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Running on empty

The seemingly boundless growth of the convertibles market is reaching its limits.

The seemingly boundless growth of the convertibles market is reaching its limits.

By Justin Schack
November 2002
Institutional Investor Magazine

Only a few months ago, it looked as if nothing could stop the convertible bond market's torrid growth. Even as the economy stagnated and stocks remained mired in the worst bear market since the Great Depression, investors kept gobbling up these hybrid securities, which combine elements of debt and equity. In 2001, 251 deals worth $100.6 billion came to market, shattering the previous year's $55.8 billion record. It was the sixth consecutive record-breaking year for new issues. A seventh seemed within easy reach: $36.1 billion of new issues came to market through April of 2002.

Since then, however, the primary market has all but disappeared. Only 37 deals worth $8.5 billion were offered from May through mid-October, according to New York research firm Dealogic.

When stocks were soaring, some investors turned to convertibles as a cheaper, safer way to gain equity exposure to a company. Now those investors are uncertain about whether the company's stock price will ever rise to the conversion value -- typically, a premium of 15 to 30 percent over issuance price. So investors take on credit risk for lower coupon payments than those generated by ordinary bonds, with the very real likelihood that the paper might not be convertible into equity for years -- an unattractive deal.

But a falling market offers another argument against convertibles issuance: the threat of massive equity dilution. When a company's stock is depressed, it must issue more shares for conversion.

"Companies do not want to be issuing either stock or equity-linked instruments when stock prices are so low and it will cost them dilution," says Yaw Debrah, head of convertibles research at Merrill Lynch & Co. "That's probably the biggest reason for the drought right now."

Many companies have recently sought to reduce debt and boost equity with "mandatory" convertibles, which automatically morph into stock at maturity rather than at the investor's option. Among the issuers of mandatory deals this year are Duke Energy Corp., FPL Group and communications plays Alltel Corp. and Corning. Mandatory issues are virtually guaranteed to trigger equity dilution, so they are drying up.

But low stock prices aren't the only culprits. After all, the stock market fell in 2000 and 2001 while convertibles issuance shattered annual records. A less tangible factor behind the decline may be skittishness among convertible-arbitrage hedge funds, the biggest buyer of new issues. Convertible arbitrage -- buying a company's convertibles while selling its shares short -- has been one of the few reliable ways to generate steady returns in this bear market.

Until recently. First came the blow-up of Kenneth Lipper's convertible-arbitrage fund late last year. Although it was attributed more to a lack of controls than any fundamental flaw in strategy, it unsettled many investors already nervous about the asset class's remarkably long run of consistent returns. This year's rash of bankruptcies among investment-grade companies heightened the tension.

Credit risk might be a chink in convertible arbitrage's armor. Gains from a short position should offset declines in the value of a company's convertibles. A rash of defaults, however, is harder to protect against.

"There's a fair amount of nervousness in the convert arb world right now, that the strategy has been too good to be true for too long," says one hedge fund manager. "So even though we're sitting on a lot of new money, people are very sensitive to credit quality. You don't want to wake up one morning and realize you're not hedged as well as you thought you were."

Some believe that convertibles will regain their old luster once the stock market does. But there's another possibility: Convertibles may be headed back to their traditional role as a niche financing option after flirting with the mainstream of corporate finance. In that case, it's unlikely that new issuance will be breaking any more records for a while.

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