Outlook 2012: Convertibles primary market set for weakness without higher rates, stronger economy

By Rebecca Melvin

New York, Dec. 30 - The level of new issuance in the convertible bond market in 2012 is expected to be more or less flat compared to the anemic $25.93 billion in 84 deals tallied in 2011, market sources say.

In the absence of higher interest rates, market players do not foresee any catalyst that could spur a significant ramp up in new issuance of convertible bonds.

New issuance for 2011 dropped for the fourth straight year, down 40% from $42.75 billion of convertibles in 100 deals tallied in 2010 and down more than 50% from $59.57 billion in 119 deals for 2009 and $61.8 billion in new issues in 2008, according to Prospect News data.

The weakness of new issuance in 2011 was seen mostly in the second half, and particularly in the last four months of the year, when new issuance across the spectrum of asset classes slowed.

"This year might not have been so bad without the last four months when there was almost no issuance," a New York-based syndicate source said.

The European debt crisis and uncertainty following a downgrade of U.S. debt to AA+ from AAA put a huge damper not only on the convertibles primary market but on the capital markets in general.

But unlike 2008 when there wasn't a single new issue in the convertible market after the first half of September, a trickle of deals, or about $3 billion in 11 deals, continued into the fourth quarter.

Even as markets gyrated in the second half of the year, issuers "opportunistically tapped the market during calmer intermittent periods, indicating that if normalcy were to return, new issuance would likely pick up," Barclays Capital Inc.'s U.S. convertibles research team said in a report published Dec. 15.

Uncertainty clouds forecasts

Neither Barclays nor other convertibles desks opted to publish a specific forecast for new issuance in 2012, citing too many wildcards potentially undermining such a prediction, but most anticipated that 2012 would bring more of the same as in 2011.

One source, however, bet 2012 new issuance would edge a little higher to $30 billion to $35 billion for the coming year.

His prediction was based on stabilization in the markets, with improvement in the economy in the second half. Still, demand for growth capital and restructuring capital would remain low, keeping a lid on corporate funding needs, he said.

"There are not a lot of deals anywhere," the syndicate source said, referring to the investment-grade and other debt markets.

That second half stood in contrast to the first half of the year when demand for new issuance was called robust, and deals were upsized and priced at the rich end, Barclays said.

By sector, the top three groups of new issuers in 2011 were financial companies, at 30%, information technology companies, comprising 26% and health care companies, accounting for 18%.

After that, materials was a distant fourth, accounting for 9% of new issuance, and energy was well down the totem pole, at 2%.

Issuer quality improves

Investment-grade issues comprised about 25% of total new issuance, compared to 19% of total issuance in 2010 and 24% in 2009. Small and mid-cap issues dominated issuance, accounting for 80% in 2011 compared to 53% in 2010 and 47% in 2008, Barclays said.

While the slight improvement is welcome, market players don't anticipate any significant shift in issuer composition in the near to medium term.

"No one expects a return of investment grade, multibillion dollar deals" of the likes of a Microsoft Corp., which issued $1.15 billion of 0% convertibles due 2013 in June 2010, or a Bank of America Corp., which priced $19.3 billion of common equivalent securities in December 2009, a New York-based sellsider said.

"All these investment grade, billion dollar deals are gone for the foreseeable future," the sellsider said, citing low borrowing costs making the straight bond markets an unbeatable competitor.

In addition to the low rates that make straight bonds attractive, stock prices are currently low and would-be corporate issuers don't want to issue convertibles when shares are low. "No one wants to sell their stock lower than they have to," a New York-based sellsider said.

Another sellsider called convertibles a "niche market place that serves the purpose of certain issuers." Generally, these borrowers are in developmental stages of business or don't have access to the straight bond markets.

In 2011, non-rated companies accounted for 66% of new issuance, Baa accounted for 25%, Ba accounted for 3% and B accounted for 6%, according to Barclays Capital.

"When you eat at Denny's, you don't plan to go there, you just end up there," a sellsider said, comparing the restaurant to the convertibles market.

"I'm not seeing it getting any better unless we have an increase in interest rates. Unless rates back up 100 basis points, or if a company doesn't have access to the straight bond market, we're not going to see much issuance," the sellsider said.

But there is potential market absorption capacity of about $85 billion in 2012, according to Barclays.

Pricing deterioration

Despite what appeared to be some weakening in the primary market in terms of pricing in the second half of the year, new deal terms in 2011 were in line with those of 2010. The average coupon level was 3.8% in 2011, compared to 4% in 2010, and the average initial conversion premium was 27.5% in 2011, compared to 26.3% in 2010, according to Barclays Capital.

"I'm not seeing anything any better unless we have an increase in interest rates," a New York-based trader said.

But while market players thought pricing needed to improve from the investors' perspective, or to cheapen, due to increased risk aversion, they didn't think that the discounting seen in the second half was going to become a trend.

"The mispriced deals are not a trend, it's just that there has been so little volume, that people are doing more desperate things and underwriters are not doing a great job gauging the market. It's harder to be spot on in a less liquid market, so you can see how Goldman would make a mistake on Regeneron," a New York-based sellsider said.

In October, Regeneron Pharmaceuticals Inc. sold $400 million of 1.875% convertibles via Goldman Sachs & Co. that had to be reoffered at 98 and slipped lower from there upon release to the secondary market. The new paper of the Tarrytown, N.Y.-based biotechnology company failed to gain traction due to stock borrow problems on the convertible arbitrage side and probably its low coupon on the outright side.

"Regeneron was a hung deal. The banks got stuck with it; Goldman got stuck with it," a New York-based syndicate sources said.

There were other repricings as well, including Human Genome Sciences Inc.'s upsized $430 million of 3% convertibles which priced at a discount of 99 via bookrunner Citigroup Global Markets Inc.

With lower underlying shares, even deals that priced at the beginning of the year at par weren't looking too good by the end of 2011.

Savient Pharmaceuticals Inc.'s 4.75% convertibles due 2018, which priced Jan. 31, 2011, traded at 64 versus an underlying share price of $2.60 recently. Shares of the East Brunswick, N.J.-based biopharmaceutical company lost almost 75% of their value in the last year and were downgraded by JMP Securities in early November to "market underperform" from "market perform" on expectations of lower sales of its gout drug, Krystexxa.

Repricings not seen as trend

As for whether more repricings are to be seen in the future in 2012, sources said they thought it all depended on how the new issue does overall, and that depends on market stabilization and whether the market rallies in the second half of the year.

New deal winners

There were some winners in the new issue market as well. In July, Electronic Arts Inc. priced $550 million of 0.75% convertibles via bookrunners J.P. Morgan Securities LLC and Morgan Stanley & Co. Inc., which traded up modestly upon release to the secondary market after pricing at the rich, or aggressive, end of talk.

At the time, the deal's, simple structure, a five-year, non-call, no put, bullet, was praised as having a positive influence on the deal, which had strong demand also due to the company's strong credit.

Later in the year, the Electronic Arts convertibles slipped in tandem with their underlying shares; in late December the paper was trading at 96.375, according to a syndicate source.

United Therapeutics Corp. priced a $250 million issue of 1% convertible senior notes in mid-October via underwriter Deutsche Bank Securities Inc. It was the first new issue to break after some time and was said to have done OK in its first week of trading in the secondary market, although the market wasn't "all that impressed by the terms," one source said at that time.

Shares of the Silver Spring, Md.-based biotechnology company are down about 20% from the August market meltdown but down only about 7% from the new issue in October.

Also in October, Nuance Communications Inc. priced $600 million of 2.75% convertibles, which were recently trading at 103.5.

While the debut for the Micron Technology Inc. $600 million deal of 1.5% and 1.875% convertibles sold via Morgan Stanley & Co. Inc. and Lazard Capital Markets LLC as joint lead manager was lackluster, the convertibles have done pretty well on a hedged basis given the volatility of the stock and depending on the hedge.

The bottom line is that stocks have struggled in the last year especially among convertibles issuers, and that has taken the bloom off the rose for many convert players in these names.

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