WSJ.com, April 20, 2009-04-20
Many markets where hedge funds were dominant players, like leveraged loans or high-yield bonds, remain in distress, with issuance still at low levels.
But the convertible-bond market has staged a comeback, despite its dependence on such investors for as much as three-quarters of demand. An influx of new investors is making them an attractive source of funding for companies.
Convertible bonds combine a standard corporate bond with an option to convert into shares once the underlying stock hits a predefined price. Hedge funds liked them because they could pick the instruments apart into their component pieces and focus on the value of the option.
However, this strategy required them to take a short position in the underlying stock to hedge the long position in the bond, and so share prices almost invariably fell when a company announced a convertible-bond issue.
If investors also were looking to strip out default risk via credit-default swaps, a sale also could push the cost of insuring a company's debt higher.
Even if these effects were temporary -- a Barclays study of three years of issuance shows stock prices are broadly stable over a longer period surrounding a sale -- they were unpleasant.
But now, regular buyers have taken over. They like all of the features of a convertible: the opportunity for gains on the underlying stock, a fixed coupon and the protection offered by the bond structure. So they don't look to hedge the exposure.
The flip in the investor base is significant. Nomura said that before September 2008, 73% of its European trading in convertibles was with arbitrage-driven hedge funds. Now, 68% is with investors who buy the bonds outright. The global trend is similar, the bank said.
That change, combined with an investor focus on companies' ability to refinance debt, means share prices are actually going up when convertibles are announced.
Steelmaker ArcelorMittal's shares rose 7.6% when it sold a €1.1 billion ($1.45 billion) deal in March that was then increased to €1.25 billion. Miner Anglo American's stock also rose as it issued a $1.5 billion bond Thursday.
The result is that everyone, seemingly, is happy. Companies have found another route to refinancing that is particularly attractive in cost terms. Anglo's convertible carries a 4% coupon, much less than the 9.375% it paid to sell straight debt early in April. Convertible investors are happy as prices are showing strong gains right after issuance, while traditional stock investors are getting a fillip as well. And investment banks are tapping into a fresh seam of fees.
Note: The April issue of Yield and Income Newsletter provides a list of recommended convertible bonds. YieldandIncome.com.
