After a year to forget, equity- linked specialists expect a revival in convertible issuance in 2023, as companies look to counter rising debt costs and hope that equity markets have a calmer time of it after 12 months of shocks around war, inflation and rates.
Following two blowout years during the pandemic, the convertible bond market suffered a severe downturn in 2022 as global stocks plummeted due to rising interest rates, record levels of inflation, and the war in Ukraine, which caused energy prices to surge.
As of November 13, the S&P 500 was down 16.2% in the year, while the EuroStoxx 50 had fallen 10%.
The selloff has been particularly brutal for technology companies, which were the biggest drivers of the primary convertible bond market over the past few years. The tech sector-focused Nasdaq Composite is deep into bear market territory, having fallen 27% in 2022.
As a result, convertible bond issuance has sufferered. Globally, just $60.3bn has been raised this year, down from $194bn in 2020 and $197bn in 2021, according to Dealogic data.
In the EMEA region, the slowdown has been even more pronounced. Just $5.8bn of new convertibles have been issued the region this year, down from $21.8bn in 2021 and $35.7bn in 2020, the data shows.
“From a primary perspective, it is a difficult year, as the pace of new issues has been very patchy,” says Thierry Petit, head of EMEA equity- linked at BNP Paribas in Paris. “Clients are now becoming more engaged on equity-linked topics, for obvious reasons. Swap rates are where they are now, and market volatility is very high. Credit spreads have widened a lot as well and the high yield market is virtually shut, so for a number of corporates, there are not that many options left on the table.”
At the end of a tough year, there is growing anticipation that the market may soon be about to roar again, particularly once inflation and the pace of rate hikes begins to plateau.
The equity market is likely to start rallying consistently once investors become more confident that inflation is under control. On November 10, the S&P 500 had its best day for more than two years after the US inflation print for October came in much lower than expected.
“Things are already starting to become a bit busier and will probably become busier the first quarter of next year,” says Juan Rodriguez Andrade, head of EMEA equity-linked at Bank of America in London.
“Rates will need to stabilise before we start to see a significant rebound in issuance, he says. “If you look at the cost of debt now though, it is so much higher than it was at the outbreak of Covid-19, companies will need to reduce their funding. For companies where their cost of debt is in the high single digits, they cannot fund at those levels for a long time. A lot of companies may need to reduce and if you look at the levels of interest rates, we are back to 2008 levels.”
Cost savings
There are signs that this process is already underway, with three large new deals in November from Sasol ($750m), Ubisoft and RAG Stiftung (€500m each). Convertibles offer an inherent cost saving versus straight debt in exchange for giving investors an option to convert their bonds into cheap stock if an issuer’s stock trades above an agreed level.
In Sasol’s case, it achieved a big saving versus what it would now have to pay in the dollar bond market.
“Sasol would have had to come to the debt market with a coupon of 9%-10%, but they did a convertible at 4.5% so that is around 4.5% savings per annum,” says Rodriguez Andrade. “On a $750m transaction, that represents around $200m of cash savings over five years, which is massive. We will see a lot more of these cases where companies from the sub-investment grade or low investment grade will issue convertibles.”
The optimism that the market’s fortunes are about to change is shared across the market. And even if volatility remains, convertibles are also much easier to issue in short windows due to the regulatory requirements being less demanding compared to other capital markets instruments.
“Corporates are looking for a bit of stability and confidence that they can approach the market without having to widen terms in the course of preparation or even during execution,” says Ilyas Amlani, head of EMEA equity- linked at HSBC in London.
“We do not necessarily need rates to taper or stabilise. One of the benefits of the convertible market, at least in Europe, is you do not need to have a prospectus, or do a roadshow. If you compare it to other funding instruments, it is much easier and quicker for corporates to access it. The market will remain volatile and windows will be shorter than what we have been used to in the past decade, so issuers need to be nimble and the convertible market does suit those issues who want to get access to the market in tight windows.
“It cannot get much worse than what we had this year.”
Higher borrowing costs hit all companies, but it is particularly troubling for high yield or cross-over credits. In 2023, these companies are likely to make up a large chunk of the dealflow.
Investment grade companies may also start to look at the market again.
“We are almost there,” says Ismail Iraqi, head of EMEA equity-linked at JP Morgan in London. “It took some time for corporates to come to the realisation that the equity market is unlikely to experience a V-shaped recovery. At the same time, many now realise that rates will go higher for longer. Therefore, if CFOs and treasurers aim to de-risk their upcoming financings, we think H1 2023 will be the right time to consider tapping the convertible market. It will allow them to replicate the type of cash cost they could get in the debt market a year ago, with the option of issuing equity at a premium to current levels if the share price performs through the cycle.”
Iraqi says with the continuous pressure from central banks, the investment grade and high yield debt markets are set to remain more costly.
“The convertible market remains open, active and the various transactions we have done show that the demand is there,” he says. “The question for corporates is how to best tap this market, at what cost, and what structure would work best for them.”
Starving investors
Investors were starved of new deals this year, and at the same time a lot of bonds matured. Buyers are eager for new issues, particularly now it is possible to earn a generous carry from convertibles again due to higher rates.
“Things have begun to improve a bit from mid-August onwards,” says Davide Basile, head of convertible bonds at Redwheel, a London-based investor with $17.9bn of assets under management, of which around $1bn is in convertibles. “We think volatility will remain higher and markets are at an interesting juncture. Getting exposure via optionality with the conservative bias of a bond floor is an attractive fundamental proposition.
“Conditions are ripe for an active primary market and we think that will feed through into next year as soon as we have a little bit of stability in the market,” adds Basile.
In recent years, the market has been dominated by technology issuers, but the pipeline next year is likely to be much more diversified, with deals from sectors such as energy and industrials as well.
“When speaking with investors, most are telling us they expect 2023 to be very busy, which is great,” says Petit at BNPP. “I am not saying it will be another 2009, but a number of corporates, in particular in the industrials space, are looking at this market again, which will be welcomed by investors because there are probably too many technology names in the asset class at the moment, and they have suffered a lot over the past 12 months.
“There is also strong appetite for energy names for obvious reasons given the market environment, and because a lot of these names disappeared from the market, I am expecting new issues in this particular space in the coming months too.” GC