Outlook 2005: U.S. convertible issuance expected to see moderate uptick to $50-$60 billion

By Ronda Fears

Nashville, Dec. 31 - Summing up the view on convertible issuance for the New Year, one hedge fund manager put it succinctly: "Back to the future."

Merrill Lynch head of U.S. convertible research Yaw Debrah also pointed out that the latter half of 2003 and 2004 saw the resurgence of the small speculative-grade issuer as the primary source of supply in the convertibles market - "reminiscent of the pre-technology bubble days."

Following 2004 when issuance fell far short of forecasts - the year's total came in at roughly half the rate of 2003 - many players have scaled back their expectations, particularly as new accounting rules have removed the popular contingent conversion structure which had been a lure to bring investment-grade issuers to the convertible market.

For 2005, hopes range from an issuance level flat with 2004 to as much as $65 billion. While that may still seem disappointing compared to the go-go pace of 2001 when the market saw an astounding record of $114.8 billion (by Prospect News' account), it's still very respectable against the historic levels of $30 billion to $40 billion annually.

"I would expect new issue activity to remain quiet again this year [2005] until the economic outlook becomes more certain and we enter the next expansionary phase. Unfortunately, this may take some time - that is, the end of 2005, or beyond," said Hart Woodson, portfolio manager of the Gabelli Global Convertible Fund, who added that on an international basis Japan may be the exception.

2004 worst since 1999

Citigroup Global Markets Inc. convertible analysts Adrian Miller and Stuart Novick noted in their 2005 outlook that 2004 was shaping up to be the worst year for new issue proceeds since 1999 when $39.8 billion of convertibles came to market.

Preliminary figures compiled by Prospect News through Dec. 27 tally $50.2 billion of convertible issuance in 2004, including investment bank exchangeables, and $45.9 billion without those transactions. The total compares to $98.2 billion tallied by Prospect News for 2003.

"Most corporates were flush with cash or came to the straight debt market instead, which had a record year, to take advantage of low rates and tight spreads," Woodson remarked. "Also, low volatility made selling converts less attractive and the change in the CoCo accounting rules shut off some issuers at the margin."

Moreover, it was a year of "de-engineering," said Darren Clipston, managing director at Drake Management LLC, as "the removal of major accounting and taxation cost-of-capital advantages of convertibles, in conjunction with low rates and spreads making regular debt more attractive to companies, has resulted a big reduction in investment-grade convertible issuance."

Citigroup sees $55-$65 billion

By Citigroup's count, convertible issuance in 2004 was around $47 billion versus over $90 billion in 2003.

"Issuance is likely to climb in '05, we believe, due to better equity performance and continued demand for replacement paper," Miller and Novick said in their 2005 outlook for convertibles.

"On balance, we're estimating convertible issuance of $55 billion-$65 billion next year, and, depending on the strength of the U.S. economy, our projected proceeds total could go higher."

Solid equity market performance will help, the analysts said, noting that Smith Barney equity strategists are presently calling for an advance of close to 10% for the Dow Jones Industrial Average and a rise of approximately 8% for the S&P 500 in 2005. Small cap issues, too, which show the highest correlation of any equity capitalization tier with convertibles, are presently expected to post similarly solid performance next year.

Merrill expects $50 billion

Merrill Lynch is projecting convertible issuance of about $50 billion in 2005 with some possible upside to that forecast.

"In the continued low volatility, low interest environment that we are looking to in 2005, we would expect smaller cap, speculative-grade issuers to dominate issuance once again, with the straight bond market being the market of choice for larger cap investment-grade issuers," the U.S. convertible research group said in its 2005 outlook piece.

"M&A activity ... where convertibles are used as part of the acquisition financing could provide upside to this number."

More traditional issuers seen

While the days of jumbo deals from investment-grade names may be waning in convertible issuance, players certainly have not written off the market as a means to raise capital for issuers. Rather, some describe it as returning to a more traditional convertible issuer profile, or as the New Jersey fund manager referred to it: "back to the future."

"Unfortunately my crystal ball's batteries are running low," said Clipston of Drake Management.

"However, I would think 2005 could see an uptick in preferred and mandatory issuance as equity-like structures come back into vogue. Indenture protection from takeover and dividend risks should be ubiquitous as well," he added, also chiming in with sellside analysts that increased merger activity could drive a considerable amount of issuance.

Michael McNulty with Context Capital Management LLC said one has to differentiate between the lower credits and/or emerging growth company segment of the market - "what I call the traditional convert issuers" - versus the larger, higher perceived credit rating companies.

"In the former category, there will always be new issues and new issuers entering the market, because converts still remain one of the most efficient ways to raise capital for these smaller or emerging companies," McNulty said.

"Going a step further, a lot of new issues over the last few years are falling through the cracks at their underwriters, and/or have declined in value since issuance, yet they still offer good value. To a lesser extent, there is also a chance that smaller issuers turn to the public/144A convert markets as more underwriters become increasingly uncomfortable with PIPE-oriented deals in light of the SEC's ongoing PIPE market investigation. But, even without these marginal PIPE issuers, the special-situation/credit-intensive part of the market will still be profitable for those funds with a good research focus."

CoCo replacements expected

New structures are anticipated in the convertible world, especially with the new Financial Accounting Standards Board requirement that CoCo convert issuers report diluted earnings per share as if the issues were converted, no long making the structure appealing to issuers.

"If one had to circle an area for surprises," said Clipston of Drake Management, there is a "greater than 50% chance of significant new structural innovation unveiled by a major underwriter and quickly copied by others."

The impact on the new CoCo accounting rule might be gleaned from noting that of the nearly $115 billion of convertibles issued in 2001 - undeniably the issuance benchmark for years to come - more than 50% of those issues were CoCo converts.

"Over the last few years, a lot of better quality companies that usually would have gone to the straight bond and/or bank markets entered the convert market in a big way," said McNulty of Context Capital.

"I believe a lot of the early growth resulted from, one, a large number of hedge-funds accepting aggressive pricing and not thinking about the consequences of dividends, takeovers or volatility declines to these positions, and, two, the proliferation of CoCo/CoPay structures where an issuer, for GAAP purposes, could effectively issue a low or no coupon bond without dilution AND get a tax deduction to boot!

"In this environment, why wouldn't a higher grade company use converts? Now that issuers are forced to offer expensive takeover protection and dividend protection, as well as worry about new CoCo rules, there is an increasing reluctance by these higher quality, cross-over issuers to use convertibles. Thus, it is highly unlikely we see a return to the heady issuance of last year for a long time."

Demand for converts still strong

There may be some money taken off the table for convertibles by the investment community but sources say that, in spite of perhaps many challenges in the convertible market, demand is still very strong for the asset class.

"On the negative side, the convert community may have to deal with early 2005 redemptions at those managers with lackluster 2004 convert arb returns, rising rates and possibly more takeovers and dividends given better corporate cash flow generation," said Context Capital's McNulty.

"However, on the positive side, a stronger economy and possible tax reform should lead to new issuance of all kinds, provide credit upgrades to many smaller/marginal convertible issuers and lead, hopefully, to more stock volatility if earnings expectations get ahead of reality."

Citigroup's convertible analysts said that particularly on the arb side, funds appear to be still taking in capital despite the relatively lackluster returns they collectively posted in the past year.

"Moreover, funds presently allocated to the convert arb strategy - like funds allocated to most hedge funds - are relatively sticky, implying that little in the way of capital is likely to leave in spite of recent performance," said Citigroup's Miller and Novick.

"Anecdotal evidence suggests that convert mutual funds and convert arb hedge funds continue to take in money. Those funds will need to be invested - a matter which is likely to support convertible valuations and also enable companies to garner steep terms for new issues. On balance then, we see a lot of capital becoming available for new convertible investments and there will undoubtedly be some new convertible paper to sop up that liquidity."

Net issuance a point of contention

Maturities, puts and calls along with the appeal of refinancing in the face of stock gains and/or rising interest rates are factors that are still taking a toll on the convertible market.

On the heels of a record amount of convertibles redeemed in 2004, however, analysts are divided about what will happen in that regard during the New Year with Merrill looking for another net outflow and Citigroup expecting a net inflow. Basically, though, it comes down to expectations for issuance.

"We are once again looking for a large amount of redemptions, about $60 billion," Merrill's Debrah said, as issues become callable, putable or mandatorily convert. That is lower than 2004's record total of about $72 billion, he added. But against the firm's issuance estimate of around $50 billion, it would still produce net negative issuance of about $10 billion for 2005.

During 2004, Merrill tracked a record net negative issuance of convertibles, with the market losing $27.8 billion through Dec. 20, as redemptions outpaced issuance.

Citigroup's analysts, on the other hand, see the situation reversing course in 2005 with a net inflow of somewhere around $10 billion. That is mostly due to Citigroup expecting issuance to hit somewhere around $60 billion.

Some $18.7 billion, or 6% of the U.S. convertible market, could go away in 2005 as a result of maturities, puts could add another $32 billion, or more than 10% of the market, to that total, and calls are likely to play a major factor too.

"It's conceivable that over 20% of the issues currently in the U.S. convert market could go away in the coming year," said Miller and Novick of Citigroup. But, they added, "Overall, we're projecting a net inflow of funds to the U.S. convertible market in 2005. We're estimating that the final tally for 2005 will come in at around $10 billion making it the smallest annual net inflow total since 1998 but representing a $25 billion turnaround from this year's likely result."

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