Corporate Financing Analysis - Convertibles Go From Strength To Strength - 27 NOV 2017


Convertible bond issuance has been on a bull run in 2017, and the positive momentum looks set to continue as we move on through into H118, supported primarily by such fixed-income instruments' relative value compared with other debt instruments. In BMI's view, there are several key advantages to such hybrid deals in an environment within which risk sentiment is creeping back in and rates are on the verge of a series of hikes across key markets, factors which will undoubtedly see a downturn in activity in the equity (ecm) and debt capital markets (dcm) more broadly.

Convertible bonds are favoured by investors while they are looking to minimise downside risk as they offer flexibility, and by extension security, and also provide a cheaper source of debt investment then other types of corporate bonds, as the equity option only has value to the investor. While we expect the forecasted round of rate hikes set for 2018 - in the US, and subsequently in other key nations - to make convertibles more expensive, we do not expect this to significantly impact issuance. Why so? Because when compared with other alternatives in the bond market, convertible prices will remain attractive on a relative basis - albeit offering more modest returns in return for a reduced level of risk for dcm investors. This is down to the structure of such hybrid instruments: the idea being that the hybrid fixed-income notes permit companies to raise fresh funds without some of the disadvantages of either straight bonds or a standard share offering, while simultaneously allowing investors to reap the rewards at a later stage. Indeed, bondholders are allowed to turn their investments into equity at fixed times (typically after three to five years, and at around 30-35% above the issuer's share price) during the bond's life. While such instruments do not offer high interest, the option of being able to switch to equity offers security and a potentially lucrative return in the long run if a firm increases in value.

Back In Vogue
Y-T-D Global Announced Convertible Bond Issuance By Deal Value, USDmn
Source: Zephyr, a Bureau van Dijk product , BMI

Hybrids Already In Vogue

While we are expecting the volume of such deals to trend higher over the coming quarters, we highlight that the appeal of such deals has already seen a spike in popularity during the prolonged period of borrowing costs being sat near record lows both in the US and beyond. According to data from Zephyr, a Bureau van Dijk product, convertible bond issuance in the 2017 y-t-d period has tallied USD88,265mn across 914 deals. This represents the second annual y-t-d increase in the value of such deals and is up from USD59,343mn (across 837 transactions) recorded by the same stage in 2016. Moreover, we highlight that deal volume is currently at its highest level at this stage in the year since the onset of the global financial crisis, and in fact we would need to go back to 2007 when the combined value of equity-linked deals reached USD96,112mn across 893 transactions to find a haul of deals which tapped investors for a greater level of funds. As a result, we believe that activity in the market is on track to record its busiest year for deals in a decade - at present, the only full-year haul of activity standing in its way is the USD94,821mn raised across 806 deals in 2009. We are still expecting activity in 2017 to fall just shy of the USD110,701mn (990 transactions) in total issuance tallied during 2007, however. In sum, such hybrid instruments represent a viable source of financing or refinancing for issuers after having spent a long time struggling to gain traction in the aftermath of the global financial crisis.

Looking ahead, interest rates are widely expected to continue heading north throughout 2018 (with the US leading the trend where we see the Federal Reserve introducing rate hikes of 50bps in both 2018 and 2019, putting us at a level of 2.16% - within a 2.00-2.25% range - by the end of 2019); a move which will make debt more expensive to issue and to invest in. While this is bad news for high-yield bonds as risk aversion spikes in response ( see ' Bad News Up Ahead For High Yield Bonds ' , November 15 2017 ) it is good news for convertibles, which offer investors the flexibility of converting debt into stock at a later stage. This means that equity-linked note sales will remain an attractive avenue on a relative basis for financing when compared with their bond market peers.

New Markets Key To Hybrid Bond Market Growth

Convertible bond deals have long been popular in developed markets (DMs) and we expect this to continue to be the case over the coming years. Alongside this, however, we highlight that there has been a recent spike of interest in such fixed-income instruments in emerging markets (EMs) and in China in particular - a region within which the convertible bond market has previously struggled to build any real momentum. This is where we expect the driver for growth in the hybrid bond space to come from, until markets there become more established ( see ' Convertibles To Remain On A Bull Run ' , August 20 2017). But for now, those new markets remain very much on the periphery.

While activity in the Chinese hybrid bond space has a long way to go to catch-up with more mature markets for such deals elsewhere, it is certainly showing plenty of signs of life, and grabbing some headlines along the way. Indeed, the emerging trend of China's interest in hybrid debt is perhaps best illustrated by the fact that the four largest global convertible bond deals to have been announced so far in the 2017 y-t-d period have all been made in China. The largest deal of the quarter to be announced happened in October, when commercial banking firm Shanghai Pudong Development Bank announced a USD7,519.13mn deal. Following closely behind in the rankings is fellow lender China Minsheng Banking with its USD7,526.24mn deal, which was launched back in Q117. The remaining two deals at the top came from construction services firm China Communications Construction and scheduled airline operator Hainan Airline Holding, which have announced deals worth USD3,021.09mn and USD2,178.83mn, respectively, in the y-t-d period. As of the time of writing, the status of all four deals is still pending.

Chinese Regulatory Change A Catalyst For Deals

In BMI's view, a major factor in the sudden spike in convertible bond issuance in China has come from a regulatory change which occurred earlier in 2017. On February 8, the China Securities Regulatory Commission (CSRC) issued a new set of rules on refinancing in an attempt to tighten the frequency at which companies were doing so via the equity capital markets (ecm) arena. As a result of the changes introduced by the regulator, Chinese firms are now required to wait 18 months between selling shares, and are subject to a 20% cap of all shares in private placements. Further tightening a few months later in May saw the CSRC put new conditions on the amount of stock that individual investors were able to offload at any one time.

With refinancing via the ecm arena having now become a challenging process for Chinese firms, convertibles - which are not subject to the same regulations - now offer a more welcoming alternative. This has certainly been the appeal for the mid-market firms of Shanghai Pudong Development Bank and China Minsheng Banking which have been looking for ways to raise fresh capital. It was back in April that we saw Chinese infrastructure firm Zhejiang Expressway end the more than two-year APAC convertible bond drought; however, with a EUR365mn H-share convertible deal ( see 'Bullish Sentiment Building Behind APAC ECM Activity', May 10 2017) that deal set the blueprint for other firms from the Middle Kingdom and the broader Asia region to follow suit. After all, Chinese companies are busy looking for alternative means to fund their growth aspirations at a time when the broader Chinese economy is slowing down ( BMI's Asia team is forecasting real GDP growth to come in at 6.6% for 2017 and then 6.3% for 2018, down from 6.7% in 2016), and we believe that for a growing number of companies, hybrid bond deals will represent that outlet. Meanwhile for investors, such debt instruments represent a potentially stable yet unremarkable source of return: the S&P China Convertible Bond Index of local Chinese currency convertible notes has returned a 4.8% profit so far in Q118.

GCC Issuers To join The Convertible Bond Party?

Beyond the Asia region, and China more specifically, we highlight that there is also strengthening potential for convertible bond deals to gain traction in the GCC region, at a time when the interest rate march higher is about to begin across the globe. Since Dubai-based global ports operator DP World launched the Gulf Cooperation Council (GCC) convertible bond market in January 2006 with a bumper USD3.5bn pre-IPO note sale, issuance of such deals has been patchy y-o-y with financial services and real estate companies contributing the largest volume of deals between them. In fact, it has now been two years that the GCC region has gone without the successful issuance of a convertible bond. We point to ultra-low interest rates having made debt financing cheap and easy, negating the need for such deals. With the tide now turning, however, we believe that there is plenty of upside potential for such deals return to the market - especially now that overseas investors are able to support such deals through the Qualified Foreign Investors (QFIs) investment structure. And if this proves to be the case, we believe that it will be at the expense of activity in the regular dcm arena in the region ( see ' Slowdown Underway In Key Markets ' , July 20 2017).