Tuesday, 20 October 2009

Micro Level Trends – Corporate Financing 2009 – Convertible Bonds Show Their Worth to Investors

The beginning of 2009 was undeniably very dour. Essentially frozen credit markets, a free-falling stock market, sizable risk premium spreads between anything but AAA rated bonds versus government instruments, and the repatriation of FDI monies to US$ & JapҰ homelands demonstrated a 'flight to safety' by investors not seen in modern history.

A combination of corporate need to access liquidity for working capital and investor expectations of a better tomorrow down the road created the perfect storm for the return of the convertible bond – a hybrid type of issue itself born from preceding tumultuous eras and so perfectly suited to the start of 2009. From a low base-level of C-B sales, the innate risk-reward structure of this asset-class matched general sentiment; that sentiment in turn assisted by the forced sell-off of 'in-play' notes by hedge-funds seeking to re-build their own cash levels. This over-discounting presented a powerful buy opportunity given their mirroring of the near-mid market picture, the above base-rate yield and above comparable normal bond coupon.

As others have remarked “2008 was the year for banking re-capitalization, whilst 2009 was the year for corporate re-capitalization”. Whilst that process was relatively stable for the banking sector with a separation of obvious winners and losers via allocated government and investor funds, has been a testing time for other sector CFOs and indeed true long-term investors themselves. This so because it has been traders - a relatively small number of market participants with powerful leverage - that has as over-excited the market since its 3rd March bottom.

As previously stated, investment-auto-motives was at the beginning of the year concerned about the occurrence of a market rally sustained by the the sentiment reaction of “less than bad news” mixed with the illusionary effects of 'cost-cut achieved earnings'. History implies that such an event was almost always going to happen, but the verocity and timespan (as more value is priced into ever positive next quarter earnings) has been surprising. When the DJIA crossed 10,000 at the end of play on October 14th the jubilation at the NYSE was monumental. And more to the point, having dropped and returned, climbing to 10,110 as of 1.30pm on 19th October, the emerging attitude is that it is sustainable.

But of course speedy effectively arbitrage-led trading floors are last place to look for the bigger-picture perspective; that's the remit of sector analysts and behind them economists.

Given the sense of caution at the start of the year created by real-world tensions which prompted in favour of 'coupon & upside' convertible bonds, it seems that the market has indeed been heavily distorted given the 'supercharging' of the FTSE, S&P, DAX. That supercharging based on a mixture of emotionally driven sentiment and very probably almost heroic achievements regards the financial engineering of the corporate balance sheet. This enabled via ongoing cost-cutting and the re-cycling of the capital 'float' obtained from both enhanced MarketCap thanks to the markets and accessed liquidity, whether from in-place roll-over credit agreements or indeed any higher-cost credit made available. And of course there is always the ability to 'manage expectations' with overly conservative pre-reporting announcements, only to 'surprisingly' surpass them come reporting day

Every tool in the tool-box will have been used over and over again.

As the FT recently illustrated, for mega-cap and large-cap global enterprises with sizable EM exposure and income (50-60%) there is an 'off-set' of inter-regional fortunes, foreign earnings assisted by conversion through the weak US$. For other small-cap (and private SMEs) with typically far greater homeland exposure or sector-specific vagaries the picture appears less positive.

So for the present, the S&P100 and FTSE 100 players are carrying the whole market, and by virtue providing possible false hope for their smaller and less flexible/capable peers simply because they are similar sector inhabitants.

Q309 earnings season, has been well underway with first Alcoa's better than expected results and the financial sector continuing its expected buoyant run thanks to greater private savings and released government liquidity serving commercial and private lending, with brokers doing well from the 6-month rally witnessed. And more recently Apple Inc has 'beat the Street' with its results.

But in the broader picture both B2B and B2C arenas have ongoing fragility as we see from heavy industry Caterpillar and in consumer high-street retail. This is set against what most market observers believe to be a frothy market. And that mixture of realism vs over-optimism points to future stock declines, whether rapid or orderly.

Back to corporate financing and the previous trend toward convertible bonds

{NB. itself promoted by investment-auto-motives – see spring marketing campaign picture in the web-log picture space].

Of late some CEOs have been bleating about their 'hit' from C-Bs.

Their concern that at the time their issuing new releases of convertible bonds – though happy at the thought of potentially paying coupon at under par – that the ensuing stock-market rise would be slow and steady. So theoretically providing at some mid-term point a normative conversion rate when the instrument matured and morphed into equity. But of course the monumental rally has delivered 'fat' present valuations which given the stepped timescales of the call-options on convertible bonds (typically at 3-6 month intervals) have seen investors happily convert at well over the expected conversion level. That some CEOs say has afflicted their enterprises with rapid and large-scale capital retraction and for a time over-weight equity commitments.

Though convertibles were a relatively small slice of the market it was a powerful force in recreating a sense of confidence which helped to start the rally. Now that those early-birds seek to lock-in their gains, like other rally risers, those same market predictors may well be seeking to sell-on their newly acquired equity, thus maintaining the share-holder obligation by the firm, but with newly added pressures.

This process in itself could add weight to the speed of any market decline via the snowball effect, as holders recognise the bubble nature of the ride, convert and get-out. For the US, UK and Europe that in turn could create downward-pressure conditions which corrects and normalizes the market. The positive outcome being that economic and corporate fundamentals taking centre-stage (as is so necessary) in the valuation process.

With the market froth disappearing and less consequential room for corporate financial engineering, the ongoing need for working and investment capital will be required given the scale of intra-sector and inter-sector structural change still necessary.

Thus we saw the return of the convertible bond popularity between February and June 2009. And we could see a similar, though at smaller volume, replay in 2010.

For whilst the banking sector has seen a good 3 quarter run, many are questioning its strength given the level of 'toxic-asset write-downs' and still to be absorbed (considered only 50-65% complete) and the requirement to repay tax-payer 'bail-out' monies. If the banking sector begins to falter itself it will react with (sensibly) over-riding caution thus effectively retracting current 'liquidity-transfer' levels toward industry and consumers.

This inescapable reality, along with the previously mentioned 'top of market' equity selling, plus possible additional pressure created by reduced foreign earnings for big-cap companies negatively affected by 'stimulus-retraction' in China / Japan / India, could create the perfect storm for taking the wind out of present-day economic and equity-driven sails.

Though painful, this process would help to normalize the contorted present conditions, both on Wall Street and Main Street, and spread risk back across proportionately to broader asset genres – also slowing the present gold-run and any possible near future commodity speculation.

If this process does indeed happen, governments and regulators must endeavour to stop the pendulum swinging too far negatively. It must stabalise what have been highly pendulous conditions. More than ever, the market en mass must not charge back in and repeat the process. Such a scenario would only be economically self-defeating and put off the real long-term traction at micro and macro levels so desperately required.

Thus in the meantime mid-term to long-term investors must seek to philosophically 'strip-down' all corporations to ascertain their real values via true transparency – both offered from Board-level and through in-depth research. This a necessity before looking to once again take up any, though far more scant (and thus potentially more attractive, relative to company characteristics) future convertible bond issuance.

[NB. investment-auto-motives' autumn/fall marketing campaign pictorially depicts this call to transparency and objectivity].