Outlook 2021: Following ‘inflection point,’ convertibles issuance to moderate, pricing to tighten

By Abigail W. Adams

Portland, Me., Dec. 31 – It started on April 1, 2020 with Carnival Corp.’s $2.01 billion offering of three-year convertible notes.

The deal reopened a convertibles primary market that had been shuttered for almost a month as the Covid-19 pandemic ravaged markets.

Eight months later, the record for new issuance was shattered as the convertibles market exploded in popularity due to its unique ability to offer both issuers and investors attractive terms.

Issuers, both well-known and new to the market, unleashed deals at a dizzying pace with coupons low and conversion premiums high – terms made possible by elevated volatility and tightening credit spreads.

The ‘no-no,’ a convertible bond structure with a 0% yield, made a comeback in the final months of the year with the terms no longer exclusive to tech companies.

While yields were low, the deals modeled cheap and provided investors with outsized returns.

“It was a phenomenal year,” a source said.

The past year was an anomaly for the convertibles primary market.

Sources expect the pace of new deal activity to moderate in the coming year with issuance to return to pre-Covid levels as the need for financing decreases.

Terms are expected to remain attractive to issuers with the era of low to no coupons and high premiums extending into the coming year.

However, deals will be less attractive for investors with pricing expected to richen due to increased demand and reduced supply.

While new deal activity is not expected to rival the levels of 2020 for some time, sources were in agreement – the past year was an inflection point for the convertibles market.

The once niche asset class has risen in prominence and prestige and will increasingly attract diverse issuers and investors.

A new record

The convertibles primary market shattered records in 2020 with the highest volume of new issuance in more than two decades.

In all, $112.27 billion priced over 201 deals as of Dec. 16.

It was the first time issuance crossed the $100 billion threshold since the inception of the Prospect News database in 2001.

The onslaught of new issuance began in April as predominantly rescue financing.

Transportation, entertainment, retail and leisure companies turned to the convertibles market in record number to shore up their balance sheets amid the economic shutdown.

Carnival paved the way with industry peers Norwegian Cruise Line Holdings Ltd. and Royal Caribbean Cruises Ltd. quickly following suit.

Then came the airlines with Southwest Airlines Co. and American Airlines Group Inc., both pricing billion dollar plus offerings.

Southwest holds the record for the largest convertible bond deal of the year with its $2.3 billion issue of 1.25% convertible notes due 2025.

Several retailers also made their convertible market debuts in April, May, and June, which were the highest volume months for new deal activity of the year.

Retailers new to the market included Callaway Golf Co., Farfetch Ltd., American Eagle Outfitters Inc., Burlington Stores Inc. and Dicks Sporting Goods Inc.

The wave of rescue financing forever altered the composition of the convertibles universe.

“The breadth of issuers has widened dramatically,” said Venu Krishna, Barclays analyst and co-author of the report “U.S. Convertible Outlook 2021: The Convert Renaissance.”

Consumer discretionary companies accounted for 20% of new issuance in 2020, a larger portion than the typically dominant health care sector, according to the Barclays report.

Following the wave of rescue financing, the primary market saw serial issuers return in force to take advantage of rebounding markets and refinance outstanding convertible debt.

Chegg Inc., Zendesk Inc., Coupa Software Inc., Wayfair Inc. and Palo Alto Networks Inc. were a part of the refinancing wave, each bringing sizable offerings and using proceeds to take out a portion of their outstanding convertible debt in privately negotiated transactions.

New deal activity was driven by opportunistic issuers in the final months of the year as companies raced to take advantage of the post-U.S. election market surge.

The ‘no-no’ was the pricing structure of choice for the opportunistic issuers making late-year passes at the market.

The pricing

Equities skyrocketed, credit markets tightened, and investors stampeded back to risk assets following the U.S. election in November with a Biden administration in the White House and a divided Congress one of the best-case scenarios for capital markets.

Already attractive terms for convertible bond issuers became even more appealing.

“Right now, the backdrop is so supportive with credit spreads and volatility, we’re seeing a lot more opportunistic capital raises,” said Michael Youngsworth, BofA Global Research’s Head of Convertible Bond Strategy.

Deals with 0% coupons and 40% to 50% conversion premiums became commonplace in the final weeks of the year.

Of the $112 billion that priced in 2020, $49.39 billion came with coupons between 0% and 1%, according to the Prospect News database.

As of Dec. 18, there have been 29 deals totaling $17.48 billion that priced with 0% coupons in 2020, according to Prospect News data.

The ‘no-no,’ a convertible bond with a 0% coupon that priced at par, had made its comeback.

The practice of issuing 0% convertible bonds at par was common in the late 1990s and early 2000s.

“They were nicknamed ‘no-nos,’ in recognition that they had both zero coupons and zero original issue discounts,” a source said. “The concept was controversial at the time.”

End-of-year market conditions provided the perfect backdrop for no-nos and several sizable offerings priced as accounts prepared to close their books.

Uber Technologies Inc. priced a $1.15 billion issue of 0% convertible notes due 2025 at par with an initial conversion premium of 52.5%; Zynga Inc. priced a $762 million issue of 0% convertible notes due 2026 at par with an initial conversion premium of 50%; and Shift4 Payments Inc. priced a $690 million issue of 0% convertible notes due 2025 with an initial conversion premium of 45% in the final weeks of the year.

The pricing structure was no longer limited to high-growth, tech-oriented names.

DISH Network Corp. rivaled Southwest’s title for largest issue of the year with its $2 billion offering of 0% convertible notes due 2025, which priced at par with an initial conversion premium of 30%.

As of press time, the $300 million greenshoe had not been exercised.

And Vail Resorts Inc. priced a $575 million issue of 0% convertibles due Jan. 1, 2026 with an initial conversion premium of 47.5%.

The terms companies were able to price with were “mind-blowing,” a source said. “But what do you expect when vol. is high and credit is tight. It’s not shocking from a pricing perspective.”

Deal terms were the most aggressive they have ever been, Youngsworth said.

However, “from a modeling perspective, our data shows convertibles still looked relatively cheap,” he said.

Deals averaged 1.3 points cheap and saw large expansions in the aftermarket, according to the Barclays report.

While the cheapness of deals started to fade into the final weeks of the year, the majority continued to perform well in the aftermarket.

Uber’s offering was marketed with assumptions of 400 basis points over Libor and a 42% vol., which looked 0.75 point rich at the midpoint of initial talk, sources said.

However, initial price talk of a coupon of 0% to 0.25% and an initial conversion premium of 42.5% to 47.5% was revised due to heavy demand.

The deal looked rich based on tightened talk of a fixed coupon of 0% and an initial conversion premium of 50% to 52.5%, sources said.

Despite that, the 0% notes were strong in the aftermarket and traded up to 104.5 on an outright basis and expanded 3 to 3.5 points dollar-neutral on their Dec. 9 debut.

Terms are expected to remain attractive to issuers in the New Year.

However, the trend toward cheapness may have run its course with new paper to become increasingly rich as supply diminishes.

The supply

The past year shattered records for new deal volume, and it is a record that 2020 is expected to hold for some time.

The convertibles market will remain attractive to issuers and new deal activity will remain robust.

However, sources expect volume to fall closer to 2019 when $58.38 billion priced over 136 deals – 2019 was also a record-setting year and, prior to 2020, held the title for the highest volume of new issuance since the Global Financial Crisis.

New deal volume is expected to be $60 billion to $65 billion in the coming year – almost half of what priced in 2020 but still an elevated amount historically, according to the BofA Global Research report “Global Convertibles: Year Ahead 2021: A silver lining can still shine.”

The market could easily absorb $80 billion in supply, according to the Barclays report.

The decreased supply in 2021 will largely be a result of decreased need, sources said.

The majority of refinancing for paper coming due in 2022 and 2023 has been done, a source said.

The next refinancing wave is not expected until companies start to address convertible notes coming due in 2024 and 2025.

While there may be additional ‘rescue financings’ in the coming year, they will not be a driving force for new issuance.

Interest rates are expected to remain low with many potential crossover issuers choosing straight debt over convertible bonds.

However, the void left by the potential issuers that will be lost to other asset classes will be more than filled as diverse issuers continue to tap the market to take advantage of attractive terms.

The base

The composition of the convertibles universe changed dramatically in 2020, and the diversification of the issuer base is expected to continue in 2021.

While issuers will remain concentrated in health care and technology, REITs, industrials, financials, and entertainment and leisure companies are all expected to be active issuers in the coming year.

As the issuer-base grows, so too will the investor base.

“The sector and issuer composition has significantly broadened the investible opportunity set for investors, especially as we enter an economic recovery phase,” the Barclays report stated.

There was a significant amount of tourism in the convertibles market in 2020, Youngsworth said.

Crossover investors became buyers of convertible bonds like never before, fueling the demand for new deals – the majority of which were heavily oversubscribed in the final months of the year.

Fund flows to the traditional buyers of convertible notes are expected to remain strong with outright and hedge players to remain the dominant players in the universe.

However, credit, equity and other crossover investors are expected to continue to turn to the convertibles market, especially as returns from other asset classes become increasingly sparse.

With the investor base increasing, supply decreasing and the macro backdrop remaining supportive, sources expect the relatively cheap pricing of convertible notes to become increasingly rich.

The future price

While there are scenarios that could shift the dynamic, 2021 is expected to be a seller’s market.

Credit markets are expected to grind tighter and equities higher in the coming year, supporting the aggressive deal terms that categorized the final months of 2020.

While moderating volatility may alter the trajectory, sources expect even more aggressive pricing in the coming year.

“The question is whether there will be negative yields,” a source said.

Negative yields have become commonplace for Regulation S offerings and may make an appearance in the domestic market as well.

Banks have been actively pitching the pricing structure to potential issuers, a source said.

However, issuers may be more interested in pricing deals with higher premiums, which can be more beneficial than the income received from a nominal yield, the source said.

While negative yields are not beyond the realm of possibility, it may be more likely for aggressive pricing in 2021 to manifest in longer maturities.

The five-year standard for convertible bonds may push out to six or seven years, a source said.

While terms are expected to remain attractive for companies, deals are expected to become increasingly rich with returns moderating.

Despite this, demand is expected to remain high.

Convertible issuance will shrink from its current levels in the coming year. However, the asset class is expected to continue to grow in prestige and notoriety.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.