had a lot of big deals from big names,” a market source said. “It made it easier to get deals done.”

The trend toward smaller deal sizes in the past few years reversed in 2018 with several billion-dollar deals pricing – the majority of which came from the tech sector.

Splunk Inc. brought the largest deal of the year when it priced $2.13 billion of convertible senior notes over two tranches in late September.

Akamai Technologies Inc. priced $1.15 billion in 0.125% convertible notes due 2025 in May.

Palo Alto Networks Inc. sold $1.7 billion in 0.75% convertible notes due 2023 in July.

Twitter Inc. priced $1.15 billion of 0.25% convertible notes due 2024 in June.

More than 56% of the new deals that priced in 2018 were larger than $250 million, according to the Barclays report.

Riding strong valuations and strong demand, deal terms were issuer friendly for the majority of the year – a trend which reversed course into the third and fourth quarter as market conditions deteriorated and the cost of financing increased.

The terms

The deal terms were decidedly issuer-friendly for the majority of the year with many coming on the rich end of talk after modeling fair value at the midpoint.

Through August, the majority of deals that came to market priced with coupons that were less than 1% and initial conversion premiums that were 30% or higher, according to Prospect News data.

“The coupon and premium combinations were exceptional,” a market source said.

When combined with a call spread, convertible bonds offered cheap financing for companies with little dilution to common stock.

Companies rushed to issue debt before the planned rate increases from the Federal Reserve went into effect.

“The narrative around interest rates has been there for several years,” a market source said. “With the Fed actually raising rates, it caused people to move ahead.”

Many struck when the iron was hot and completed their deals on terms favorable to the issuer. That environment disappeared in the latter part of the year.

“We saw extremely aggressive pricing in Q1 and Q2,” a market source said. “That began to soften in Q3.”

The market was starved for issuance in the beginning of the year and underwriters were able to push the envelope with rich pricing terms and longer six- and seven-year duration bonds.

“Investors were clamoring for exposure,” a market source said.

However, the market pushed back as supply increased and volatility began to roil markets with several new convertibles trading off as their high-flying stock came in.

“The overall increase in volatility and choppiness definitely had an impact on issuers,” a market source said. “It effectively raised the cost of financing.”

While terms are expected to be attractive compared to other asset classes in the coming year, they are expected to come cheaper with the aggressive pricing seen in the first half of 2018 no longer possible.

The case for a slower pace

While many are optimistic that the pace of new deal activity will continue in 2019, some are expecting a drop off in deal volume and a return to more balanced issuance from the sectors in the universe.

The increased cost of financing and an expected continuation of choppiness in the markets will dampen new issue activity, sources said.

“A lot of it will depend on valuations,” a source said.

Some see new issue activity returning to the more normal post-financial crisis pace of $30 billion to $40 billion with more balance between the sectors of the universe.

Biotechnology had lower than average issuance in 2018, but new deal activity from the sector is expected to pick up in 2019.

However, some sources expect new deal activity from the tech sector to decrease in the year ahead.

The surge in 2018 was partly driven by companies in the sector that tapped the market after seeing competitors do the same.

“That should be a one-off event,” a source said.

New deal activity from the tech sector is also expected to decrease for the simple reason that many of the companies already tapped the market.

While the jury was out on which sector will be the “sector du jour” of 2019, there is expected to be increased volume from some of the quieter sectors of 2018 and a decrease in the preponderance of tech paper.

Onward and upward

While some sources saw a case for a slower pace, others are predicting a modest increase in new deal volume in 2019 with the expansion of the convertibles universe continuing.

New deal volume is projected to be between $55 billion and $60 billion in 2019, according to the BofA Merrill Lynch report.

The convertibles universe has the absorption capacity for $60 billion to $65 billion in 2019, according to the Barclays report.

While rising interest rates were seen as a deterrent to convertibles issuers who traditionally tap the market due to a lack of access to straight debt, others see the increased interest rates as supportive to new issue activity.

With rising interest rates and a cap on the interest rate deduction, convertibles will be an attractive asset class compared to high-yield debt, according to the Barclays report.

“There’s a lot of paper coming due in high yields,” a market source said.

If rates continue to increase at the current pace, high-yield issuers may start to cross over to convertibles, the source said.

The low rates of the post-financial crisis era crushed new deal volume in the convertibles universe with potential issuers flocking to straight debt.

The current interest rate environment may change that, sources said.

Refinancing was a primary use of proceeds for the convertibles deals of 2018, with 40% of the refinancing deals from first-time issuers of convertible debt, indicating “sizable demand in 2018 to refinance non-convertible paper in the converts market,” according to the BofA Merrill Lynch report.

While convertibles new deal volume increased by 40% in 2018, high-yield new deal volume decreased almost 40%, according to Prospect News data.

The balance between the two asset classes shifted in 2018. Convertible issuance had been 17% of high-yield issuance since the global financial crisis, as opposed to 80% prior, according to the BofA Merrill Lynch report.

However, over the past year convertible issuance increased to 35% of high-yield issuance – a percentage that is expected to grow in the coming year.

© 2015 Prospect News.
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