Time to convert?

Australia is missing out when it comes to using convertible bonds as a corporate financing option. But the demand is there for an investment that combines income and growth, without downside equity risk.

Insto.com.au

The time is right for convertible bonds to be re-introduced as a viable corporate financing option. This year alone, offshore issuance of convertible bonds has topped $US80 billion, according to Thomson Reuters’ latest report. In Australia, until very recently, that figure was closer to zero.

This week has seen two convertible bonds deals for investors to ponder: a cross-border $US250 million CB deal by ASX-listed Aquarius Platinum, also listed on the London and Johannesburg exchanges; and the Commonwealth Property Office Fund's (CPA) proposed $A200 million for two recent property acquisitions in Brisbane and Perth. Neither was offered directly to investors here, however.

This is somewhat surprising, as these types of funding transactions are well suited to mid-sized producing resources companies and industrials like CPA – what’s needed is a reliable cash flow.

And here’s one big reason for the reluctance to go retail: to really make an Australian CB market work, say the investment bankers behind some of the recent convertible bonds deals, retail investors – including the trillion-dollar pool of SMSFs – need to be tapped. So far, the cost of preparing a prospectus has hampered moves in that direction, in a similar manner to the stifling effect a 100-plus page prospectus has had on retail bonds.

Still, demand is there. As one investment banker noted – and he was not on either deal this week – the bottom line is that, had these deals been listed on the ASX, more investors would have had access to the transaction, potentially raising a lot more money from both retail and institutional investors.

He added: "The market is ripe for re-opening as there is a huge demand for a convertible instrument by investors who want the combination of income and growth, without downside equity risk. Hybrids have come to the retail market, however in most cases they do not have the equity upside participation that’s attractive to investors. Word was that if the CPA convertible bond deal was issued in Australia, insto investors would have bought into it.”

Hybrids have had a mixed run over the past year, ANZ’s recent CP2 notwithstanding. As seen with the Multiplex and Fairfax hybrids, for instance, these securities traded at well below 50 per cent of their issue price at the height of the GFC as there was no precise date for redemption, hence no firm capital value. And with the newer types of bank hybrids, what’s not so well known is that if the bank’s share price materially drops between issuance and maturity, APRA may not allow conversion into shares, or even redemptions.

And so to Aquarius Platinum, taken to market this week to raise a minimum of $US250 million six-year debt at a 4 per cent coupon by an increasingly self-confident Goldman Sachs. Aquarius is a tri-listed company, although the funding deal was done via a fairly standard RegS transaction (that is, in US dollars, but offered to investors outside the US, mainly in Europe and Asia.)

The real attraction of this deal to the company was that, even allowing for a 15 per cent payout premium to eliminate a similar type of security – one that one-third the size of the new raising, and denominated in rand – it was a far superior funding option. "It gives them a very strong balance sheet – they are one of the world’s largest pure-play platinum providers. It gives them flexibility on the balance sheet and the ability to go and make further acquisitions, from a facility that is three times the size, but with the same total interest cost. So it’s 4 per cent over 6 years, rather than 11 per cent for less than three years, denominated in US dollars, not South African rand,” says Hayden Stockdale, who ran the Australian leg of the deal structuring and offer from Goldman Sachs’ Australian office.

His colleague, Sean Hogan, a managing director within the investment bank’s Australian financing group contends that "domestically, we don’t have an institutional investor base that is of sufficient size substance or scale that will support a pure Australian dollar domestically offered issue, so we are very much focused on the international buyer base. The biggest issue for corporate issuance is still one of education – there is still a reluctance and a resistance at the board and senior executive level, mainly over concerns that conversion will result in dilution of existing shareholders’ interests."

"Our belief is that there is quite significant interest, particularly out of retail, in the convertible product. The need for a prospectus, though, is still an issue for issuing in Australia (to retail investors).”

Hogan says the issue is one that is likely to come into sharp focus next year: "What we’ve been seeing over 2009 is the re-equitisation of a large number of balance sheets. What we might find in 2010 is all about trying to make those balance sheets more efficient. So, if companies think they’ve got sufficient capital, that the balance is weighted too far in favour of equity, there may be more debt-financed share buybacks.”

One way to do this, says Hogan, is to use a convertible bond – it’s cheaper, from a coupon perspective, than debt and effectively issuing an equity option that’s above the price of buying back the equity today, for a higher price in the future. This effectively locks in an arbitrage between issuing equity – potentially at a higher price, while buying it back at a lower price.

That’s down the track a touch – meanwhile, Stockdale is happy. He says the Aquarius CBs are "trading at 101” – investors have a bit of upside already, but the company hasn’t paid out too much.

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