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Elaine Wah

Modern Markets, Modern Metrics - A Blog By IEX

In this blog by IEX's Elaine Wah, the newest public exchange looks to refute public claims that the metrics it uses are designed to inflate its own volume numbers and mislead people.

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May 3, 2010

Pent-Up Demand Seen for Converts

By John D'Antona Jr.

Convertible bond issuance is expected to rise, as U.S. equities markets improve and institutions looking for steady cash flow increase their demands.

Prasanth Burri Rao-Kathi

And brokers are ready to capitalize on this--a number of firms have recently jumped into the business. Firms like Nomura Securities International and BTIG have opened convertible trading desks, while Keefe, Bruyette & Woods is expanding its operations in this hybrid security. Why?

The one-two punch of projected growth in mergers and acquisitions and a shrinking outstanding supply for convertibles is expected to generate new revenue for the firms in this niche market. Convertibles offer companies a cheap source of financing and are an attractive alternative to an equity offering.

By definition, convertible bonds are debt securities in which buyers get a coupon payment and the option to exchange the bonds for common or preferred shares if a company's stock climbs past a given price. Investors benefit as the bonds pay a fixed coupon cash stream and can appreciate if the underlying stock increases in value.

Issuing companies also benefit because convertible bonds do not dilute outstanding shares and usually pay investors a smaller coupon than other bonds, lowering their funding costs. Also, the rating agencies often treat them as equity, less of a burden than other debt.

Convertible bonds fell out of favor in late 2007 when hedge funds, always big investors in the instrument, sold them so that banks could use the funds to put up more assets as collateral on credit lines, as a result of the financial crisis. The plunging equities markets also made the bonds' embedded equity options worthless.

During 2006 and 2007, bond funds put on trades where they purchased convertible bonds and then shorted the underlying company's stock. This trading strategy was stymied and halted in 2008, when the Securities and Exchange Commission banned the short selling of financial companies for several months, also hurting the sector.

But as the equity markets rebounded from last year, interest in convertible bonds has also increased as the value of the embedded stock call option has grown.

According to market estimates, the convertible bond market globally is $500 billion in bonds outstanding, with 50 percent in the U.S.-up from $325 billion globally in 2007. In 2010, U.S. issuance is projected to reach $50 billion.

"The market definitely has a number of compelling reasons to get to $50 billion and north, but it's dependent on M&A transactions," said Prasanth Burri Rao-Kathi, head of equity-linked capital markets at Bank of America Merrill Lynch.

Fifteen to 20 percent of all M&A activity historically has been financed by convertible bonds, Rao-Kathi said. So if the economy continues to rebound and M&A activity increases, so will convertible bond issuance, the thinking goes.

Another supporting argument for convertible bond market growth is a $25 billion imbalance since 2007 of new issuance to roll off-the amount that comes out of the market through either bond calls or paydowns. "In this market, redemptions have outpaced new issues for four of the last five years," Rao-Kathi said. "Investors are looking to replenish their portfolios. And companies that are coming to market are being greeted with heavy over subscriptions."

In 2009, 50 percent of new issue U.S. convertible offerings were upsized due to investor demand and by an average of 40 percent, according to Rao-Kathi's data. Given that backdrop of demand, more growth and issuance is likely, he said.

 

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