Defusing The Convertibles Timebomb

02-27-2003 | Source: Corporate Finance

Some unusual records were set in 2001. Ellen MacArthur completed the fastest solo female circumnavigation of the globe, Denis Tito became the most expensive space tourist in history paying Russia $20 million to visit the international space station and Susan Carroll and Scott Hamblen tied the knot in the largest ever underwater wedding attended by 39 certified divers.
Whilst Ellen, Denis, Susan and Scott were busy setting these personal marks, CFOs and treasurers all over the world were establishing records of their own in the convertible bond markets. In the US there was a bumper $105 billion of issuance and in Europe the market for convertibles expanded to its largest ever at 50 billion ($53.33 billion).
Few can have appreciated the problems being stored up for the future. Convertibles were the cheapest form of finance around and everybody was jumping on the bandwagon. France Telecom issued a 3.1 billion exchangeable into Orange, an offer which was made simultaneously with the IPO of the mobile phone group. Incredibly total demand for this issue topped the 22 billion mark.
Another indication of the almost insatiable appetite for convertibles was Vivendi Universal's 1.8 billion exchangeable into Vivendi Environment. Within three hours of placement the bond was more than five times oversubscribed. And in the US one and two year puts were becoming the fashionable way to get hold of short-term finance.
Two years later and part of the 2001 vintage of convertibles is maturing, together with issuance from previous years. The problem is that only about 10% of the bonds are actually going to convert. Instead the debt which corporates once hoped would turn into equity will have to be refinanced. In Europe $35 billion will need to be refinanced this year, as a result of maturing debt or put options held by investors. This is equivalent to the size of the entire European convertible market in 2000.
Describing the Asian market, Simon Ollerenshaw of UBS Warburg says: "Assuming markets stay at these levels, the vast majority of existing CBs will redeem or be put early by investors. Over the next two years, around $4.25 billion will redeem, $2.2 billion be put early and only $140 million convert."
 Potentially Problematic Puts
In the US alone, investors hold $23.6 billion in puts which are exercisable this year. Richard Ng-Yow, head of equity linked origination at UBS Warburg in the US, comments: "The puts have caused problems for some, but have not been so detrimental as to force companies to file for Chapter 11 - yet." Deustche Bank has taken the step of publishing a list of companies, who might find investors exercising their puts a "potentially problematic" experience. The corporates listed are Tyco - despite its record $4.5 billion convertible in January - Omnicom, Xerox, IPG, AMT and Elan.
In Europe companies facing puts or maturing convertibles include Vivendi Universal, Aventis, PPR, France Telecom, Metro, Roche and Ciba. The companies prepared to comment are seemingly untroubled by the prospect of having to refinance. A spokesperson for PPR, referring to the company's 800 million OCEANE bond which matures in 2007 but is subject to a put in May of this year, says: "The treasury follow this very closely and everything is anticipated." Others, such as Swiss specialty chemical producer Ciba, say they have the necessary cash to pay for the redemption of the bonds - in Ciba's case a $681 million issue which matures in July of this year.
But corporates who are not in such a fortunate position will need to consider their options. Ng-Yow comments: "Treasurers can sweeten a put, refinance it, call it, or tender for the bonds before they reach maturity. There is almost an unlimited amount of things they could potentially do."
Corporates with real credit worries will be tempted to offer a sweetener. Sweetening a put is a trend which has become increasingly common in the US. It involves offering an incentive to investors not to exercise a put. The practice has been relatively successful since Comcast started the trend in December 2001 by offering an additional put. Financial services firm Eaton Vance was notable for twice persuading investors not to exercise a put. In August of last year, it offered investors an additional opportunity to put in November and a cash payment of $3.24. None of the bonds were put and in November the company was able to sweeten yet again by offering an additional coupon on 1.627% annually. Once again none of the bonds were put.
The prospects for corporates looking to sweeten a put this year appear good. Investors were starved of quality paper last year - James Eves of UBS Warburg in London comments: "Over the summer it felt like we fell off a cliff." As a result investors should be keener to hang on to what they already hold. But European convertible issuers may find it more difficult than their US counterparts - typically their credit quality is higher and investors feel under less pressure to accept sweeteners as a consequence.
For some, sweetening can be a more attractive option than refinancing. Referring to industrial manufacturing group SPX, Deutsche Bank comments in a recent research note: "With stock at current levels it is cheaper to sweeten than to refinance." Those who do seek to refinance maturing issuance should find the markets relatively attractive. Low interest rates and tightening credit spreads mean that it is a good market for prospective issuers. And as Jean-Francois Mazaud of SG comments: "Investor appetite is clearly there - a large number of investors have not been able to take part in primary issues and their portfolios are still unbalanced."
There is also a sense that the convertibles market has matured, with both bankers and corporates fully understanding the way the instruments work and being prepared to structure tailored solutions. The merger of the equity and equity-linked divisions at many of the major investment banks has helped the market for derivative structures. One example of such innovation is Deutsche Bank's Brisa exchangeable, which was issued in Deutsche Bank's name into the stock of the Portuguese toll road operator. The 183 million transaction was notable for Deutsche Bank, the issuer of the bonds, linking the bonds to Brisa's credit, so that in the event of a default by Brisa the bondholders would receive the recovery rate that unsecured unsubordinated Brisa debt pays out. This was the first such credit-linked exchangeable issued in Europe.
Innovating To Survive
Mazaud argues: "The indebtedness constraints of many corporates in Europe have led to a lot of innovative thinking by bankers and treasuries. And investors keen to rebalance their portfolios, but with only a limited number of issues to choose from, have been willing to accept more innovative structures."
In Europe mandatory bonds - where the debt automatically converts into equity at the end of the term - and deeply subordinated debt issuance are becoming more common as corporates try and ensure that ratings agencies treat the instruments as much like equity as possible. Examples of such structures include: Vivendi Universal's 1 billion mandatory issued on November 14 2002 and Alcatel's 630 million issue on December 12 2002. While such issues do receive a near full equity credit from the ratings agencies, they can be a costly method of financing and attract an investor base which largely consists of hedge funds.
Even if corporates are confused about the wide array of options available to them, they are operating in a market in which banks are bending over backwards to impress clients. Jeremy Howard of Deutsche Bank in New York comments: "Treasurers get very good advice, whether or not it is solicited. Looking smart in front of a corporate treasurer is like gold dust at the moment."
The one or two year puts which were so common in the US a few years ago are probably a thing of the past though. Ng-Yow says: "The stock market worked against a number of companies who did one year puts. People got uncomfortable with these instruments and quickly realized it was not worth their while." But in Europe the trend towards mandatories and subordinated issuance should continue with treasuries still concentrating on repairing fractured balance sheets.
So what could go wrong? Ask almost any equity-linked banker around the world and they will tell you that they expect 2003 to be a relatively good year. They will admit to a lack of transparency in the first quarter ,driven by investor concern over a possible war in the Gulf and uncertainty over how corporates will choose to address their refinancing needs, but they will quickly return to the positive. After all, interest rates are at all time lows and credit spreads are narrowing in the markets. Corporates point to the same combination of circumstances to explain why they are unfazed by their refinancing needs.
But predictions have a habit of going widely wrong - just ask the legion of bankers who forecast the FTSE index would end 2002 above 6,000. Corporates should be prepared for the worst. Spreads could start to widen; equity prices could keep falling, pushing more and more bonds out of the money; and interest rates could rise. The friendly refinancing environment that market participants are assuming will exist may quickly disappear. But what is certain is that, barring a miraculous rally in the stock markets, 90% of convertibles will remain out of the money during 2003.
Corporates have to tread a fine line in deciding the most advantageous time to refinance, sweeten or renegotiate. In doing so they should bear in mind the words of Ng-Yow quoted earlier in this article: puts "have not been so detrimental as to force companies to file for Chapter 11 - yet."
President George Bush's proposal to eliminate taxes on dividends has been well received in the equity-linked market. The proposal was announced at the beginning of January and bankers and tax attorneys were immediately reported to be hard at work devising structures to take advantage of the proposed new law.
Companies have traditionally preferred to issue debt rather than equity because they have been able to set interest on the debt off against their taxable income. This will still be the case, but from the perspective of investors equity will become much more attractive and corporates will find it easier to get equity or equity-linked issues away.
If the proposed changes do come into law, preferred stock issuance is likely to increase rapidly. Preferred stock pays a set yield in a similar manner to a bond, but typically the shares carry no voting rights until they are converted into ordinary shares. For investors preferred stock will therefore have similar characteristics to a convertible bond.
But such predictions of a boom in preferred issuance may be a little premature. Despite the Republican triumph in the US elections held at the end of last year, Bush is still facing opposition to his proposed tax cuts. Even Republican legislators have voiced doubts, calling the proposals, unworkable, unfair and ineffective. So for now at least, the carefully laid plans of bankers and tax attorneys will have to stay under wraps.

Bush dividend plan boosts equity-linked market President George Bush's proposal to eliminate taxes on dividends has been well received in the equity-linked market. The proposal was announced at the beginning of January and bankers and tax attorneys were immediately reported to be hard at work devising structures to take advantage of the proposed new law.

Companies have traditionally preferred to issue debt rather than equity because they have been able to set interest on the debt off against their taxable income. This will still be the case, but from the perspective of investors equity will become much more attractive and corporates will find it easier to get equity or equity-linked issues away.

If the proposed changes do come into law, preferred stock issuance is likely to increase rapidly. Preferred stock pays a set yield in a similar manner to a bond, but typically the shares carry no voting rights until they are converted into ordinary shares. For investors preferred stock will therefore have similar characteristics to a convertible bond.

But such predictions of a boom in preferred issuance may be a little premature. Despite the Republican triumph in the US elections held at the end of last year, Bush is still facing opposition to his proposed tax cuts. Even Republican legislators have voiced doubts, calling the proposals, unworkable, unfair and ineffective. So for now at least, the carefully laid plans of bankers and tax attorneys will have to stay under wraps.

French regulators threaten mandatories As this edition of Corporate Finance goes to press a decision is expected from the French stock market regulator, the Commission Des Operacion de Bourse, on the future of mandatory issuance in France.

The regulator imposed a temporary ban on mandatories following Vivendi Universal's and Alcatel's issuance at the end of last year. Both Vivendi and Alcatel used the instruments to gain rapid access to the equity capital markets. Vivendi issued a ,1 billion ($1.02 billion) mandatory to fund the increase of its stake in Cegetel and Alcatel relied on its ,645 million issue to strengthen its balance sheet and increase its flexibility during a financial restructuring.

Two main issues are being considered by the regulator. Firstly equity and convertible bond issues in France must comply with the 10 out of 20 rule, which provides that companies cannot issue shares at a price which is less than the lowest average price on 10 out of 20 days before the date of the placement. Vivendi managed to comply with the 10 out of 20 rule by issuing at a premium to the reference price under the rule, and then returning this premium to investors with an immediate coupon payment. Alcatel followed suit one month later. The regulator is examining whether this structure does in fact breach the 10 out of 20 rule.

The second topic under discussion is the disturbance of stock prices that tends to take place when a company is issuing a mandatory - the Alacatel share price fell 15.6% on the day of its issue. Such drops can be due to the activities of hedge funds, which are among the main investors in mandatories. They short sell the stock of the company involved to cover the position they take.

It is unlikely that the COB will ban mandatory issuance altogether. Other options include preventing companies from prepaying coupons or taking any prepayment of a coupon, into account when examining compliance with the 10 out of 20 rule. But a decision on how best to regulate the activities of hedge funds may have to await a broader European initiative on the subject.