No, I’m not talking about the little soft-top variety (although they make for better pictures). I’m talking about those chameleon-type securities that change from stocks into bonds and vice-versa. In the US, convertible issuance exceeded $30 bn in 1997, compared to $28 bn in 1996. Worldwide issuance in 1997 reached $45 bn. About 60 percent of all new convertible issuance involves bonds, with the total value outstanding reaching $100 bn for the first time ever in 1997, topping at about $140 bn in April 1998. The number of issuers now exceeds 700, and the average size of issues has more than doubled in the last ten years, from $50 mn to $125 mn. And many big players have issued convertibles in the $1 bn range in recent times.
Convertibles have come a long way since the mid-19th century, when they were first issued to finance the building of US railroads. But their volatility showed even then. Dissatisfied with the cash returns they were receiving from their investments when compared to the returns railroad stockholders were receiving, bond investors balked. Seeking to assuage them, the railroad barons created the first participatory bonds that repaid investors with hefty shares of stock in lieu of cash. Still, characterizing the rise of convertibles since then as ‘meteoric’ would be wrong; ‘slow and steady’ is more appropriate.
In the period between 1860 and 1990, convertibles operated as a cottage industry in the shadow of the great stock and bond markets. Even in the gung-ho 1980s, only a handful of investors circulated around the $4-5 bn worth of convertible issuance. But with corporate issues like Ford Motor’s 1991 $2.3 bn convertible bond offering and other big-tickets in the steel and airline industries, convertibles have elbowed their way to the front of the line on Wall Street during the 1990s. On the flip side, only a handful of the big Wall Street investment banks underwrite corporate convertibles, leading to what some industry observers feel is a ‘take-it-or-leave-it’ environment for investors clamoring for a piece of the action. Overall, about 55 percent of all such issuance is handled by top five Wall Street firms like Goldman Sachs and Merrill Lynch.
Good upside, low downside
The big lure of convertibles is that the yield of a convertible security offers a bigger return than what you’d get with the dividend payout from the underlying stock. The second benefit ties into the oft-made statement about convertibles offering the best of both worlds: since the price of a convertible bond typically mirrors the underlying stock, convertible bond performance will tag along when the stock rises, marking up big gains. But if the stock declines, a built-in yield cushion softens the performance blow registered by the downward-spiraling stock.
The latter notion held true this past spring, when the Dow Jones Industrial Average fell several hundred points in late April. During that short period, mutual funds that specialized in convertibles fell 1.38 percent, compared to a 1.9 percent slide in the S&P 500. And when Southeast Asian markets dropped 36 percent in 1997, convertibles from those countries fell one-third as far – only 12 percent. Normally, experts say, convertibles participate in about 70 percent of the underlying stocks’ gains.
‘Convertible bonds have performed brilliantly in recent years,’ says Simon McGuire, head of global equity at SBC Warburg Dillon Read in London. McGuire says that convertibles have benefited from soaring stocks markets and low interest rates. But if stocks decline and rates fall, watch out. ‘Then the downside protection (of convertibles) might be less than expected,’ warns McGuire.
Companies love convertibles because they allow them to raise capital at a premium to their stock price (investors don’t convert until the stock reaches that price). Between the point of purchase and the point of conversion, companies can deduct the interest expense on the convertibles.
Ed Cassens, portfolio manager of the $700 mn Pacific Horizon Capital Income Fund in Spokane, Washington, points out that smaller, more nimble companies like high-tech start-ups with a critical need for capital are joining the convertible craze. ‘One attraction for smaller companies is the lower interest rates they pay for convertible bonds compared to straight bonds. Eventually, these companies want to build up equity on their balance sheets by selling stock at a higher price than the current price.’ Typical issuers of this stripe, Cassens says, usually have a B or BB credit rating, which means these are not investment-grade companies. ‘But I don’t call them junk bond issuers because there are many fine companies, like Starbucks, that started out this way.’
Timing is everything
Not all the news is good for investors on the convertible front. Some are getting skinned alive by companies selling convertibles just as the underlying stock is topping out.
Remember Sunbeam? The appliance-maker made big news in June when it canned fabled downsizer ‘Chainsaw’ Al Dunlap as CEO. Poor performance was the reason given by the board of directors, but a more revealing look centers on the company’s convertible security performance. Back in March when its stock was trading at about $45, Sunbeam raised $750 mn of convertible zero coupon debt. But the bottom fell out on the company’s earnings and the stock price was cut in half by June 1, to $22.50. While the convertible bonds fell only 17 percent during that time, it was a shocking loss nonetheless for a brand new bond issuance. The spirit of Chainsaw Al lives on, if only to haunt investors instead of employees.
In late April of this year, Cendant Corp followed a similar blueprint that allowed it to get out from under a precipitous decline in its stock price. On April 15, the company’s stock fell 45 percent, after the company announced serious bookkeeping errors in its 1997 earnings statements that resulted in Cendant reducing earnings for that year and downgrading expectations for 1998 as well. Sounds like bad news all round, right?
But not as bad as you might think for some Cendant investors. Only two short months beforehand, the company sold $1.5 bn worth of convertible 7.5 percent Prides (preferred redeemable increased dividend equity securities) through Merrill Lynch at $48 each. After the bookkeeping mishaps were revealed, the Cendant Prides’ price fell to about $36. Loss to convertible investors? Some 25 percent of their investment in 60 days. Painful, but not as bad as for equity investors.
Lyon kings
Another trend is the burgeoning ‘branding’ strategy practiced by underwriters to secure a bigger slice of the convertible pie. Companies like Merrill Lynch and Salomon Brothers have rolled out over a half-dozen new products in the last five years. Besides Merrill’s Prides and Feline Prides (flexible equity-linked exchangeables), some of the more well-known names include Lyons (liquid yield option notes, Merrill Lynch’s zero-coupon notes); Decs (debt exchangeable for common stock, Salomon’s version of a mandatory convertible product); and Strypes (structured yield product exchangeable for stock).
Such ‘synthetic’ convertibles alter the convertible landscape by de-emphasizing corporate issuers and emphasizing the marketing offices of investment banks. While synthetics only account for one percent of the convertible market, critics worry that they are being crammed down investors’ throats, when all they want are the traditional, big-name, Ford Motor-type issues that offer better performance. With the US and European economies going great guns, the prevailing wisdom goes, there’s little need for larger companies brimming with cash to venture out into the convertible market. That leaves a wider opening for the synthetic products favored by private issuers, if not investors.
Yet investor demand for convertibles still runs high. In mid-1997, the French cosmetic firm Clarins offered its first ever convertible bond – a $160 mn (Ffr900 mn) Lyons offering with Merrill Lynch that paid the lowest yield on any Lyons ever at 2.75 percent. The Clarins convertible also offered a longer maturity – 15 years – than many investors would have preferred. So were company executives worried about the offering’s chances for success? Hardly.
The deal, launched at 5 pm, was five times oversubscribed by 10 am the next day. Says Farley Bolwell, chief of equity-linked issuance at Merrill Lynch: ‘Issuers have taken advantage of newer, more sophisticated convertible products to satisfy corporate finance goals that otherwise may not have been achieved with more traditional products. At the same time, investors have become much more open to the newer convertibles.’
Thus, a seller’s market endures, with investors overlooking some questionable numbers in their haste to gain a foothold in convertibles. In that type of environment, raising capital through convertibles makes a lot of corporate sense.
