Outlook 2006: U.S. convertible primary market expects boost from increased volatility, spreads

By Rebecca Melvin

Princeton, N.J., Dec. 30 - With increases in volatility and credit spreads expected to raise the competitiveness of convertibles as a means of financing in 2006, research analysts and players are forecasting a pickup in new issuance. Also playing a role will be an expected rise in M&A activity.

Coming in around the same level as other predictions, research analyst Yaw Debrah of Merrill Lynch said: "We are forecasting new issuance of about $50 billion for 2006, up from 2005's anemic issuance of about $35 billion year-to-date excluding December."

December was actually a busy month for new issuance and total new issuance for 2005 ended at $40.6 billion, according to Citigroup Global Markets.

Using the latest tally, new issuance for 2005 was down 19%, compared to 2004, when total issuance stood at $48.2 billion, according to Merrill data.

As far as the sheer number of deals, 2005 was lower at 107 new issues for the year to December, compared to 182 new issues for the same period of 2004, according to Merrill Lynch.

Citigroup's tally in late December was 124 deals, which compared most closely to 1999 when there was $39.8 billion in new issuance in 112 deals, Citigroup said.

Prospect News figures show convertibles issuance at $43.93 billion in 468 deals for 2005, or $38.30 billion in 118 deals excluding investment bank exchangeables. Those were down 13.9% and 17.1% respectively from $51.00 billion in 463 deals and $46.20 billion in 205 deals for 2004.

The new Merrill prediction for 2006 is flat on its 2005 forecast and other forecasts have been in the same general range. For example, Lehman Brothers Inc. predicted last year new deals for 2005 would total $47 billion to $54 billion, a range which is expected to be close to its 2006 forecast. The number was still being weighed due to considerations related to M&A activity expected.

The consensus of $50 billion in new issuance for 2006 represents a 23% increase over 2005.

Why the pickup?

"Volatility continues to hover near multi year lows, it's just a question of when, not if, it's going to turn up: whether in 2006 or 2007. To me, it's been down and should turn up by the second half," according to a Citigroup desk analyst.

"Interest rates may not lift every time, but there will probably be a couple of increases in 2006, and there are implications related to where rates go. The economy starts to slow [with higher rates], and then credit spreads widen out," he said.

"Volatility helps new issuance because selling a convert is selling an option and the higher the volatility, the higher the value of the option," Merrill Lynch's Debrah said in an interview.

Low issuance in 2005

In the same vein, the main reason for the lack of new deals in 2005 was historically low levels of implied volatility, according to the convertibles research team of Barclays Capital plc.

In Europe, short-term implied volatility fell to its all-time low in February. Longer-term option implied volatility, as indicated by the Euro Stoxx 50, also dropped to a low in February, according to the Barclays Capital 2006 convertible market outlook report.

In addition, many large companies didn't re-leverage their balance sheets during 2005 and therefore their requirements for funding remained modest, the Barclays report said.

However, higher volatility in 2006 as well as a significant increase in M&A activity could spur further convertible issuance, Barclays said.

One point where consensus is lacking is how well equities will perform in 2006.

Some feel that new issuance will be pretty strong if the equity markets perform well. But there is risk to the downside for equities, according to the Merrill Lynch outlook, although the report predicts equities will perform flat to slightly negative in 2006.

"History shows quite clearly that employment, capital spending, dividends, M&A activity and share repurchase all tend to subside when the profits cycle significantly decelerates," according to the Merrill Lynch report, which expects the 12-month return for the S&P 500 to be negative 2%, based on the Nov. 30 S&P 500 close.

Although further new highs of the averages are likely before the post-2002 cyclical bull market is finished, it is probable that it is in a late stage of cyclical advance, the report said.

Therefore, if the uptrend peaks by early 2006, the market could be vulnerable to a 20% to 25% decline for the Dow Jones Industrial Average and S&P 500, and a 30% to 35% slide for the Nasdaq Composite Index in 2006, prior to an upswing in 2007 to 2008, the report said.

Profile of new issuance

A pickup in new issuance begs the question of what form convertibles will take.

Mandatory convertibles were part of the picture every month in 2005, with a lot of mandatory issuance every quarter and especially in June, when half of new issuance was accounted for by mandatories, according to Citigroup Global Markets. But that tally was lifted mainly due to the large $1.8 billion mandatory deal issued by MetLife Inc.

A Connecticut-based hedge fund founder expects more preferreds in the profile of convertible new issuance. "It's the lowest of the barrel from a credit standpoint. Convertibles issuers have either been desperate like Blockbuster or opportunistic like Chesapeake," he said.

He was referring to Blockbuster Inc. and Chesapeake Energy Corp. Blockbuster launched in early November $100 millioin of cumulative convertible perpetual preferred stock, which was talked to yield 7.25% to 7.75%, with an initial conversion premium of 20% to 25%.

In early November, Chesapeake Energy priced $500 million of cumulative convertible preferred shares that were priced to yield 5% with a 30% initial conversion premium. The company also priced in early September an upsized $300 million of convertible preferreds to yield 4.5% with an initial conversion premium of 35%.

"Preferreds can be more volatile; they move around a lot. There's definitely been more in the last couple of years, although they've been around a long time," the Connecticut based hedge fund founder said.

Implications of Intel convertibles

In mid December, Intel Corp. priced $1.4 billion of 30-year convertibles at par to yield 2.95% with an initial conversion premium of 18%.

The junior subordinated convertible debentures, which are non-callable for seven years and have no puts, priced toward the middle of talk for the coupon, which was talked at 2.875% to 3.125%, and at the cheap end of the initial conversion premium, which was talked at 18% to 20%.

It was a Rule 144A deal sold via bookrunner JP Morgan.

Because the Santa Clara, Calif.-based chip giant has such strong credit ratings, the deal was somewhat unusual for the convertibles market, and one that kept players talking for awhile.

Some couldn't see the logic of the deal for such a large cap company that didn't really need the money.

But others suggested possible reasons. "I think they were monetizing some of the volatility. They bought stock on the other side of the deal. It was a good trade," the Connecticut based hedge fund buyer said.

Another source said, "I read the prospectus. It was a contingent debt instrument for tax purposes. They were deducting a higher interest rate than they're paying. It's like having a free mortgage."

Regardless of its reasons for doing the deal, the Intel issue was seen as a good thing for the convertibles market. "Intel has delivered a message to other high-quality companies that convertibles are a good, low cost financing option," a New York based fund manager said.

Evolving features of new issuance

"I'd say the most important new structural feature in 2005 was the 'electing shareholder' treatment added to takeover protection," a New York-based sellside analyst said.

"In 2006, I'm hoping for some structure innovation that could help to boost new issuance, especially by larger better-credit companies. But I'm not sure whether this hope will be realized," the analyst said.

"I don't see any features going away: even features like CoCo still provide some flexibility to issuers, even though its biggest benefit was cancelled with last year's FASB ruling," the analyst said.

Electing shareholder language has to do with the choice shareholders get to make between cash or stock in a takeover situation. And it was worked into takeover protection in reaction to the case of Teva Pharmaceutical Industries Inc. taking over Ivax Corp., the analyst said.

Teva proposed to offer Ivax shareholders $26 in cash or a certain number of shares of Teva stock. The problem was that the number was set at the time the merger was announced, and subsequently Teva shares started to run up dramatically. In response all the Ivax shareholders wanted more stock because it was worth more than $26 in cash.

Without the electing shareholder language, convertible holders are classed as non-electing and end up getting what is left over, as happened with the three convertible bonds of Ivax, including the 1.5%, the 1.875%, and the 1.5% due 2025.

"It creates a problem in non-electing stock traded as a cash and stock option, meanwhile convertibles will only convert into cash afterwards," the analyst said. "But ever since the Ivax case surfaced, new issues since August started including non electing language, or explicit language making sure that convertible holders will have consideration in what they will convert too as well."

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