Convertible issuance tops $100 billion with new structures, wider range of issuers, buyers

By Ronda Fears

Nashville, Tenn., Nov. 20 - Convertible issuance has roared to record heights this year - total supply passed $100 billion with Monday night's deals, according to data collected by Prospect News - bringing the market into a place that has won the attention of a wider variety of issuers and investors.

That, in large part, is attributed to the creativity of the investment bankers that have come up with new structures like the contingent conversion and contingent payment features that have lured investment-grade issuers into the marketplace.

It also speaks of the positive, or at least better, returns convertibles have provided than other asset classes, whether equity or fixed income.

"We're not dealing with the convertible market of my father," said Tom Dinsmore of the Davis-Dinsmore Management Co., which manages several funds like the Bancroft Convertible Fund.

"This is a positive thing. The convertible market is one of the most dynamic markets in terms of the brainpower that is put into how these issues keep coming. All these new convertible vehicles - contingent conversion, contingent payment features - have been very constructive. It has attractive to new investors and has attracted new types of issuers, the Northrop Grummans."

Monday night's three deals for $2.9 billion took the year-to-date total past the $100 billion mark, far ahead of the previous annual record of $64.43 billion set in 2000. For 2001 through Tuesday, a total of 241 deals have come to market for a total of $101.2 billion in volume, according to Prospect News data.

Participation in convertibles has been virtually overtaken by hedge funds, which market sources estimate accounts for 70% or more of the trading volume. Dinsmore said that while he has no problem with a wide variety of players for the market, it has eaten into the allocations that dedicated convertible funds have traditionally been given on new deals.

"Over the past two or three years we're finding that it's not just ordinary hedge funds in our market," said Yaw Debrah, head of convertible research at Bear Stearns. "A very important point is the number of different types of hedge funds today that is heavily involved in our market."

The type of hedge funds playing convertibles has expanded from convertible arbitrage to include a host of different types of hedge funds, like options strategies, risk arbitrage, short bias, macro, aggressive growth, special situations, value, opportunistic, equity market neutral, event driven and others.

"We definitely are seeing a broader mix of players," said John Zerweck of the hedge fund Zazove Capital Management. "In our world, with the number of hedge funds and the returns for hedge funds being what they are, the guys playing convertibles are expanding. That is good. You don't want just a market filled with hedge funds who strip out the volatility" feature of a convertible that is linked to the equity option portion of the security.

That itself, the striping of a convertible into two separate pieces - the equity option portion and the fixed income portion - has boosted volume on the derivatives desk of many investment banks, sources say, but it is nearly impossible to get a grasp on the volume levels in that market. Deals structured as long paper with short puts or multiple put options, many times with contingent features, have created the most demand for swaps, Dinsmore said, and provide investment banks another opportunity to turn a buck on the deal by brokering the asset swap.

"Those deals, the CoCos and CoPays, have tax consequences that make it very, very attractive for the issuer, and the hedge funds because they can strip out the equity option, but it's very onerous to taxable funds like us," Dinsmore said. "We still are very active. There still are a sufficient number of vanilla convertibles for us to participate in, and some of the CoCos are not totally unattractive. But our allocations are going down, because of so much hedge fund participation, and we have a long history of buying new issues."

Much of the attraction to convertibles has been their performance against most other benchmarks, which can be in part attributed to the defensive high-premium convertibles that have been introduced over the past year which provide a cushion to the drop in prices for the underlying stocks. Still, the most profitable area for convertibles has been with hedge funds. Through the end of October, the Bear Stearns convertible index was down 5.4% while the Nasdaq was still off 21.7% and the Dow Jones Industrial Average was down 7.5%. Also through the end of October, the CSFB/Tremont hedge fund convertible arbitrage subindex was up 13.4% and the Tuna hedge fund index, compiled by HedgeFund.net, showed its convertible arbitrage index up 14.4%. The Tuna fixed income fund index was up 7.58% for the 10-month period.

New issues have generally outperformed the broader convertible market, too, which continues to bolster strong demand. The Merrill Lynch convertibles new issue index was up 2.3% in October versus a 2.1% rise in Merrill's convertibles master index, and compared to a 3.1% advance in the underlying shares.

Whether the convertibles market can continue to bring new supply will depend on two things, most sources say: if stocks don't take a dive and if hedge funds can hold on to their returns.

"There's a place in time when the hedge funds will fall away. They have done it before, in 1987, 1990 and 1994 and in 1998. Hedge funds can completely disappear at times," said Dinsmore. "And we will still be there, those of us who simply buy and hold."

Craig Farr, head of convertible origination at Salomon Smith Barney, agreed that so long as stocks hold up convertible issuance should keep up its new pace. "Issuance has been very healthy. There's a lot of cash out there and a lot of issuers. We don't see any reason for it to fall off dramatically."

As for the window closing on hedge fund participation, it is somewhat more tenuous to gauge.

"What will hurt our market is that convert arbs will get over-leveraged at some point," Zerweck said. "But that's not the case right now. We're not even close to that right now. As long as stocks stay here, or go up, we will continue to see this level of issuance."

Note: The issuance total includes all dollar-denominated offerings sold in the U.S. as public or Rule 144A deals reported to Prospect News. Amounts are based on the total sales price (face amount multiplied by the offering price). Bonds are included that convert into the issuer's or another company's stock or the cash equivalent; bonds that convert into other bonds are excluded. Units made up of a bond and stock are included; units made up of a bond and warrants are excluded. Preferred issues are included using the same criteria as for bonds. Figures include greenshoes where reported to Prospect News.

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