Outlook 2014: U.S. primary market looks stronger after 'turning a corner' in Q4; terms may cheapen

By Rebecca Melvin

New York, Dec. 31 - The outlook for new issuance in U.S. convertibles is bright and expected to be as strong, if not stronger, than this past year when the convertible primary market "turned a corner" in the fourth quarter, seeing more than a third, or $16.6 billion of the year's total $49.03 billion in new issuance launched and priced.

The convertible primary market "turned a corner" in 2013; and looking ahead, "we expect issuance to continue to gather steam in 2014...." Barclays convertible analysts Venu Krishna, Manoj Shivdasani and Piyush Anchliya wrote in their global convertibles outlook report, published Dec. 13.

The analysts said their forecast was based on a continuation of the backdrop of improving domestic growth, a pickup in capital spending and gains in equities.

Additional drivers for new convertible issuance are the return of fund flows into equities, a diversified, fundamental buyer base, including equity and credit, a benign funding rate environment and strong demand for balanced paper, the Barclays analysts said.

Stronger issuance ahead

A New York-based syndicate source said issuance of $50 billion to $60 billion is reasonable "on the back of some investment-grade issuance and continued flow in non-investment grade and non-rated issuers."

But financial markets will be watching the pace of the Federal Reserve's taper of its asset purchasing program under its third round of quantitative easing to see if the phase-out proceeds and how it affects rates and, subsequently, equities.

The unfolding of events with the Fed taper could either hinder or encourage new issuance, sources said.

On one hand, the 2014 taper of the Fed's quantitative easing program may create a backup in rates that encourages new issuers to the market.

"I would expect it to go higher," a West Coast-based trader said of new issuance. "Would-be high-yield issuers might come to our market to save on coupon."

On the other hand, higher rates could contribute to lower equities, and as such that would discourage would-be issuers that like to issue convertibles at the top of their stock price.

The taper could contribute to a correction in the stock market, and high stocks are an important ingredient for new issuance, sources said.

Barclays analysts said, "Risks to the positive outlook include a stock market correction and continued low all-in yield credit markets against a backdrop of low interest rates."

No one knows what will happen, sources agreed, but one thing is certain, market players will be watching the process carefully and they aim to be flexible enough to react to the impact of either more or less issuance in the market, and its effects on the secondary market.

Market still hungry

The investor base for convertibles is still hungry for new issuance, which had been depressed for several years prior to the recent uptick. Despite a short-lived dip in the market, resulting from the sudden onslaught of supply, pricing recovered to levels where they had been before.

Even though more paper materialized in the market than had been the case for several years previously, there was still a big chunk going out, with the net result that company redemptions, or paper leaving the market due to calls, puts or maturities, was nearly equal to new paper entering in 2013.

Issuance in 2013 stood at $49.01 billion in 157 deals as of Dec. 23, according to Prospect News data. Market redemptions totaled about $47 billion, resulting in a "tepid net supply," Barclays analysts said. They estimate that for the coming year there is significant absorption capacity for up to $60 billion to $65 billion.

As least several large redemptions hit in the middle of last year, including the June 1 maturity of NetApp Inc.'s $1,265,000,000 of 1.75% convertibles. Earlier in the year on Feb. 14, Amgen Inc.'s $2.5 billion of 0.375% convertibles "went away" due to maturity.

Nevertheless, the new issuance tally for 2013 was the highest since 2009 - or 2008, depending on the data used. (2009 was the year that Prospect News' data was boosted by Bank of America Corp.'s $19.3 billion of common equivalent securities, an issue that wasn't considered a true convertible by many market players and therefore not included in new issuance volume totals.) Meanwhile, since 2009, the primary market has slid every year since to a nadir of about $22 billion in new paper in 2012.

The tight supply combined with the attractive coupon income that convertibles provide has resulted, and will continue to result, in substantial appetite from investors, the Barclays analysts said.

On the supply side, catalysts for increased issuance include rising interest rates and improved equity valuations, the analysts said.

In addition, they believe that the market has adequate pent up demand and absorption capacity to digest the expected sustained issuance: "We project the potential for redemptions at $30 billion in 2014 and estimate absorption capacity at roughly $55 billion to $65 billion in 2014, assuming $10 billion organic growth recovery and $5 billion of buybacks.

New, improved run rate

Fully one-third of 2013's issuance, or $16.6 billion, came in the October to December time frame.

"I think that the attractiveness of the convertibles market will carry over to the new year, although there are accounting and dilution issues that could curb its appeal," a West Coast-based market player said.

"I think that the attractiveness of the convert will carry over to the new year despite those issues. If I were a company I would be doing a convertible. But it all depends on accounting procedures and how the convertibles sit on their books and whether they bifurcate it. Each company is specific how they do the accounting," the market player said.

A second market source said that he expected the uptick in new issuance in the past few months to continue in 2014 "if equities move higher, and credit remains stable or slightly improves."

A third source was not as sanguine.

"Who knows if the run rate that we saw in the last few months will continue into next year. We gauge investors' sentiment in new issuance for next year and we are not sure that it's sustainable," he said. It will depend on the backdrop.

Economy eyed

As for what's ahead for the economy and financial markets, Barclays strategists expect rates to continue to drift higher in 2014 largely reflecting a baseline view that the economic backdrop in the United States will continue to improve. Gross domestic product growth in the United States will improve to roughly 2.5% in 2014, short of the pace the Fed and consensus expect, which is 3% and 2.8%, respectively.

Barclays equity strategists put the 2014 year-end price target for the S&P 500 stock index at 1900, based on their earnings forecast. Price/earnings multiples are expected to contract as the valuation expansion during 2013 seems to have discounted much of the improvement in earnings growth. The key upside risk is growth accelerating beyond current expectations.

Despite the fundamental improvement, evidenced by the analysis of business cycles, the current mix of earnings growth and valuation appear somewhat unfavorable for stock market returns in 2014 in any environment other than when the Fed is increasing monetary accommodation.

On the positive side, the market message seems clear - growth is improving - but the rally fueled by multiple expansion has pushed valuations slightly beyond mid-cycle levels. The risks to the forecast include continued below potential growth could lead to a sharp correction in the cyclical stocks. Also, Fed policy-related correction could be steeper given exit delay and valuation levels.

Improving price points

Pricing of new issues was skewed in favor of issuers in the past year, with convertibles coming at lower yields and higher initial conversion premiums.

Pricing power was on the side of issuers and there were more than a couple opportunistic financing deals that were completed, including Priceline.com Inc.'s $1 billion of 0.35% seven-year convertibles, priced early in the year, and Yahoo! Inc.'s $1.35 billion of 0% five-year convertibles, priced late in the year.

But looking ahead the consensus is that new deals will come more cheaply to investors as issuance levels pick up. Yields should rise and premiums fall. At the same time lower yields and higher premiums were what attracted new issuers to the convertible market in the first place.

"More issuance leads to better terms for investors, so coupon/premium will be better for investors," a New York-based trader predicted for 2014.

The yield-premium trend in convert new issuance for 2013 was for paper on average yielding 4.8%, with an initial conversion premium on average of 24.3%. That compared to an average 6.1% yield and 27.8% initial conversion premium in 2008 - which was very favorable to investors. In 2007, the average coupon was 3.2% for new issuance and a 30.9% premium.

Coupons, which ticked lower in 2013, should regain previous levels given that interest rates are generally expected to move higher. Premiums, some of which have been very high, need to stay low, especially given that stock markets have climbed.

Theoretical cheapness and one-day delta hedged performance attest to both attractive valuation and strong demand of converts.

Such cheapness allowed many deals to get done successfully and then expand upon release to the secondary market.

Tesla tops 'best deal' list

The best new issues of 2013 were both big and small deals and were dispersed evenly throughout the year, although the bulk of new issuance priced in the October-December time frame. In terms of the equity market backdrop, there was only one trend: up, albeit with evenly spaced pullbacks. (But for all intents and purposes, since March 2009 when equity markets bottomed, they have been on a sustained run.)

Nearly everyone agrees that one of the best deals of 2013, hands down, was Tesla Motors Inc.'s upsized $660 million of five-year convertible bonds, which priced on May 16 at par to yield 1.5% with an initial conversion premium of 35%.

"Tesla is a marquee name," a New York-based trader said. And while it performed OK on its debut and did extremely well subsequently, "it's more than performance," the trader said. "I think it helped make the space trendy to issuers once again."

The Tesla issue came at the rich end of price talk, which was tightened during marketing. There were also concurrent stock offerings. And the deal came with a call spread, as did many new issues this past year, as the trend toward call spreads grew.

Goldman Sachs & Co., Morgan Stanley & Co. LLC and J.P. Morgan Securities LLC were the joint bookrunners of the notes for Tesla, which is a Palo Alto, Calif.-based maker and marketer of fully electric vehicles and electric vehicle powertrain components.

At the time of the deal, the company had a market capitalization of $10.6 billion.

About $452.4 million of proceeds from both the convertible and equity offerings went toward prepayment of a Department of Energy loan, about $50.9 million will pay for the bond hedge and remaining proceeds from the offerings plus the subsequent private placement of shares will be for general corporate purposes.

"Tesla is probably your No. 1," a second New York-based trader said, regarding the year's best deal. "It's got old-style, sexy growth and it's a high vol. name."

The second trader mentioned that on first-day trading it went to 104 and now trades in the 140s.

The big and the small

Like 2012, the convertibles market also saw a number of larger, $1 billion deals, which were helpful in attracting a broad swath of investors and promoting liquidity in a space that often suffers from light trading trends.

In addition to Priceline's $1 billion of 0.35% convertibles priced in the spring and Yahoo!'s $1.25 billion of 1% convertibles priced late in the year, there was SanDisk Corp.'s upsized $1.3 billion of 0.5% seven-year convertibles, which priced in late October, and a number of dual tranche deals that were pretty toppy in size, including Cubist Pharmaceuticals Inc.'s $800 million of convertibles in two tranches that priced in early September, following by a similar deal by BioMarin Pharmaceutical Inc.'s $700 million of dual convertible bonds in early October.

Even though pricing was seen as rich to start, "SanDisk is a pretty appreciated story," an East Coast-based analyst said, and he thought that it was likely to continue to richen like other recent new issues that came with pretty tight pricing.

"Other new issues have richened up 3 or 4 points," the analyst said, referring to Cubist Pharmaceuticals and BioMarin Pharmaceutical.

In early September, Cubist priced a dual-tranche deal of $300 million of 1.125% convertibles due 2018 and $400 million of 1.875% convertibles due 2020. On a dollar-neutral, or hedged, basis, the Cubist As jumped about 4 points on their debut, while the Bs gained about 2 points delta neutral.

In early October, BioMarin priced $340 million of 0.75% convertibles due 2018 and $340 million of 1.5% convertibles due 2020.

In addition, there was Micron Technology Inc.'s upsized $600 million of convertible senior notes that priced in February and have subsequently done well, investors said.

Micron's deal included $300 million of 1.625% convertibles referred to as the E notes and $300 million of 2.125% convertibles referred to as the F notes. Both series have a 37.5% initial conversion premium, according to a syndicate source.

Pricing came at better than the tight end of talk on the E notes, which was for a yield of 1.75% to 2.25% with an initial conversion premium of 32.5% to 37.5%, and at the tight, or rich, end of talk on the F notes, which was for a 2.125% to 2.625% yield and 32.5% to 37.5% premium.

The E notes are non-callable until Feb. 20, 2018 and are freely callable thereafter, with investor puts at Feb. 15, 2018 and Feb. 15, 2023.

The F notes are non-callable until Feb. 20, 2020 and are freely callable thereafter, with investor puts on Feb. 15, 2020 and Feb. 15, 2023.

Morgan Stanley, Goldman Sachs and JPMorgan were the joint bookrunners of the deal for Micron, a Boise, Idaho-based maker of semiconductor devices, which at the time of the deal had a market capitalization of $8.12 billion.

Call spread highlighted

In connection with the convertibles, Micron entered into capped call transactions with counterparties that lifted the premium from the issuer's perspective to 82.5%. The call spread accompanied many of the year's deals and was a pronounced trend. The feature lifts the initial conversion premium of the bonds from the issuer's perspective.

At the other end of the spectrum, Horizon Pharma Inc., which at the time had a market capitalization of about $400 million, was also considered a winner with its deal for $150 million of five-year convertibles that were priced to yield 5% with a 20% initial conversion premium on Nov. 19. It is a prime example of one of the market's most successful deals from the investors' perspective.

JMP Securities LLC and Cowen and Co. LLC were joint as lead bookrunners of the Section 4(a)(2) and Regulation D Horizon deal, which priced on an overnight basis.

Horizon's deal also came with a capped call with initial investors that are expected to raise the effective conversion premium of notes from the issuer's perspective to about 50%.

Deerfield, Ill.-based Horizon Pharma is a specialty pharmaceutical company focused on primary care orthopedic surgeons and rheumatologists.

"Horizon was the best. It went to 125 before it even settled," a syndicate source said.

The stock was obviously a big driver, but the bonds did well on the way up, as well," the source said. Currently the Horizon 5% convertibles are at 138 with the underlying shares at $6.75.

The mandatory convertible preferred offering of Maiden Holdings Ltd. at the end of September was upsized to $150 million and priced at the midpoint of talked terms for a 7.25% yield and a 25% initial conversion premium.

Given a general scarcity of new paper at that time, some thought the deal was likely to be played by both outright and hedged players despite the fact that the three-year, set strike structure has traditionally appealed to outrights.

"I think now people are willing to take a shot at anything," a New York-based trader said.

A look at issuers

Financials and discretionary were the biggest issuers in 2013 with 40% of the issuance pie. Small and mid-cap companies, with market caps of less than $8 billion, accounted for 65% of issuance.

Many market players expect new issuance in the coming year to build on stronger-than-expected deal volume in 2013, especially in light of expected tapering of the Federal Reserve's quantitative easing program and likely backup in rates.

"Would-be high-yield issues may come to our market to save on coupon," a New York based syndicate source said.

Over the past few years, the buyer base mix has shifted in favor of fundamental outright investors. They account for 47% in 2013, up from 26% in 2007, according to Barclays analysts.

Leverage deployed by arbitrage funds also continued to remain modest at 1.5x to 2.0x.

The funding markets have been functioning efficiently and are likely to remain so but for any serious risk flares. Anecdotally, fund flows have recently picked up, driven by strong returns and preference for equity exposure in a rising-rate environment.

As net supply has been lower than expected, demand for the product remains strong as well.

"We view these factors as favorable to the marketplace. Liquidity, though, has been trending lower and is a cause for some concern although the declines are not as sharp as what has been observed in the high-yield market. With a continued pickup in primary market activity we expect the liquidity to improve," the Barclays analysts said.

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