In the world of real estate, which is historically well known for its long and liquid lunches, is there such a thing as a free lunch?
British Land’s £350m convertible bond two weeks ago is the first UK issuance at a zero coupon, and follows on the back of European property company Unibail-Rodamco’s €500m (£357m) issue in April, also at a zero coupon. Yet convertibles are not universally popular. So where is the hitch?
Convertibles occupy that space between bonds and equity. They look to all intents and purposes like a bond, except the coupon is lower, which is offset against a built-in option to convert to equity at a premium to the share price on issue. Buyers of this product sit in a category of their own. Typically an investor will be looking for wealth preservation, so holding a bond that ranks in security terms ahead of equity, but with a potential equity kicker if there is strong share price growth. The natural issuer is therefore a mid-cap business with a compelling growth story.
Indeed, this was seen in the real estate industry with convertibles issued over the past couple of years from the likes of Hansteen, Unite, Helical Bar and Derwent London. It provides them with diversity of capital and a lower cost of funding. Since 2010, European real estate companies have raised €11.5bn from 47 convertible issues and the UK has seen 12 issues raising £2.1bn.
The majority of convertible investors own the convertible outright, but in the event of any share hedging, liquidity in the shares is often improved, with shorting taking place where the option is expected to be in the money, ie share price growth on maturity is greater than the premium on the convertible. Holders therefore forward sell, or “short”, the stock to lock in gains as they are not natural holders of the equity, with its concomitant risk profile.
Bigger businesses also opportunistically tap into the convertible market – for example, Sainsbury’s and Siemens. So why are conditions currently favourable for issuers? QE has undeniably created a liquidity bubble. At the same time, with low interest rates, property is seen as delivering an attractive yield, resulting in share prices trading well off asset levels that have already seen significant growth over the past couple of years.
This looks like a win-win situation. So why, in the midst of all this euphoria, do equity investors sometimes end up disgruntled? For all but index trackers, the very fact they hold equity is because they believe in the story and potential returns and do not want those returns to be diluted by what could potentially turn out to be an expensive bond. Neil Green, head of European equity research at JP Morgan Cazenove, recently analysed the true cost of convertibles. Taking the workout of historical bonds from 1997 to 2014, the average total return to the convertibles was 8.15% (comprising an average coupon of 3.56% and capital return of 4.59%). This compared with an average coupon on straight debt of 4.4%.
Clearly the outcome varies materially depending on the point in the cycle, but there are also strategic reasons for companies to issue convertibles. Speaking with Lucinda Bell, chief financial officer at BL, the symmetry between convertibles and its development pipeline was an important factor in the decision. Both typically have modest or no income, with the potential for upside gains – through development profits or share price appreciation. Also important was the diversification of funding sources – a theme I suspect no chief financial officer who lived through the global financial crisis will lose sight of in a hurry.
The past couple of weeks have seen bond markets getting choppier, with rising concerns around Greece and the global deflation trade unwinding with vengeance. However, maybe BL’s timing was just about spot on – with a dearth of recent investment-grade issuance, its convertible was five times covered from investors, and the pricing meant it was well received by wider stakeholders. So rather than a fixed-price lunch, it was perhaps more of an “only pay for it if you enjoyed it” option.
Rebecca Worthington is chief executive at Lodestone Capital
