Tough market conditions create lull in convertibles

By Ronda Fears

Nashville, Tenn., April 11 - Tough conditions prevailing in stocks and the credit markets overall have caused a lull in convertible issuance as well as trading volume, but market watchers point out that after a long, strong run it was time to take a breather.

Until volatility levels pick up or there is some economic impetus market watchers are not expecting much change for the market, outside of event-driven opportunities in specific names.

Several factors are at play: stocks for many potential convertible issuers are at low levels or perceived to be undervalued, the high-yield bond market opened up in the first quarter after a hiatus, hedge funds are finding it tougher to make money in converts and issuers are have trouble readjusting to more normal pricing terms after the zero-coupon craze.

"Issuers are sitting there with a pitch from a year ago that showed they could do a deal with a 0% coupon, 0% yield and a high premium and they want to do that deal today. But the market just won't accept that today," said Jeremy Howard, head of U.S. convertible research at Deutsche Bank Securities.

"I really think that's the predominant factor as to why we're not seeing a lot of issuance at this particular moment. In first quarter we saw some distressed names, people that just absolutely had to raise money. Now, the issuers can be a little more opportunistic, take some time."

Still, issuance has been healthy - up 25% to 30% over first quarter levels.

"Issuance is up by about 25% from a year ago," said Kimberlee Brody, convertible analyst at Wachovia Securities.

"Sector diversification is still good and we're seeing a lot of new structures. Mandatories are at 11.5% of issuance, compared to 5% a year ago, and those are good in a rising rate environment, so those will continue. I think we'll continue to see new structures in search of favorable tax treatment."

But for the last half of the quarter, most of the deals have been small and provide little trading opportunity. Until the Duane Reade deal Wednesday for $190 million in proceeds, there hadn't been a new deal in a week.

That, in itself, doesn't causes some onlookers to worry, mainly because of the strong showing convertibles have made in the capital markets arena with issuance gains of 50% year-over-year for the past three years.

And, it's not caused anyone to pull back from their expectations for this year, although no one is forecasting another 50% gain. In fact, most expected a decrease of about 20% from the 2001 level.

"We've had an incredible run over the past couple of years. It's only understandable that the market would take a breather," said Yaw Debrah, head of Americas convertible research at Merrill Lynch & Co.

"We're just in a very slow period. These are very, very difficult times everywhere. A lot of factors are holding things back. We will need some economic stimulus to get the market going."

Venu Krishna, head of convertible research at Lehman Brothers, agrees. But he also points directly to the difficulty hedge funds are having in making money with converts as a contributing factor that affects both the primary and secondary markets.

"It's getting more difficult to make money in the convertible market. The overall pull back in volatility has limited the contribution of hedge funds (in trading) so they're waiting on the primary market and there's not been a lot there," Krishna said.

Volatility has been contracting strongly for about the last six weeks to two months, and has been deeply affecting hedge fund performance. While on an outright basis convertible performance has been turning around, hedge funds are estimated to account for 70% or more of the volume in convertibles.

In the primary market, not only have terms become less favorable for issuers, but for buyers as well. Krishna estimated that in first quarter deals came on average about 1.5% cheap, compared to 2.0% to 2.5% cheap in 2001 and a historical average of 4.0% to 4.5% cheap.

"This is not necessarily a negative thing, taking a break. It gives the market time to digest what is going on," Krishna said.

There probably is some adjustment to the market-player profile that needed to take place, in terms of reducing the presence of hedge funds, in order to keep it more efficient, he said. Not that any widespread liquidations are seen happening, nor was the Lipper Funds situation in the first quarter a major factor.

"Anytime you see any one participant of the market begin to account for a larger proportion it has the potential to create inefficiencies. Perhaps we are at a point where hedge funds make up too much of our market," Krishna said.

"I do get a sense that there are more fundamental players participating, and that includes high yield guys and institutional equity funds because those are fundamental holders."

There's still room for some refinancing efforts in the convertible market and stock price gains would improve the outlook immensely. Krishna also sees a call for more floating-rate note convertibles, which debuted in first quarter.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.