Outlook 2020: Convertible issuance sets record; net supply expected to double in 2020

By Abigail W. Adams

Portland, Me., Dec. 31 – Convertibles supply was strong and the deals trended cheap in 2019, which was another record setting year for the primary market.

New deal volume topped $58 billion in 2019, an $8 billion or 16% increase from the previous post-financial crisis record set in 2018.

Repeat issuers, mandatory offerings and foreign-based corporations drove supply, which came on more favorable terms for investors than in previous years.

New deal activity is expected to temper in 2020. However, the trend toward cheapness and the diversification of issuers is expected to continue.

And, with redemptions and maturities lighter than in previous years, the net supply is expected to more than double.

A record setting year

Views were mixed about new deal volume heading into 2019 with some predicting a pullback after the primary market in 2018 logged its best year for new issuance since the financial crisis.

For much of the year, those expecting a decline in new deal volume were right with primary market activity lagging in the first half of the year.

Then came August and September.

September saw the highest new deal volume in nearly a decade, sources said.

The third quarter saw $22.4 billion in new issuance, the most issuance in a quarter since the Barclays Bloomberg Index was created, according to the Barclays report “U.S. Convertibles Outlook 2020: Room to Run.”

The convertibles primary market priced approximately $58 billion in 136 deals, according to Prospect News data. It was the best year for new deal activity since the financial crisis.

Net supply rose to about $12 billion, a more than 395% increase from the net supply of $2.4 billion in 2018, according to the Barclays report.

The low rate environment, sky-high equity markets and easing trade war tensions created the perfect recipe for issuers to tap the convertible market, sources said.

And they did.

The issues

There were several interesting features to the new deal activity of 2019, sources said – the amount of volume from repeat issuers, the surge in mandatory issuance, the number of foreign-based corporations tapping the market, and the diversification of industries tapping the market.

Many of the convertible bond deals of 2019 came from repeat issuers of convertible notes – many that had tapped the market as recently as 2018.

Akamai Technologies Inc., Okta Inc. and Zillow Group Inc. were among the issuers that tapped the market again after pricing deals in 2018; each came with deals that were $1 billion plus.

“There was no reason not to,” a market source said. “It was a good time to raise money.”

With the recently priced issues by the companies not trading too rich, it was easier for them to retap the market.

The outstanding issues did not take too big a hit from a new offering, so there was no backlash from investors, a market source said.

Mandatory issuance also surged in 2019 and accounted for 28% of the new deal volume compared to 14.2% in 2018, according to the Barclays report.

Investment-grade companies in need of a capital raise tended to price mandatory convertibles as opposed to straight debt to protect their rating status, a market source said.

Broadcom Inc.’s $3.25 billion issue of series A mandatory convertible preferred stock was the largest deal of the year.

There was also a growing trend of foreign-based corporations tapping the convertible market, especially companies from China.

Pinduoduo Inc., YY Inc. and iQIYI Inc. were among the China-based internet companies to price large offerings in 2019 as U.S.-Sino trade war tensions ebbed and flowed.

There were about 14 deals from emerging market countries with the “ADR space” a growing corner of the market, a source said.

Traditionally, a country’s sovereign debt has been a benchmark with companies unable to issue straight debt with a lower yield. “That’s been thrown out the window,” a market source said.

Emerging market issuers have been able to issue convertibles with yields well below their sovereign debt because their market caps are large and their vol. is high, a market source said.

And the deals are sought after by convertible investors.

“Arb guys play it, outright guys play it if they feel comfortable they’ll get their money back,” a source said.

The influx of emerging market paper also helped diversify the convertible universe.

While the universe remains dominated by tech and health care, other sectors are beginning to have more of a presence, sources said.

Real estate investment trusts, utilities, industrials and cannabis companies were all contributing to a broader base for the convertible universe, sources said.

Cheap

While pricing of new issuance has tended to be rich in the post-crisis era due to demand, deals were starting to cheapen.

Deals tended to come about 1% cheap in 2019, said Venu Krishna, Barclays analyst and co-author of the report “Room to Run,” compared to about 0.5% cheap in 2018.

“It was fairly sane issuance this year,” a market source said. “Nothing was stupid cheap. No one got piggy on pricing.”

The cheaper pricing was attributed to a shift in the supply-demand dynamic in the universe, which was becoming more balanced with the influx of new paper.

Traditionally, demand far outstripped supply in the post-financial crisis convertible universe.

There was also a growing trend of confidential, over-the-wall marketing for new deals, which helped keep the pricing reasonable, a market source said.

“Accounts are having more say in pricing,” the source said.

Trends to continue

Sources were mixed on whether some of the trends seen in 2019 will spill over to the new year.

While diversification among issuers is expected to continue, tech and health care will remain the dominant sectors of the convertibles universe, sources said.

Whether or not China-based companies will continue to tap the primary market will largely depend on the status of trade talks, sources said.

If the relationship deteriorates in the coming year, issuance from China-based corporations is expected to dry up.

However, if the relationship improves, sources expect to see more activity in the ADR space from China-based companies.

So long as market conditions remain supportive, convertible issuance is expected to remain driven by well-known names in the universe.

And while new deal volume is not expected to reach 2019 levels, the supply-demand dynamic is expected to continue to support cheap pricing.

The growing universe

New deal volume in 2020 is expected to remain robust provided credit and equity markets remain supportive, sources said.

The 2020 elections and developments on the trade front will be an enormous wildcard for markets.

However, the increased volatility will be a boon for convertibles, as long as it does not affect the company’s fundamentals, a market source said.

While equities are at all-time highs, the equities underlying the convertible universe still have room to grow, which will support new issuance.

To the extent the economy remains healthy and M&A activity continues, there will be a need for growth capital, Krishna said.

While the environment is expected to remain supportive of new deal activity in 2020, few expect issuance to top the current year.

However, with redemptions expected to be significantly lower in 2020, net supply is expected to increase.

Barclays estimates absorption capacity of $41 billion to $46 billion in 2020. With redemptions expected to be $19 billion, the net supply is estimated to be $27 billion in 2020 – more than double the current amount.

The trend of negative net supply in the post-financial crisis convertible universe was an enormous concern, a market source said.

However, the contraction of the market seems to be in the rear view.

“At the end of the day, the net supply is growing, the market is growing,” Krishna said. “It’s a very healthy trend.”

© 2015 Prospect News.
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