Outlook 2023: Convertibles issuance expected to gain steam; crossover issuers to drive volume

By Abigail W. Adams

Portland, Me., Dec. 30 – Following the record-setting issuance of 2020 and 2021, the convertibles primary market broke another record in 2022 – this time for record low issuance resulting in a historic market contraction.

The exuberance and growth sparked by the easy money of the Covid-19 era came to an abrupt end in 2022 as the Federal Reserve embarked on an aggressive campaign to tame sky-high inflation.

Global markets plunged.

“The magnitude and speed that rates went higher took markets by surprise,” said Michael Youngworth, BofA analyst and author of the report “Year Ahead 2023: Extra Credit.”

No asset class was safe from the repricing.

Credit spreads blew out, equities collapsed and deal-making came to a virtual standstill.

“This year was bad,” said Manoj Shivdasani, Barclays analyst and co-author of the report U.S. Convertibles Outlook 2023: Bridge Over Troubled Water. “Whenever there’s a sharp correction in equities, everything stalls.”

The convertibles primary market is closing the books on a year with the lowest new deal volume since 2012 and the fewest number of transactions since at least 2001.

But that is expected to change.

While the environment will remain challenging in 2023, sources expect to see a significant uptick in deal-making as crossover issuers turn to convertibles as a cheap alternative to straight debt.

And while the convertibles market will stand out as a cheap financing alternative, pricing will remain attractive for investors with less aggressive terms that offer more profit potential and downside protection than the pricing of previous years.

A historic lull

The convertibles primary market saw another record-setting year in 2022 – a new decade low for new deal volume and a multi-decade low for number of transactions.

The domestic convertible bond primary market has priced $30.57 billion in 61 deals as of Dec. 15, according to the Prospect News database.

It is the lowest new deal volume since 2012 when $22.37 billion priced in 84 deals and the fewest number of transactions since the inception of the Prospect News database in 2001.

The 84 deals that priced in 2012 previously tied with 2011 for the fewest number of transactions since 2001.

“That speaks a lot more to the environment than the volume,” a source said of the drop off in transactions.

The anemic pace of new issuance combined with redemptions resulted in a historic net contraction of the convertibles market.

Youngworth said the domestic market saw a net contraction of about $40 billion during 2022 with the total market size now $240 billion.

The global convertibles market’s net contraction was the largest decline since 2011, according to the BofA report.

Barclays pegged the net contraction at about $29 billion with the current market size $274.21 billion.

The Federal Reserve’s aggressive rate hike campaign, the sharp repricing of equity and credit markets, and the uncertain economic climate were contributing factors to the abrupt slowdown in convertibles issuance.

Companies were flush with cash entering into 2022 after raising capital at rock bottom interest rates during the Covid-era.

However, the hypergrowth and expansion of the Covid-era quickly shifted to a “belt-tightening phase,” Shivdasani said, with rates soaring, recession fears growing and stocks plummeting.

“No company wants to issue when their stock is down,” a source said.

Convertibles issuance plunged in 2022. However, that is expected to change.

The primary market is poised for a significant uptick in activity in the coming year, sources said, with crossover issuers the driving force of volume.

The crossover

The convertibles market’s explosive growth during the Covid-era, which resulted in new deal volume of $93.12 billion in 2021 and $112.65 billion in 2020, is not expected to be seen again for some time with net contraction expected to continue in 2023.

Tight monetary conditions and an uncertain economic climate will be continued headwinds for deal-making in the coming year.

However, the convertibles primary market is poised for a significant uptick in new deal volume in 2023 with the market an attractive place amid elevated rates.

Convertibles issuance is expected to normalize to pre-pandemic levels with BofA forecasting $45 billion to $48 billion in issuance in 2023.

The driver is expected to be crossover issuers tapping the market as a cheap refinancing alternative to straight debt.

The cost of financing that weighed on convertibles issuance was felt across asset classes with the high-yield primary market seeing an issuance decline of about 80%.

Lower quality credits were virtually shut out of the market.

High-yield issuers have looming debt maturities of about $70 billion coming due in the next two years – $40 billion which comes from companies with publicly traded stock, according to the BofA report.

Crossover refinancings from high-yield issuers represents an enormous opportunity for the convertibles market, which is poised to capture at least $10 billion of high-yield refinancing needs.

“Some issuers can get as much as 6 to 7 points lower in the CV space,” Youngworth said. “It’s a sizable opportunity. It’s the No. 1 reason we’re optimistic.”

The conversations have already begun with primary market sources citing a significant uptick in queries from high-yield companies over the past year.

Barclays expects to see a pick-up in issuance from investment-grade companies as well.

The combined maturity walls of the high-yield and investment-grade market is $688 billion in 2023 and $787 billion in 2024, according to the Barclays report.

Investment-grade companies accounted for 43% of the convertibles market in 2003 but their market share has dwindled to just 8%.

“Many of the traditional companies stopped issuing convertibles and went to straight debt,” Shivdasani said. “We expect some reversal in that trend.”

While convertibles offer non-dilutive features such as net-share settlements and call spreads, Youngworth still sees crossovers from investment-grade names as limited.

Investment-grade companies tend to be very protective of their balance sheets and wary of stock dilution.

“We’re hopeful,” Youngworth said. “But we’ve been hopeful for a long time.”

The convertibles primary market has already seen a significant uptick of activity with two-thirds of the total amount to price in 2022 coming in the second half of the year.

Refinancings were “the trade of the day,” a source said, with the majority of deals accompanied by repurchases or exchanges of outstanding convertible notes.

Refinancings from convertible issuers is expected to diminish in the year ahead, but the uptick in new deal volume is expected to continue as high-yield and investment-grade companies address their looming maturities.

The pick-up in new issuance is expected to be the primary source of secondary market returns in 2023 with pricing that will have plenty of buyside appeal.

Coupons

The convertibles primary market’s aggressive pricing terms of previous years came to an abrupt end in 2022.

“There are coupons again,” a source said.

The low interest rates and equity bull market since the global financial crisis fostered a decade-long convertible pricing environment of low coupons and high premiums.

Approximately 21.51% of the deals to price since 2001 came with coupons below 1%, according to the Prospect News database.

The all-time tights in credit markets and elevated equity volatility of the Covid-era fueled the resurgence of the No-No, a 0% coupon convertible bond that priced at par, which accounted for 42% of the new deal volume in 2021.

That has changed.

“The days of 0, up 50 are over,” a source said.

In 2022, approximately 14.5% of the deals to price came with a coupon under 1% – the majority priced in the first quarter.

Approximately 24.21% of the deals to price in 2022 came with a 2% handle – the majority priced in the second half of the year.

Premiums also narrowed with only 15% of deals coming with conversion premiums above 40%.

The majority of deals to price came with conversion premiums between 30% and 35%.

“There’s been a pretty significant shift in deal terms,” Youngworth said.

The repricing in the market could be seen in Wolfspeed Inc., which priced a $750 million issue of six-year convertible notes in February and a $1.75 billion issue of seven-year convertible notes in November.

The February deal was talked with a coupon of 0.25% to 0.75% and an initial conversion premium of 30% to 35%.

The deal was marketed with assumptions of a 350 basis points spread and a 42% and modeled 1.8 points cheap at the midpoint of talk.

It priced rich with a coupon of 0.25% and an initial conversion premium of 35%.

The November deal was talked with a coupon of 1.625% to 2.125% and an initial conversion premium of 32.5% to 37.5%.

It was marketed with assumptions of a 375 bps spread and a 42% vol., and modeled about 2.5 points cheap at the midpoint of talk.

It priced at the midpoint of talk with a coupon of 1.875% and an initial conversion premium of 35%.

New deals have traditionally modeled cheap based on underwriter assumptions, even with aggressive pricing terms.

New deals on average priced 0.82 point cheap in 2022, in line with the average pricing of 0.83 point cheap between 2016-2020, according to the Barclays report.

The cheapness in primary market pricing has long served as a source of returns for the convertibles market.

Returns are expected to be modest in 2023.

However, the trend toward less aggressive pricing with real yields and lower premiums will offer greater profit potential and more downside protection than the terms of previous years.

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