Outlook 2018: Convertibles issuance expected to increase, but views on macro factors mixed

By Abigail W. Adams

Portland, Me., Dec. 29 – There has been a recognizable uptick in new issuance in the convertibles market in 2017 with some market sources predicting a further increase in 2018.

The deal sizes were smaller and pricing richer over the past year.

With large cap companies turning toward straight debt and demand for new paper in the convertible space outweighing supply, those trends are expected to continue.

It will remain an issuer’s market in 2018, a market source said.

However, sources were mixed on the impact macro factors will have on issuance in the coming year with the GOP tax changes the great unknown.

The volume

New issuance in the convertibles market has been “meaningfully better” over the past year but “still a far cry from what it used to be,” said Bill Feingold, co-founder of Hillside Advisers LLC and a 20-year veteran of the convertibles market.

There has been $35.80 billion in new paper issued in 112 deals as of Dec. 15, according to data compiled by Prospect News. The previous year as a whole saw a total of only 87 deals with $34.53 billion in new issues.

“I thought this year was kind of disappointing,” Feingold said. With the Federal Reserve increasing interest rates and president Donald Trump’s administration in the executive branch, “I was anticipating a bigger pick up. I thought there would be much more activity,” he said.

The majority of new deals were convertible bonds with a marked drop off in the issuance of mandatories, which accounted for just 14% of total issuance in 2017, compared to 38.2% in 2016, according to the Barclays report “U.S. Convertibles Outlook in 2018: Firing on all Cylinders.”

The issuance of preferreds was negligible in 2017 and will remain so in the new year, with the strong demand for straight equity expected to continue.

While still a shadow of its former self, the convertible market has grown and is expected to grow further in the coming year with increased primary market activity.

“The environment is ripe for a pickup in convert issuance,” according to the Barclays report.

Given demand, the market could easily absorb $63 billion to $68 billion in new paper, outstripping the $50 billion projected in redemptions, according to the report. Other sources pegged new issuance in 2018 at $45 billion to $50 billion.

“Overall, the convertibles market is really healthy,” said Jason Wood, founder of J. Wood Capital Advisors, which works with U.S. corporations on the issuance of convertibles and other structured debt.

“There has been a slight uptick in issuance in terms of dollar volume, and there also has been a slight increase in dollars coming into the space from investors. Most deals are oversubscribed. There’s been a lot of demand for new issues,” Wood said.

However, low interest rates continue to dampen the attractiveness of the convertibles market for issuers. Until that changes, Wood said he does not foresee a substantial increase in volume.

The demand for new paper continues to outweigh supply resulting in deals predominantly falling on the rich or tight end of talk. New deals “have favored the issuer,” a market source said. “I expect that will continue.”

An issuer’s market

The pricing has been tight on most new deals in 2017 with the lion’s share coming with a coupon below 2% and a premium of 30% or higher and within, rich or richer than price talk, according to data compiled by Prospect News.

The trend in pricing is driven by the ongoing supply demand imbalance for new paper in the convertible space, said Barclays analyst Venu Krishna, noting that most new issuances saw their valuation increase when they hit the secondary market.

“Investors monetized new issuance despite them coming in richer,” Krishna said, an indication of the strong demand that exists for convertible securities.

Technology and health care dominated primary market activity, accounting for 54% of total new issuances in 2017, according to the Barclays report. Deal sizes, however, have been smaller with about 56% of the deal sizes for new issuances under $250 million.

Large deals from investment-grade companies are becoming a thing of the past, sources said.

Years ago, there was a decent amount of large cap companies issuing convertibles as part of share buyback programs, Wood said.

“Fast forward to today, all of those companies can access the investment-grade bond market at very low rates. When you compare straight debt to convertible securities, it doesn’t make sense for them to do convertibles,” he said.

Previously, convertibles issuance from large cap companies was driven by tax and accounting features, which have become less relevant. Companies tapping convertibles now are predominantly looking for either growth capital or capital for restructuring, Krishna said.

“Small and mid cap companies are an important part of the convertible securities market,” Krishna said. For small and mid cap companies that don’t have a long enough history for straight debt, convertible securities offer cheap, opportunistic funding, he said.

While large cap companies still account for 55% of the convertibles market, only 11 priced new deals in 2017, according to data compiled by Prospect News. Small and mid cap companies dominated primary market activity in 2017 and will continue to do so in the new year.

Some market sources were hopeful that macro factors would help draw large cap companies back to convertibles and increase liquidity in the market. Whether tax reform will be the catalyst that many hope for remains to be seen.

Macro impact

The environment is prime for an increase in primary market activity in 2018 with a strong economy, higher equity multiples and the potential impact of U.S. tax changes supporting new issuances, according to the Barclays report.

The Federal Reserve’s planned interest rate increases in 2018 are a welcome sign to the convertible space. “The hope has been, as rates start to go back up and as equity value goes up, the company will have more desire to monetize the gains in stock prices,” Feingold said.

However, the rate increases are expected to be slow and steady, still leaving the market with historically low interest rates.

“Interest rates are expected to rise,” Krishna said. But with inflation contained “this is not an environment where rates are likely to move dramatically.”

The flattening of the Treasury yield and the macro credit risks it implies remains a concern to the market, sources said.

For many, the impact of tax changes on the convertibles space is a crystal ball prediction.

The reduction in the corporate tax rate is being promoted as a spur to economic activity.

And market sources have pointed to the proposed cap on the interest debt deduction as a potential catalyst for convertibles.

The cap may cause businesses to seek out convertibles as an attractive alternative to high-yield bonds, a market source said.

However, there are elements of the tax proposal that could harm the issuance of convertibles, especially deals that come with a call spread.

“In a call spread there are additional tax benefits,” Wood said. “If the tax rate goes down, it would potentially provide less of an incentive for a company to do a convertible.”

However, Wood noted that many of the companies active in the convertibles space, especially from the biotech sector, are not taxpayers because they are not yet cash flow positive, and will be unaffected by any potential tax changes.

Taxation remains the great unknown for the convertibles market in 2018. “Like any change, it will take time to play out,” Wood said.

“The environment is ripe for a pickup in convert issuance.” – A Barclays report

“Overall, the convertibles market is really healthy.” – Jason Wood, founder of J. Wood Capital Advisors

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