Convertibles in Europe gained 16.6% in the first half; more moderate returns seen ahead: Barclays

By Rebecca Melvin

New York, July 10 - While the convertibles market across the globe has rebounded impressively since the end of 2008, last quarter saw some new opportunities arise in Europe via cheap new issuance and bond tenders, as well as asset class appreciation due to rising equities and credit, according to Barclays Capital convertibles research in London.

Convertibles in Europe gained 16.6% in the first half, outperforming investment-grade credit and equities but lagging high-yield credit.

And for the third quarter, the bank's analysts expect a traditional summer slowdown in primary market and probably secondary market activity, particularly relative to the near-record pace of new issuance in Europe last month.

"We do not envisage issuance to halt completely over the summer, however, as some companies still have pressing refinancing needs," the analysts Luke Olsen, Heather Beattie and Angus Allison said in a report titled, Convertible Market Update Q3 09: Pausing for Breath.

"We expect investors to adopt a fairly cautious approach to managing and adding convertible risk during the summer period, especially following the impressive returns of Q2," the report stated.

New issuance has been a "welcome distraction" for convertible investors in Q2, but it has also taken focus from relative value opportunities, notably versus credit, the analysts wrote.

New opportunities have arisen to switch from straight bonds into convertibles for a yield pick-up or to capture negative basis versus credit default swaps, though they are not as compelling as some of the opportunities that were available in the fourth quarter of 2008.

More balanced convertibles seen

Another key theme is convertible-implied volatilities, the Barclays analysts said. At the beginning of the year, implied volatility had little relevance as a valuation metric for European market and Asia convertibles, given the near-total predominance of "busted" convertibles. Post the recovery in equities and the substantial supply of new issues, the "balanced" portion of the market is now much more significant.

Greater stability in the market over the past few months has meant that rational convertible pricing, modeling and hedging are more feasible now compared with the end of 2008 and the beginning of 2009. This means that market participants are now focused again on implied volatilities for a number of bonds.

This said, the lower participation versus a year ago of hedged investors, combined with higher costs and lower liquidity of credit, equity and option hedging, mean there is less volatility trading, or gamma capture, than in the past.

This may be one reason there has been a convergence in convertible implied volatilities across different names, despite their very different volatility profiles, the report said.

"Specifically, we have observed that many balanced convertibles are indicated with implied volatilities in the 30s, whilst their realized and option-implied volatilities are much more widely dispersed," the analysts wrote.

More moderate returns expected

Convertibles in Europe gained 16.6% in the first half, outperforming investment-grade credit and equities but lagging high-yield credit. Asian convertibles gained 27.4% in the first half, outperforming investment-grade and high-yield credit but lagging equities.

More moderate returns are expected in the third quarter as the recovery in convertible risk appetite pauses.

New issuance accelerated in the second quarter, particularly in Europe, raising €10.6 billion, which is close to the full-year 2008 total.

New issuance year to date now stands at €12.6 billion, outstripping the €6.4 billion of redemptions.

Asian new issuance has lagged, at $2 billion year to date, compared with $4.3 billion of redemptions. Hence, net supply is positive in Europe but negative in Asia.

Issuance volumes are expected to dip during the summer holidays, before picking up later in the third quarter.

Implied volatility has become a more significant relative value metric for convertibles following the rebound in valuations and new issuance. Notwithstanding, relative value versus straight equity and credit (bonds and CDS) remains a key theme, with some specific compelling trade opportunities, the analysts said.

Following the reopening of the convertible market on March 24, the second quarter saw a further 24 new issues, totaling €10.6 billion, and there have been a further three deals in July, taking year-to-date issuance to €12.6 billion.

April saw benchmarks set: all five deals from the month were investment grade, greater than €500 million equivalent in size and offered vanilla terms for investors together with liquid credit and equity hedges.

The restoration of market confidence was clearly illustrated by comparison of the second ArcelorMittal convertible to its first offering, which had occurred only a month earlier and had reopened the primary market.

In that time, the z-spread of the straight bonds due 2013 and 2018 had tightened to 670 bps from 1,100 bps, and the new convertible offered a coupon that was 2.25% lower than its predecessor.

Following the benchmark set by April's issuance, May saw greater diversity arrive from the convertible primary market. There were five new issues raising €2.1 billion, but all were from unrated companies, presenting limited hedging opportunities and including the year's first exchangeable bond.

May's smallest, largest and average issue sizes were €196 million, €700 million and €427 million, compared with €509 million, €1.292 billion and €710 million for April, respectively.

"We then witnessed a veritable flood of issuance in June, totaling €4.9 billion from 14 new deals, representing an average deal size of €352 million," the report stated.

The majority of the new deals remained attractive for investors, with the deluge allowing investors to be more selective in their participation. As such, a greater proportion of the terms began to fix at the mid-points or in favor of the investor as opposed to the issuer, which had been the previous trend, the report said.

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