Demand for Convertibles Set to Rebound - Financial Times 12/19/10

The spotlight is set to shine on convertible bonds in 2011 as issuance is forecast to rebound and market developments boost demand for the hybrid securities.

Convertibles – bonds that can be exchanged into stock at a set price or time – are becoming more attractive to investors like Pimco, the world’s largest bond fund, because of rising equity prices.

Meanwhile, the prospect of rising interest rates could force companies to seek alternatives to straight debt issuance.

The rebound in stock prices has led convertibles to return 15.5 per cent so far in 2010, according to Bank of America Merrill Lynch, versus 14 per cent for high-yield bonds and 8 per cent for investment grade debts.

The S&P 500 stock index has returned 13.7 per cent.

Last year, companies eschewed issuing convertibles that carry the risk of stock dilution in favour of selling straight debt, which was available at record low rates as anxious investors poured money into bond funds. That also helped prices rise as supply was curtailed.

But after falling from $92.3bn globally in 2009 to $72.6bn last year, according to Dealogic, bankers anticipate that global issuance of convertibles may again approach $100bn next year.

“We are hearing more credit-oriented shops are dedicating more dollars to the convertible asset class,” said Prasanth Burri Rao-Kathi, head of Americas equity-linked capital markets at BofA.

He said US issuance could increase from $36bn this year to $45bn-$50bn in 2011.

Issuers tend to be non-investment grade, like General Motors. It increased an offering of convertible preferred shares during its initial public offering by $600m to nearly $5bn. But Microsoft, an investment-grade group, made its first-ever convertible sale of $1.15bn in June. Asia also saw its largest-ever deal in September, when China Unicom sold $1.8bn of convertible securities.

But riskier or highly leveraged groups are expected to make up the bulk of new issuers. Nielsen Media, which was taken private in a leveraged buyout, is expected to sell convertibles as part of an IPO next year. Emerging Asia is also expected to continue to see a rise in issuance.

“There’s a strong case that convertibles will be a big source of capital next year,” said David Puritz, head of convertible bond trading at Nomura Securities in New York.

At the same time, bond funds like Pimco have been drawn to the asset class as the US economy appears to be gaining steam and bond prices are at risk of falling further. Yields on 10-year US Treasuries have gone up 100 basis points since October to nearly 3.50 per cent.

Larry Keele, who oversees $8.5bn of convertibles funds at Oaktree Capital Management, said demand has also been strong among still-cautious equity investors – convertibles participate in most of equities’ gains yet offer downside protection as capital-preserving bonds.

A shift in the mix of investors in convertibles may also help to support prices, even as supply rises.

Hedge funds using arbitrage strategies – exploiting differences in the bond and equity markets – made up the bulk of investors before 2007. But they are now less than 50 per cent, according to Barclays, as mutual funds make up a growing majority of the market.

He also said many bond fund managers are trying to hold on to record retail investor inflows into their funds in 2010 by adding some exposure to equities.

“Fundamental investors tend not to be as price-sensitive on new issues as hedge funds using quantitative strategies,” said Peter Ramsey, head of US convertible trading at Barclays Capital.

By Telis Demos in New York

Published: December 19 2010 23:00 | Last updated: December 19 2010 23:00