Convertible pros anticipate 2004 issuance in $80 billion area, largely driven by M&A

By Ronda Fears

Nashville, Jan. 1 - Convertible issuance in 2004 is expected to trail 2003 but remain healthy, as economic recovery continues, the world becomes more peaceable and merger activity picks up. Refinancing will still be an important element of the primary market, as well.

Market professionals also expect that terms on new issues will become more buyer-friendly as a continuing bullish stock market would make lower premiums more popular and yields should get a corresponding boost from rising interest rates.

"I think our sense is that it's more of the same. Refinancing will be a big component of issuance, but in growth names and mid-caps there will be a lot of M&A driven finance needs," said Craig Farr, head of convertible origination at Citigroup Global Markets Inc., the top underwriter for convertibles in 2003.

Citigroup unseated Merrill Lynch & Co. Inc., the long-standing leader for convertible underwriting, for the top spot in 2003. Citigroup lead 14% of the 2003 total, which according to Prospect News statistics came to $97.5 billion.

The year's total was a 61% gain over the 2002 total of $60.4 billion, but still trailing 2001's record $114.8 billion that Prospect News tallied.

Citigroup's convertible research team - Stuart Novick, Adrian Miller and Lynn Hambright - are predicting 2004 issuance of about $80 billion, with maturities, puts, calls and other repurchases weighing heavily on market. The analysts pointed out in a recent report that some $35 billion in converts are putable in 2004 - more than twice the amount in 2003 - and another $13 billion is set to mature.

"Particularly as interest rates rise, I would anticipate the issuance pace to continue next year," said Simina Farcasiu, chief portfolio strategist with the huge hedge fund Silverback Asset Management in New York.

Widening credit spreads would tend to limit returns, both in new issue product and on whole, but Farcasiu expects issuance volume to remain strong and the convertible market to continue to grow.

Richard Russell, portfolio manager for Ariston Capital Management - the best performing outright convertible fund in 2003 according to Morningstar Inc. - also foresees issuance staying high, with more of the same for refinancings, but also with more new capital earmarked for business expansions and takeovers or merger activity.

"They are out of the bunker from a psychology point of view with relation to capital expenditures," Russell said of corporate leaders' frame of mind since about October 2002, which he considers the market nadir.

"They still need to raise capital, for business expansion, takeovers, especially in growth sectors, technology."

Russell's fund, the ACM Convertible Fund, is ending 2003 with a return of about 43.5%, which is the top ranking convertible fund tracked by Morningstar. But as wild as that sounds, it's down from around 50% earlier this year.

The bull stock market was the driver of those returns, Russell said, as the fund is specifically geared to high delta convertibles that will participate in large part with the gains in the underlying stocks.

Because the bull market is continuing, he also expects that new issue terms will moderate - from a buyer's perspective - from the 0% yield, up 100%-plus seen in the spring of 2003.

Tom Dinsmore, president of Davis-Dinsmore Management Co., anticipates that new issue terms will become friendlier to buyers, but also that that could weigh on issuance volume. The bull market, too, could lure some issuers away from the convertible market, he said.

"New issues will not be so strong [as 2003]. They did so well because the market did so well. We're now going through a period where buyers realize some were poorly priced," Dinsmore said.

"There are still buyers, and issuers, available. But a year ago some of these issuers were using the convertible market as the market of last resort [to raising capital]. Now they have other options."

Nonetheless, if merger activity continues to track the pace of last six months, some risk arbitrage managers say that companies' capital needs may present enough force to keep convertible issuance very strong, plus provide an opportunity to make a big contribution to their returns.

"I don't want to sound insanely optimistic. I'm cautiously optimistic," said Jeff Cohen, president of Silverado Capital Management, which operates a convertible arb strategy as well as a risk arb strategy.

"This business [risk arb] has had its fits and starts over the last three years. But it has, over the last six months, seen a re-emergence of financial buyers. There was the Duane Reade situation. [The New York drugstore chain agreed to a buyout by management and private equity firm Oak Hill Capital Partners LP on Dec. 23] Kolberg Kravis is active again. You didn't see that for a long, long time.

"If these financial buyers see an economic recovery, they might want to lock in low financing costs."

Corporate buyers also have reactivated acquisition plans, he added.

"The corporate buyer has really been stifled, or stifled themselves, subsequent to 9/11, the war, the bubble bursting. There's a backlog of deals that seems to be creeping back to the forefront," Cohen said.

"There had been a resistance to do deals, sort of like during World War II when there were no marriages."

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