|
Firms eye convertibles
|
 |
May 29, 2001: 3:49 p.m. ET
Convertible bonds mix features of bonds, stock options for investors
By Eric J. Savitz
|
NEW YORK (thestandard.com) - Merrill Lynch last month tapped the public markets for $2 billion. EchoStar likewise found $1 billion from new investors. Nextel raised $1 billion, too. Where did they raise all that cash? Not from the usual places. Shunning conventional stock and bond offerings, these companies and many others have created boom times in a typically sleepy segment of the securities landscape: convertible bonds.
Convertible bonds combine features of bonds and stock options. Like other bonds, convertibles pay investors interest. But they also provide an option to exchange the bonds for stock at a set price. The idea is to let investors benefit when the stock goes up, while softening the blow if the stock sells off. So when the stock goes up, convertible buyers make money, though less than common stock investors do. If the shares decline, convertible investors who hold the bond until maturity lose nothing (barring a bankruptcy) and get paid interest while they wait.
Scott Lange, director of U.S. convertible research at Goldman Sachs, estimates that, over time, convertibles provide investors 70 percent of the upside in rising markets, but only 50 percent of the downside when stock prices are falling. Says Lange: "It's a pretty attractive risk-reward proposition."
Convertibles aren't new. But they certainly are hot: Convertible bond issuance is on pace to set a record in 2001. Indeed, more convertibles have been issued in May than in any previous month. According to ConvertBond.com, a Web site run by Morgan Stanley, companies raised more than $16 billion in 31 convertible offerings in the month through May 23, topping the record $11.9 billion raised in February. All told, companies have raked in $47.8 billion via convertibles this year, which puts the market on track to beat the record $61.6 billion raised in 2000.
Anand Iyer, head of global convertible research at Morgan Stanley, says the surge in convertible issuance reflects the Fed's chopping of short-term interest rates – allowing companies to find buyers for their converts at very attractive rates – and nervousness about the stability of the equity markets.
Convertible bonds are no substitute for IPOs, of course – they are not an option for new companies. But they do offer an attractive resource for established companies looking for cash. Baxter International recently raised $800 million, for instance, in a convertible deal; Verizon raked in $3 billion; and Royal Caribbean scooped up $300 million. Tech companies have been using converts, too. Recent issuers include Amkor, Brooks Automation, EchoStar, E-Trade, Jabil Circuit, and Lam Research, among others.
Why they're doing these deals is no surprise: With the corporate earnings picture still quite weak, many companies are looking for ways to improve their balance sheets.
Craig Garber, treasurer and vice president for corporate finance at Lam Research, which makes semiconductor-manufacturing equipment, says Lam had good reasons for raising additional capital. "In this business," he says, "you need to have a very strong balance sheet and a very strong cash position." And Garber says there were good reasons to raise that cash in the convertibles market.
| |
|
|
| |
|
|
| |
Most of the converts that have been issued recently have been issued by attractive companies but aren't that attractive from an investment standpoint.
|
|
| |
|
|
| |
|
|
| |
|
|
| |
Andrew Davis
Davis Convertible Securities Funds |
|
"The first is that the cost of capital is fundamentally lower than selling equity," he says. "And we're selling equity at a premium, so the ultimate dilution is less than straight equity."
To translate: In May, Lam sold $300 million in convertible bonds. Investors in the bonds will receive annual interest payments of 4 percent. They also get the right to convert those bonds into common stock at $44.93, which is 42 percent above where the shares were trading when the bonds were sold. The bonds come due June 1, 2006. If on that date Lam's stock is trading for less than $44.93, the investors simply get their original investment back. But if the stock at any time before that trades above $44.93, the investors can profit by converting their bonds to stock. The company benefits in that case, as well: If the bonds convert, the company doesn't repay them.
That particular feature of convertibles is even more alluring for companies with credit good enough to issue "zero coupon" convertibles. With zeros, investors get no interest payments at all. Instead, the bonds are typically sold at a discount to their face amount: A bond with a face value of $100 maturing in 30 years might be sold for $50 (not unlike U.S. savings bonds).
If investors convert their zero-coupon bonds into stock, the company benefits in two ways. One, it sells stock now at a price not to be reached until later. And two, it avoids paying investors either principal or interest. Franklin Resources, Merrill, Royal Caribbean and Starwood Hotels have all recently taken advantage of the favorable market for zeros.
As is the case with many convertible bond deals, the recent Lam Research deal was targeted at "qualified buyers" and filed under the Securities and Exchange Commission's Rule 144A, which allows the bonds to be issued without filing a registration statement. That allows companies to raise capital quickly – literally overnight – and then to register the securities later.
Indeed, individual investors don't play much of a role in the convertibles market. Rather, two breeds of institutional investors dominate. One group consists of "straight" convert buyers, mostly specialized mutual funds, which offer retail investors a chance to invest in stocks and still get some income. The other key players are convertible arbitrage hedge funds, which use converts as the basis for highly complex trading strategies.
Both types of funds have been strong performers: In 2000, convertible arbitrage hedge funds returned an average 25.6 percent, according to the CSFB/Tremont Hedge Fund Index, compared to a 10.1 percent decline in the S&P 500 over the same span. And the trend has continued. For the year through April, a period in which the S&P fell 5.4 percent, those funds gained 7.6 percent. Convertible bond mutual funds likewise have outperformed the broad market, though not as dramatically. "At a time when a lot of other investment options were having a tough go of it, they had a good time," says Goldman's Lange. "So money has flowed into the strategy."
Managers of some convertible mutual funds have avoided the flood of new issues. "Most of the converts that have been issued recently have been issued by attractive companies but aren't that attractive from an investment standpoint," says Andrew Davis, manager of the Davis Convertible Securities Fund. The combination of low yields and high conversion premiums, he says, "makes the paper appealing to somebody, but not to us."
The somebody in question seems to be convert-oriented hedge funds, which use complex trading and hedging strategies to essentially rip the converts apart into their stock and bond elements. A common side effect of their work is that the issuance of a new convertible is sometimes met by a surge in hedge-related short sales of the underlying stock, often temporarily depressing the stock price.
But in the long run, the active trade in convertible bonds is good for the public markets in general and for technology stocks in particular.
"For the first time ever, convertibles have made it into the mainstream," says Goldman's Lange, "becoming a viable financing option of choice for almost any major company." While new companies are still having trouble raising cash to invest in capital goods, acquisitions and research, more-established players are finding ways to get the financing they crave. 
|
|
|
|
|
 |
|
