Convertible Bond Issuance up four-fold... - August 2009

Convertible bonds issuance has risen and fallen over time, we currently seem to be on a rising wave:

“Global issuance in the latest quarter was up four-fold on the first three months of this year. In the US, $15.7bn worth were issued – compared with just $6.1bn for the whole of last year. In Europe, issuance jumped to $10.2bn this quarter from just $1.9bn in the early months of the year…” (FT, Jun 26, 2009)

A convertible bond is a bond which may be repaid in shares rather than cash at the investor’s option.  Typically the convertible’s coupon is lower than that for a plain-vanilla bond, and should the bond be converted to shares, it would be at a share price premium to today’s price. 

For issuers, the current rise in issuance is driven by the practical need to get around the high cost of debt (not to mention its lack of availability) and the high cost of equity. On the opportunistic side, the high implied volatility in the market helps to improve convertible pricing, thus improving proceeds raised. Of course, for some, the convertible may be the cheapest (and available) of the rescue options. 

For traditional long-only investors, the convertible can be thought of stream of coupons (net of dividends foregone) with the potential for upside if the equity conversion option becomes in the money. 

For hedge funds, particularly convertible “arbitrage” funds, convertibles offer another means to trade “volatility”. These funds’ performance is currently outperforming up 5.8% in July and up 31.14% on the year (source:  hedgeindex.com, benchmark broad index performance)

There have been significant deals recently, but let us focus on 2 specifically: Peugeot’s Euro 575 million (closed Jun 26, 2009) and the failed (Jun 2009) Rio Tinto convertible for Chinese company Chinalco’s investment. 

Peugeot’s deal is significant in tapping a new investor pool.  The traditional investors of convertibles tend to be institutional investors including equity funds (convertibles are like “equity with income”) and hedge funds (particularly “volatility” or “arbitrage funds”).  The issue with hedge funds is the shorting of shares at issuance as part of their hedging strategy – though there are structuring solutions around this.  The Peugeot deal appears to tap the domestic retail market, which is not only a new pool, but leaves the institutional equity investors untapped (held in reserve?).  However, in light of Peugeot’s overall funding needs, one does worry that the convertible bond may not be the best solution, unless it is part of a greater program. 

Rio Tinto needed to raise $19.5 billion to meet the next 2 years’ debt maturities and negotiated an investment from client, and 11% shareholder, Aluminum Corp. of China (“Chinalco”) in February of this year. The investment was in 2 parts, a direct investment in various aluminum assets which various equity research firms covering Rio Tinto opined was fairly priced, and two $7.2 billion convertible bonds, which the equity research firms opposed. 

The terms of the convertible bonds are a 9% coupon, and a conversion premium of 79% to pre-announcement share price.  In addition, Chinalco would get 2 seats on the board. 

For Chinalco, the convertible is in lieu of outright investment, with the converted shares bumping its holdings from the current 11% to 18%, whilst getting around the Australian Foreign Investment Review Board’s limit on foreign ownership of 15%. 

Rio Tinto’s shareholders, on the other hand – as expressed by some published equity research – see the deal as disadvantageous.  We agree, but think the published research, with due respect, do not fully reveal the effective cost to Rio Tinto shareholders.  For one, the typical EPS dilution on an “if converted” method favored by IFRS for existing convertible bonds is not relevant.  For another, the classic view of the convertible bond as “bond with warrant/call option” misses the true value to Chinalco (and thus cost to Rio Tinto shareholders).

A slight re-opening of the capital markets in April allowed Rio Tinto to raise $3.5 billion in 5-year and 10-year debt.  Together with growing support for an equity rights issuance and agreement on joint ventures with BHP Biliton allowed Rio Tinto, in June, to turn Chinalco down. It will be interesting to see if there is long-term impact on Chinalco’s and Rio Tinto’s relationship, but that is a matter for another class. 

In our convertible bond classes, we will focus on the convertible bond, discussing the Peugeot and the Rio Tinto cases, and other interesting landmark and or relevant cases.

Associates and vice presidents in investment banking, equity capital markets and equity research may be interested in the ½ day or 1 day session where we cover the terminology, intuition on valuation for the sake of trying to maximize proceeds whilst balancing issuers’ needs on cash flow, dilution, etc., structuring ideas to mitigate hedge fund shorting activity, and managing the conversion process.

Sales and trading may be interested in the ½ day or 1 day session where we cover terminology, intuition on valuation for the sake of identifying risk/reward, and the concept and practice of trading volatility.

Find out more about our convertible bond course.