Outlook 2022: Convertibles issuance to moderate, pricing to cheapen in 2022

By Abigail W. Adams

Portland, Me., Dec. 31 – It was feast or famine for the convertibles primary market in 2021 with the past year marking both the highest and lowest monthly volumes for new paper in two decades.

While three months accounted for more than 50% of new issuance in 2021, the primary market still logged one of its highest volume years in decades.

High-momentum growth names drove the timing and pricing of new issuance with torrents of new paper unleashed amid record heights and tights for equity and credit markets.

The No-No, a 0% coupon convertible bond that priced at par, increased its market share, accounting for about 42% of total new deal volume.

However, the macro backdrop that gave rise to the surge in issuance with aggressive pricing has already changed.

Sources expect that change to be reflected in the primary market activity of the coming year with issuance to moderate and pricing to cheapen.

However, while issuance is expected to temper in the coming year, investor demand for the asset class will remain strong.

And while the aggressive pricing of 2021 is expected to wane, the convertibles market will remain attractive for issuers.

The flood and the draught

The convertibles primary market roared into 2021 with the first quarter shattering records for new issuance.

In the first three months of the year, 77 deals totaling $41.93 billion priced, according to the Prospect News database.

More than half of first-quarter issuance came in March alone with 44 deals totaling $25.05 billion pricing.

It was the largest monthly total in the history of the Prospect News database, which dates back to February 2001.

However, as issuers stampeded to price convertible bonds in March, the bull market showed signs of waning.

The growth stocks driving the surge in convertibles issuance were beaten down amid a rising 10-year Treasury yield and the GameStop short-squeeze fiasco that called equity valuations into question.

While the primary market slowed substantially in the second quarter, it continued at a steady pace with a base of $5 billion a month.

However, new deal activity became increasingly choppy as the year progressed with equity and credit markets pricing in an end to the Federal Reserve’s pandemic-era stimulus.

Only one convertible bond deal priced in July, and the primary market went dormant in October.

October 2021 marked the lightest volume month for new issuance in the Prospect News database.

However, October was followed by a surge of new deal activity in November as positive earnings reawakened the bull run and the S&P 500 index and Nasdaq Composite again hit all-time heights.

Nineteen deals totaling $12.71 billion priced in November – five of which were No-Nos and nine of which had coupons of 0.5% or under.

While the primary market set the record for both the heaviest and lightest month for new deal volume in the past two decades, 2021 still ranks as the fourth largest year for new issuance since 2001.

Approximately $92.82 billion priced over 168 deals.

While a decrease from the $112.65 billion that priced over 202 deals in 2020, the convertibles market continued its net expansion with net supply increasing $46.1 billion in 2021, according to the Barclays report “Grinding Higher: U.S. Convertibles Outlook 2022.”

Combined with the $67.8 billion net expansion in 2020, the convertibles market increased in size to $383.43 billion.

The new deal activity was driven by growth companies capitalizing on credit and equity conditions that enabled the most aggressive pricing in the market’s history.

However, the high-multiple stocks of the companies driving new issuance were particularly vulnerable to the inflation, rising rates and rotation to value stocks that rocked equities throughout the year.

Oh-No

The surge in convertibles issuance came amid all-time heights in equities and tights in credit markets.

The environment was reflected in the pricing of deals with more than 70% of new issuance coming with coupons of 1% or under and 38% of new issuance carrying conversion premiums of 40% or higher, according to Prospect News records.

The No-No accounted for approximately 42%, or $37.5 billion, of total new deal volume in 2021.

“The pricing was richer this year,” said Venu Krishna, Barclays’ analyst and co-author of the report “Grinding Higher.”

However, the pricing was a product of the environment.

Strong demand from a convertibles market that has been starved for new issuance for over a decade, coupled with a macro backdrop bolstering risk assets fueled the stampede of issuance with aggressive pricing.

Young tech companies with limited credit history and substantial equity appreciation drove new deal activity.

The aggressive pricing secured by these companies, “helped create a feedback loop, encouraging more issuers to launch CBs opportunistically – ultimately, CBs had become too attractive for borrowers to ignore,” BofA analyst Michael Youngworth wrote in the report “Year Ahead 2022: The best of what’s around.”

While convertibles issuance has historically been driven by companies in need of growth capital and liquidity, the past year saw a new class of growth companies tap the convertibles market – de-SPACed companies.

Approximately $10 billion to $12 billion in new supply in 2021 came from companies that went public through SPAC mergers, Krishna said.

Affirm Holdings Inc.’s $1.725 billion issue of 0% convertible notes due 2026, SoFi Technologies Inc.’s $1.2 billion issue of 0% convertible notes due 2026 and Lucid Group Inc.’s $2.01 billion issue of 1.25% convertible notes due 2026 were among them.

Deal terms were aggressive. Yet they continued to model cheap based on underwriters’ assumptions.

However, their longer-term secondary market performance did not reflect those assumptions as credits pushed out and equities pulled back as markets priced in a higher rate environment.

The high-multiple, growth stocks that drove new issuance in 2021 were among the hardest hit.

Affirm’s 0% convertible notes were changing hands at 88 on Dec. 17, about one month after pricing.

The conversion premium, which was 55% at the time of pricing, more than doubled to 118%.

It was a similar story for the majority of growth companies that priced deals in 2021.

Approximately 60% of new issues had negative year-to-date returns by mid-December, according to the Barclays report.

The convertible issuer base is not expected to change much in the coming year with growth companies continuing to dominate primary market activity.

However, the pricing terms these companies are able to access will.

The future

Following two years of record-setting issuance that saw the net size of the convertibles market grow by $100 billion, new deal volume is expected to moderate in the coming year as risk assets grapple with rising rates.

BofA analysts are projecting new deal volume to return to pre-Covid norms with $60 billion to $65 billion in new supply expected.

While Barclays analysts do not project new deal volume, issuance is expected to remain healthy with the market capable of absorbing $85 billion to $115 billion in new supply.

“Issuance will remain robust, mainly because equity valuations are still full,” Krishna said.

However, the equities of high-growth names that drove the surge in issuance over the past year have already been hit hard in the downturn in equities.

Their weakening equity valuations will also be the primary reason for the decline in issuance in 2022.

Higher rate environments have historically supported convertibles issuance with convertibles offering attractive pricing compared to straight debt capital raises.

However, high-growth stocks will have limited pricing power in a higher rate environment as their high-multiple valuations contract.

“Some of these high growth names will have weaker equities. It will be more difficult for them to price aggressively,” said Youngworth.

The decline in the pricing power of high-growth convertible issuers was evident in the final deals of the year.

Investors pushed back and called valuations into question.

Lucid Group priced its $2.01 billion issue of five-year convertible notes at the cheap end of talk for a coupon of 0.75% to 1.25% and an initial conversion premium of 50% to 55%.

The deal came with a discounted offer price of 99.5, which was not included in initial talk.

While the deal was marketed with a credit spread of 350 bps over Libor during bookbuilding, it traded with an implied credit spread of 550 bps its initial day in the aftermarket.

“People are getting sick of it,” a source said of the aggressive pricing.

“No one believes these valuations anymore,” another source said.

With the decline in pricing power will come a decline in the opportunistic capital raises and a decline in new deal volume.

There is the possibility for increased issuance from higher-quality credits due to new accounting rules, which will make convertible bonds more attractive than other asset classes, Youngworth said.

However, there will always be a need for growth capital, and the convertibles market will remain the preferred asset class to find it.

Growth names and speculative credits from the tech, biotech and consumer discretionary sectors are expected to remain the staples of primary market activity.

The convertibles market is also expected to continue to attract select de-SPACed companies.

While the issuer base will largely remain constant, the pricing terms they are able to access will not.

Higher coupons and lower premiums are expected to become more commonplace in the coming year.

Large coupons are expected to remain limited to highly speculative companies in need of liquidity and restructuring finance.

However, sources expect to see a return to pre-pandemic pricing norms for the majority of issuers tapping the market.

Sources anticipate more deals with coupons in the 0.5% to 2% range and premiums in the 25% to 35% range in the coming year.

“New issues have lagged,” Krishna said. “Some of these higher growth, more aggressively priced issues have not worked out in terms of YTD returns. It’s one of the reasons pricing will cheapen. Investors will be more cautious.”

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