Midyear Update: Convertible pros cut 2004 issuance forecast by $10-$20 billion to $50-$70 billion area

By Ronda Fears

Nashville, June 30 - Revisions for convertible issuance in the second half of 2004 have shaved off about $10 billion to $20 billion from the total, which is now seen in the $50 billion to $70 billion area by market onlookers, as new deals thus far have fallen short of expectations.

Perhaps more ominous, with a record amount of convertibles expected to be taken out of circulation this year via redemptions, calls and the like, some analysts see the market shrinking by $5 billion to $15 billion.

Citigroup sees $60 billion

"We are projecting about $60 billion in issuance, down from our $70 billion-plus estimate from six months ago," said Citigroup convertible analyst Stuart Novick. Citigroup's convertible research team also noted earlier this year that some $35 billion in convertibles are putable in 2004 - more than twice the amount in 2003 - and another $13 billion is set to mature.

"Our primary rationale for cutting the expected convertible issue proceeds in the U.S. this year is the small average deal size [$144 million median issue size in May]," Novick said.

"In fact, if you were to extrapolate the number of convertibles issued through May - 100 - you'd come up with a full year tally of 240 issues, which would be the second highest annual total. Doing the same thing with proceeds, however, would only bring the full-year figure to about $63 billion - somewhat below our $70 billion to $80 billion initial projection from back in December and around one third less than last year."

Novick said Citigroup's expectation for total issuance was revised chiefly due to erratic equity market performance year to date and sooner-than-expected interest rate hikes.

Merrill sees $50-$70 billion

Merrill Lynch convertible analyst Tatyana Hube lowered her expectations even more drastically, also noting heavy redemptions. In fact, she expects redemptions to be at a record high of $60 billion to $75 billion this year.

"We expect total convertible new issuance in 2004 to be in the range of $50 billion to $70 billion - it's about $26 billion year to date - revised ... down from $70 billion to $80 billion at the beginning of the year," Hube said, pointing out that Merrill previously anticipated 2004's total to be similar to or somewhat lower than 2003's, which was about $87 billion.

Prospect News tallied $98.2 billion for 2003, including synthetics brought to market by the banks. That was a 64% gain over the 2002 total of $60.04 billion, but still trailing 2001's record $114.8 billion tallied by Prospect News. Through the end of June, Prospect News' total is $31.83 billion.

Deals seen more buyer-friendly

For a variety of reasons, some external to the convertible market and some arising from turmoil within, Novick expects new-issue terms to be more sensitive to buyer demands.

"We continue to look for average new issue yields to rise in tandem with higher interest rates and for average premiums to contract slightly as volatility remains range bound at or near multi-year lows," he said, although "valuations, despite longer average call protection - about 5 years on average in 2004 - remain less 'cheap' than they've been historically."

Cash takeover protection and dividend protection will become nearly universal in new issues, he added, as a result of big losses convertible arbitrage players experienced in the Kroll Inc. and Mandalay Resort Group all-cash takeovers. Those situations caused buyers to insist on protection features on virtually all new deals since late May.

Small, weaker credits prevail

The convertible market has historically been home to more junkier type credits than the blue chips, but in the past couple of years the market has lured considerably more high-grade credits into the field. The latter will likely wane as more typical market conditions return following unusual events during the recession.

"In terms of new issue trends for the rest of the year, we expect continued dominance of smallish, weaker-credit issues which will carry higher coupons and lower premiums. At least a few investment-grade companies that will bring new deals may structure them as floating-rate paper, given the demand for this type of paper and lower initial cost in the current interest rate environment," Hube said.

"We believe most refinancing deals were accomplished last year and in the beginning of this year, when interest rates were lower. We should see some M&A [mergers and acquisitions] driven deals as companies seem to be more keen on using cash nowadays even for larger deals."

Redemptions zap growth

Compounding lower expectations for new issuance, market pros project that redemptions will further drain the convertible market.

Merrill forecasts convertible redemptions to be at a record high of $60 billion to $75 billion, noting there has been about $27 billion year to date.

Hube noted that there are numerous mandatories coming due in 2004 and 2005 and there are still many busted convertibles outstanding with 2004 puts.

"We continue to see high redemption activity via call-forced conversions and cash calls of high-coupon converts - money for which was successfully raised earlier in the convertible and straight debt markets," she added.

"As a result of high redemptions, we anticipate negative net issuance of $5 billion to $15 billion in 2004."

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