By Brian Sozzi
"Although convertible bonds are called bonds, they behave like stocks, work like options, and are cloaked in obscurity." –Benjamin Graham
Debt underwriting has been a hot place for an I-banker to reside within the confines of the biggest financial institutions around during the risk asset rally. Straight U.S. debt issuances clocked in at $1.2 trillion in 2010, about on par with 2009, though on a fewer number of issuances. Companies have sought to capitalize on the attractive interest rate environment courtesy of the Federal Reserve to re-lever, or lever for the first time, their balance sheets to undertake a combination of: (1) capex funding; (2) share repurchase program and dividend plan funding; (3) debt maturity extension; (4) the bringing in of low cost funds for a rainy day should the economy hit the skids once more.
Lately, a paradigm shift has surfaced, where those in the executive suites have decided to add leverage in their attempt to juice earnings per share via share repurchases. The thinking here is that money at a cost of 5% or less is best used to reduce the number of shares outstanding, propping up earnings per share in the meantime, and hopefully triggering a rally in the stock price that makes a 5% investment seem modest. Why is this now happening? Stock gains have moderated this year from the impressive rally off the August 2010 lows, with the S&P 500 up a shade over 4% YTD, held back by geopolitical unrest, cautious commentary on 4Q calls and ensuing road shows, and preliminary signs of margin softness by corporate America. Moreover, it would be hard to argue that a rate tightening cycle is not on the horizon (the hawks inside of the Fed have been vocal of late). First, quantitative easing will go dark in June followed by a hike in the Fed funds rate sometime in 2012. So executives are electing to bask in the good graces of the Federal Reserve, sweep under the rug the slower rate of organic earnings growth, and lever up while the iron is still hot.
What about the convertible debt issuances that legendary investor Ben Graham had little respect for? Convertible issues, in my view, are one of the classic indicators of market tops. For example, global sales of converts reached $183 billion in 2007, up 47% from 2006. We are all fully aware of what happened in the markets from there. Converts tend to come out of the woodwork near the end of a bull market, largely as subpar companies have enjoyed stock returns high enough to make the conversion feature attractive. Investors are caught up in the speculative froth that transpires at the peak of an asset bubble, and in the case of converts only see the potential for stock price appreciation instead of the risks to investment. In exchange for the conversion privilege, the investor usually foregoes something important in quality, yield, or both. On the flip side, if the company gets its money at a lower cost due to the conversion feature inherent in the bond, it's surrendering in return part of the common shareholders' claim to future enhancement.
For dyed in the wool bulls in this market, rest easy for now as the convert issuance alarm bell is not sounding. Global sales of converts have exceeded $14 billion this year, speculative fervor not exactly, but already ahead of the 2010 total of $13.3 billion. I would say the crowd has only caught a whiff of smoke, the first step in walking to the alarm bell and then exiting stage left. Recent deals on the convert front align with Graham's notion of poorer quality companies seeking to cash in on the appetite for their shares or companies that are apt to spin a bad story into a good story to issue high yield debt with a convert option.
James River Coal (JRCC)
* Stock price from March 2009 lows: +108%
* Priced $200 million convert on March 24
* Debt to equity ratio: 114%
* Stock was down 16% to start the year prior to recent bounce
* Stock price from March 2009 lows: +1,100%
* Closed a $115 million convert deal on March 28
* Business model is under attack, hurting greatly financial performance
* Priced $150 million in converts on March 9
* Stock decimated relative to highs established in April of last year
* Stock down 14% year to date on concerns following its convert issuance
* Recently closed on a $1.67 billion convert deal
* Debt to equity ratio: 94%
Classic Example of Graham's Views
Energy Conversion Devices (ENER)
Issued $316 million in converts in 2008 with a strike price of $90; stock at the time was trading in the 70s. Closing price as of March 30, 2011 was $2.41.