Outlook 2014: U.S. secondary market poised for continued strength, but investors eye Fed taper

By Rebecca Melvin

New York, Dec. 31 - U.S. convertibles are poised for a strong performance in the secondary market in 2014 as a combination of factors, including higher equities and concerns about higher interest rates, remain in play and drive renewed enthusiasm for the asset class.

But there is scope for caution as the risk for a potential correction in stocks has grown and the U.S. Federal Reserve's planned tapering of its $75 billion per month in asset purchases could spur unexpected fallout in addition to higher rates.

As the market readies to flip the calendar to a new year, U.S. equities stand at record highs and whether the market is at its top or will continue to run higher is anyone's guess, but some investors believe that the risks have increased dramatically for the equity rally to run out of steam and they are meaningfully "short." Meanwhile, higher rates are expected to hinder corporate straight debt. Yet, this may be the perfect financial environment for convertibles.

It is interesting to note that the convertibles market is composed of both hedged and outright investors, whose interests are largely opposed in terms of how market dynamics affect their returns. But both types of investors had a positive 2013. Returns for outright investors were about 20%, and for hedged investors, 8% to 9% on average.

In some ways the 2014 outlook for convertibles is not much different from the 2013 review. Higher rates and higher equities drove strong returns for convertibles in 2013. But what is different is the solid uptick in new issuance in the fourth quarter that spurred interest in the convert space further, if not taking a little wind out of the sails of the secondary market, albeit temporarily.

2013 marked the highest level of new issuance in the convertible market for five or six years, or since about 2008, when the market crash depressed convertibles issuance and the low-rate environment that ensued turned most would-be convertible issuers into high-yield, straight debt issuers.

Equity markets eyed closely

Still, a lot will ride on the equity markets going forward. And that outlook is not altogether rosy. The return expectations for stocks in 2014 following dramatic gains in 2013 are modest," Barclays convertibles analysts wrote in research published Dec. 13.

U.S. convertibles would be hurt by an economic slowdown or a technical correction of equity markets. But against a backdrop of modest return expectations for credit, rates and equities, "we believe U.S. convertibles are well positioned to deliver competitive returns, especially in the context of potential monetary policy-related turbulence/headwinds, Barclays analysts Venu Krishna, Manoj Shivdasani and Piyush Anchliya wrote.

Nevertheless, recent economic data continues to point to strength in the U.S. economy, and therefore strength in stocks. In addition more new issue supply hasn't hurt the demand side of the equation. As of Dec. 6, the secondary market was fairly quiet and fairly resilient, one trader said.

The year-end slowdown was certainly in effect, and "traders might be fatigued from all the activity," a New York-based trader said. "But overall, more is going away than is pricing; there is still decent demand."

For the year there was about $49 billion of new convertible issuance and an estimated $47 billion in redemptions as a result of calls, puts and maturities.

During the week of Dec. 2, there was $1.87 billion in base deals priced in nine deals by eight issuers. Several of the deals were upsized, and/or came at the rich end of talked terms.

The only one that came at negative pricing was RAIT Financial Trust's $125 million of 20-year 4% convertible senior notes, which priced at a discount to par of 99, the trader pointed out.

Most of the deals that debuted in the market performed well, including GT Advanced Technologies Inc.'s 3% convertibles, Endologix Inc.'s 2.25% convertibles, SouFun Holdings Ltd.'s 2% convertibles and American Realty Capital Properties Inc.'s 3.75% convertibles.

Valuation and returns

The convertibles market is seen fair value to slightly rich at the end of 2013, compared to fair value at the end of 2012 and cheap at the end of 2011.

A large part of the current richness is due to limited investment-grade quality paper, and that segment of the market is rich. But U.S. non-investment grade convertible bonds, which account for 65% of the market, are slightly cheap in aggregate, according to Barclays, and valuations are expected to remain relatively strong on the back of sustained outright demand in the face of a shrinking investment-grade universe.

"Though convert valuations have improved on an absolute basis over the year, the asset class still offers modest value relative to other asset classes such as high yield. The combination of decent yield with risk-controlled equity exposure is attractive in the current market cycle, in our opinion," the Barclays analysts said.

An East Coast-based buyside analyst concurred: "This is not to say that there aren't parts of the markets that are expensive, there are: investment grade converts being the most obvious. Right now, though, the overwhelming theme is that converts offer investors a sweet spot (defensive positioning, equity upside) and supply/demand seems to be in a good place as well. 2013 may well mark the start of a longer-term recovery in the convertible bond market; certainly we are all hopeful of that."

While valuations could come under a little bit of pressure under a sustained pickup in new issuance, the market already cheapened somewhat at the end of this year and "any further cheapening, if any, would likely be limited," Barclays said.

Barclays predicts an outright return of 5.25% for 2014, based on 6% equity returns, modest spread contraction and headwinds from rising rates, as well as a backdrop of 2.4% expected 2014 GDP growth as its base-case scenario. That compares with a 6.5% return forecast at this time last year for 2013. But in fact, convertibles returned more than 20% on an outright basis in 2013, with the S&P 500 stock index up 28%.

Interestingly, stocks underlying U.S. convertibles returned 36.1% compared to the 28% S&P 500 return, 28.9% return for the Russell 1000 and 33.9% return for the Russell 2000. The outperformance can be attributed to the higher beta and the bias toward small capitalization stocks underlying the convert universe.

Using an upside scenario, Barclays predicts 7.25% total return for convertibles, based on a 10% equity price return. The downside case is for a negative 3% return, assuming a 10% decline in equity prices.

Hedged returns for convertible arbitrage funds are difficult to predict and depend on delta, which changes virtually every day and is difficult to measure over an extended period. But the hedged returns for 2013 were in the high-single digits this past year, sources said.

Convertible arbitrage was up 7.41% for the year to date, according to hedge fund research, slightly better than 6% plus return for the same period last year and reversing a negative 3% return for 2011.

The returns are competitive relative to high-yield straight debt, investment-grade debt, equities and Treasuries.

Supply rebound

New supply in the United States rebounded to $49 billion for 2013, which was more than double from $21.89 billion in 2012 - a decade low, and $25.95 billion in 2011, according to Prospect News' data.

What occurred this past year is what market players were praying for, a combination of widening spreads, rising equity prices, and rising rates, which helped the cycle turn back.

Perhaps, the convertible market, which by historic measures is typically capable of bringing $40 billion to $60 billion in new issuance per year, can return to previous norms.

Biotechs outperform

Biotechnology was probably the strongest segment in the convertible space this past year. There were a couple of losers, but far more winners, an East Coast-based buysider said.

Examples of winners among biotechnology names were Theravance Inc. and Vertex Pharmaceuticals Inc. early in the year, Isis Pharmaceuticals Inc. and BioMarin Pharmaceutical Inc. later in the year.

Existing paper in the biotech space from an outright perspective did really well, he said, on the back of strong stocks in general and company-specific events.

Isis and BioMarin were very strong on both an outright and swap basis, the buysider said.

Theravance was buffeted, but ultimately climbed on a combination of takeover speculation, drug data, and news that the San Francisco-based biotechnology company was splitting itself up into two publicly traded companies. One company, retaining the Theravance convertibles, is the royalty stream company minus the developing drug pipeline, and was seen as largely negative for convertible hedged players because it dampens volatility in the name.

The Theravance bonds jumped to about the 130 context in the early part of the year, from par for the newer Theravance convertible, which priced in January.

The Vertex convertibles steamed higher in April on both an outright and dollar-neutral, or hedged, basis as shares of the Cambridge, Mass.-based specialty drug company surged 62% on favorable results from a mid-stage study of its cystic fibrosis drug.

The Vertex 3.35% convertible senior notes rose to 173 bid, 173.25 offered versus an underlying share price of $84.00. That was up compared to 118.25 versus an underlying share price of $52.87 before the news.

The 55-point outright climb represented about 13 points to 14 points of expansion on a dollar-neutral basis if the bonds were held on about a 60% delta, a trader said.

A second trader said that holders made 12 points on a dollar-neutral basis if the bonds were held on a 65% delta. A third trader said that the gain on swap was 7 points "out of the gate" if people were on a 70% delta.

"Vertex moved on both data and productivity and those stocks did quite well," 'the buysider said. "There were both positive data trends and additional product."

A bit of caution

Looking ahead, the buysider said, "We are a bit more cautious. The market can still trend solid returns next year, but they are somewhat extended and valuations are a little stretched on an equity basis."

He said there may be "a bit of a correction next year."

"If the economy doesn't hold up and rates go higher, that's a difficult environment for equities and convertibles," he said.

"There may be more volatility. There is the risk that the stock market continues to move higher and this forces investors to take on more risk. We will watch the data, watch the economy: if the taper is more aggressive, rates will back up more. We will be cautious going into it and more aggressive as equities are selling off. There is not going to be an overriding concern over a recession or economic calamity," he said.

We will stick to shorter-dated, higher gamma paper at the outset, and as we move through that situation [the taper], then we may have the opportunity to get more aggressive with more in-the-money names," he said.

Convertibles have both bond and equity components, and if one component stumbles the other one holds it up, he said, But they are not immune; they got hurt in '94,' he cautioned.

Whether this investor will remain in the biotech sector as heavily as he was in 2013 is "something that we are thinking about," he said. "Obviously if a sector goes up that much, you might take some chips off the table. But there are strong arguments that it is going to continue to do well."

Positive play

Covanta Holding Corp.'s 3.25% convertibles due June 1, 2014 skidded as much as 20 points on Oct. 24, touching a low mark of 112 after having traded as high as 132 in the previous session. But shares of the Fairfield, N.J.-based waste disposal and renewable energy company also fell, ending at $17.72, or down 12%. So on a dollar-neutral basis, the bonds expanded 1.5 points or more, depending on the delta hedge.

"CVA went from a 100% delta down to an 85%, maybe even lower," a trader said, adding that the bonds expanded, but "guys were on all sorts of different deltas coming into today so it is hard to pinpoint exactly how much they expanded."

Covanta's third-quarter results beat estimates, but its full-year earnings forecast was lowered pretty significantly.

Losers in 2013

Cobalt International Energy Inc.'s convertible, one of the best deals of 2012, turned into a real lemon in 2013. In December 2012, Cobalt came at a 0.75-point discount to par, and traded up to 102 bid, 102.5 offered versus a $25.45 share price on its debut, which was better on a dollar-neutral, or hedged, basis by 0.5 point to a point. Shares of the Houston-based oil exploration and development company fell 7.3% on the same day.

But this past month, a year later, Cobalt took another leg down in active trade after reporting that its Gulf of Mexico Aegean #1 exploratory well didn't encounter commercial hydrocarbons after reaching its objective total depth. A few weeks earlier it had taken a leg lower after reporting that a key well in Angola registered higher natural gas levels than expected, thereby reducing the prospects for higher-margin oil.

Cobalt's 2.625% convertibles due 2019 have fallen from near par to the lower 80s and then pared losses to trade in the upper 80s.

Exide Technologies Inc.'s 0% convertibles cratered to 9 bid after a news article in early June said the Milton, Ga.-based car and machine battery maker was preparing for a potential bankruptcy filing by this summer. The small, $55.8 million issue of Exide convertibles, which matured in September, had previously been 30 bid, 40 offered.

In fact, the company filed for Chapter 11 bankruptcy protection the day after the news article.

The issue was first smacked down in early April to about 64 from 95, and the stock fell to $1.37 after word that the company hired Lazard to be its financial adviser. In February they were 95 bid, 96 offered.

Curb appeal

U.S. convertibles remain appealing heading into 2014. They boast a healthy yield of 3.2% (current yield of 2.9%), relatively short duration of 3.3 years, and an effective equity exposure of 58%. They have a weighted average time to maturity of 5.1 years and premium of 26%.

The combination of reasonable income, risk-controlled equity exposure, fair valuations, strong demand-supply technicals, expected vibrant primary calendar and lower duration relative to other asset classes has attracted some crossover investors of late.

Meanwhile the buyer base remains healthy with a balanced mix of arbitrage and long-only investors. Barclays puts this split at 53% and 47%, respectively. The bank also estimates leverage deployed by arbitrage funds saw a slight uptick in 2013 but that it remains modest at 1.5x to 2.5x. Liquidity also remains healthy both on an absolute basis and relative to the high-yield market.

"We expect strong issuance momentum to be sustained into 2014. Improved equity valuations due to strong returns, a potential end to a period of extraordinarily low interest rates, and an expected pickup in GDP growth should continue to drive normalized issuance levels. With projected redemptions of $31 billion face value in 2014, the Barclays convertible analysts estimate the market can easily absorb $55 billion to $65 billion of new paper.

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