Market Analysis: Time is ripe for return of convertible bonds in GCC
Convertible bonds are overdue a renaissance in the GCC region as fertile market conditions provided by rising interest rates combine with elevated levels of demand from investors.
This is boosted by regional trends including a number of economic programmes for the majority of GCC countries.
These economic programmes include Saudi Arabia’s Vision 2030 and UAE Vision 2021, which not only create a new pool of money from sovereign wealth funds, but renewed investor attraction into options for investment. Large-scale projects such as Dubai Expo 2020 are also seeing the UAE redoubling its infrastructure development in preparation, providing ample investment opportunities. Furthermore, there is now a significant focus on Saudi Arabia’s equity market expansion.
All this new activity across the GCC sets the background for potentially rejuvenated investor interest in GCC convertible bond issuance across diverse sectors, including infrastructure and real estate.
Convertible bonds are a conventional, fixed-income bond with an embedded option to convert into equity should a company’s share price reach a certain higher level in the future. They provide a cheaper source of debt for issuers than corporate bonds, because the equity option has a value to the investor, allowing coupon rates paid by issuers to be significantly lower.
This creates a package of exposures – including equity, credit, rates and volatility – which deliver value beyond the sum of its parts. The two elements divide out as follows: the fixed income bond has interest payments from a coupon and repayment of principal at maturity; the conversion option gives the holder the option to convert the bond into a specified number of common shares of the issuer at any given time.
The advantage of convertible bonds is that they are highly flexible, filling the entire spectrum from debt to equity. Terms can be tailored to meet the specific needs of the company.
There is currently strong investor appetite for GCC convertible and exchangeable bonds, in particular when issued using standard structures rather than sukuk. This investor demand stems from suitable market conditions for the product.
Rising interest rates create the ideal environment for convertible bonds to flourish. Historically, convertibles have always seen large volumes of issuance increases when interest rates have risen.
Furthermore, no convertible bonds have been issued for more than two years in the GCC, owing to the ultra-low interest rate environment making it easier for companies that wish to raise debt on capital markets to issue plain vanilla products.
Built-in market timing provides upside participation when markets rise and, crucially, downside protection when markets fall. A portfolio of varying bond floors will see re-investment into new and balanced issues keeping the bond floor strong and the downside limited.
There are a number of opportunities presented by convertible bonds in the region.
The GCC is home to numerous accessible and liquid underlying stocks, while Saudi Arabia’s equity market is rapidly expanding and becoming increasingly open to Qualified Foreign Investors (QFIs). Issuers can maximise investor demand by tailoring the structure, size and terms of their equity-linked issues to the current sweet spots within the equity-linked market.
In the current investment climate, where investors are seeking to limit downside risk relative to equities, convertibles can provide a security blanket for investors wishing to participate in the growth of a particular company but seeking the protection of bond cash flows in the event the stock does not perform as hoped.
International investor preference has evolved away from traditional sukuk structures to more conventional convertible bond structures. The current environment is less conducive to regular sukuk, with income generation mechanics historically having triggered onerous selling restrictions. Conversion mechanics are not straightforward and carry complexities for Islamic issuance, but these are not insurmountable. Credit assessment can be complex, with issuer opacity proving unhelpful. Furthermore, stock borrow availability can prove an issue for hedge funds. On that basis, issuers looking to attract foreign investors may find it a smoother process to issue conventional convertible bonds, but should not necessarily shy away from Islamic products with built-in conversion options.
So why Issue a Convertible? For companies considering issuing convertible bonds there are many benefits. They are a highly flexible tool to meet financing needs – for example M&A, Capex, share buybacks and other corporate finance requirements. They provide a high level of flexibility, filling a wide spectrum from debt to equity, with the possibility of tailoring terms to meet the specific needs of the corporate. Convertibles provide cheap debt, which leads to substantial savings in yield versus straight debt and a way to manage cashflow. Equity can also be sold at a premium and volatility in share price can be monetised.
To summarise, Middle East convertibles have undergone a decade of gradual evolution since the US$3.5 billion pre-IPO sukuk from DP World launched the GCC convertible bond market in January 2006. Since then, 20 issues with notional value of $23bn have been issued in the region, with financial services and real estate companies comprising the majority of issuance.
The time is right for this as yet relatively unexploited market to expand at a more aggressive pace – the international investment appetite is there and issuers now need to seize their moment.
Martin Haycock is a senior partner specialising in convertible bonds, for Fisch Asset Management, a member of The Gulf Capital Market Association