Debt Issuance
Offshore Markets:
Offshore issuance: Securities sold outside the United States to non-U.S.
investors do not have to be registered with the SEC. The largest of
the offshore markets is the Eurobond market.
Seasoning: Once securities have been issued outside the United Stated and
have traded for at least 90 days, they can be purchased by U.S.
investors. After 90 days of trading, the securities are said to be
seasoned.
International Syndicates: Assembled to sell U.S. securities outside the
United States.
Dual Syndications: Includes both a domestic syndicate for selling within
the U.S. and an international syndicate for selling outside the U.S.
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Debt Issuance
Issuance through Private Placements:
Private placements involve the sale of securities directly to a group of
qualified investors (as defined in rule 144A). These investors include
mutual funds, insurance companies, hedge funds, and pension funds.
Over the years, the number of institutional investors has grown very rapidly.
Today, institutional investors hold the overwhelming bulk of common stock
and most bonds, on behalf of the beneficial owners, which remain, for the
most part, small investors.
Private placements most often involve debt issuances and preferred stock
issuances, as opposed to common stock issuances.
Note: Rule 144A does not permit U.S. corporations to sell common stock
through a private placement but it does permit foreign corporations to sell
common stock in the United States through a private placement.
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Debt Issuance
Benefits of Private Placements for the Issuer:
Sales of securities to qualified investors are exempt from registration with
the SEC under rule 144A. This reduces both the cost of preparing the
issuance and increases the speed with which the issuance can be made.
Securities are sold to a smaller number of investors, which reduces various
administrative costs (e.g., annual report mailings, registrar costs, paying
agent costs, etc.)
The securities can be structured to suit the needs of the issuer and the needs
of the investors in ways that would not be possible if the securities are
issued through a public offering.
Securities can be sold that do not have a top-rating or which do not have
any rating at all.
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Debt Issuance
Benefits to the Investor:
Because the issuer saves considerably from not having the incidental
expenses associated with a public offering, the issuer can pay a higher
coupon than it would have paid on a public offering and still come out with
lower cost.
The investor can obtain a structure with investment characteristics that it
could not have obtained in the public offering market.
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Debt Issuance
Example:
Suppose that a corporation can do a public offering of a ten-year debt
security and sell the security at par if it pays a coupon of 8.00%. However,
the flotation costs (including underwriting fees, accounting fees, legal fees,
filing fees, rating agency fees, etc.) and the ongoing administrative costs
amount to an additional annualized cost to 1.75%. Thus, the all-in cost of
the issuance is 9.75%.
If the corporation does a private placement of the securities, the lower
flotation costs and lower administrative costs work out to an annualized
cost of 0.75% a year. The corporation agrees to pay a coupon on the
private placement of 8.50%. This is .50% more than it would pay on a
public offering, but the final all-in cost is only 9.25%.
Conclusion: The issuer saves 0.50% a year and the investor earns 0.50% a
year more.
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Debt Issuance
Structuring Securities in Private Placements:
Privately placed securities are often highly structured, meaning that they
have been “engineered” from component parts in order to satisfy the needs
of both the issuer and the investor. The needs of these two parties can be
very different.
The component parts of the structuring process often include over the
counter (OTC) derivatives. When structuring will involve OTC derivatives,
then the private placement desk will work closely with the Derivative
Products Group (DPG).
Derivative products include forwards, swaps, and a variety of options.
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Debt Issuance
What is a swap?
A swap is a bilateral agreement in which two parties, called
counterparties, agree to exchange a series of payments over time.
payment
counterparty 1
counterparty 2
payment
Swaps range from very simple structures, called plain vanilla, to very
complex structures, called exotics.
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Debt Issuance
What are the main categories of swaps?
Currency swaps (introduced in London in 1979)
Interest rate swaps (introduced in London in 1981)
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Debt Issuance
What are plain vanilla interest rate swaps?
A plain vanilla interest rate swap is a bilateral agreement between two
parties in which one party agrees to pay a fixed rate of interest to the
second and the second agrees to pay a floating rate of interest to the first.
These payments are made at regular intervals (usually semiannually) for a
specified number of years.
By fixed rate of interest we mean an interest rate that is set at the time the
swap is negotiated and which does not change over the life of the swap.
This fixed rate of interest is called the swap rate.
By floating rate of interest we mean that we periodically observe some
benchmark rate. We observe the benchmark rate at the beginning of a
coupon period and then pay it at the end.
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Debt Issuance
Common benchmarks for the floating rate:
LIBOR (6-month LIBOR, 3-month LIBOR, 1-month LIBOR)
T-bill
prime
repo
CP
CD
pay
observe LIBOR
repeat
repeat
time
first payment
write swap
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Debt Issuance
USD notionals
receive rate
Counterparty 1
LIBOR
USD notionals
Counterparty 2
Goldman Sachs
USD notionals
pay rate
Counterparty 3
LIBOR
USD notionals
How does Goldman Sachs make money from its role as a swap dealer?
Indicative Pricing Schedule
Tenor
1
2
3
4
5
7
09/01/01
GS pay rate
TN + 40 bps
TN + 44 bps
TN + 46 bps
TN + 52 bps
TN + 58 bps
TN + 62 bps
GS receive rate
TN + 44 bps
TN + 48 bps
TN + 51 bps
TN + 58 bps
TN + 64 bps
TN + 69 bps
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T-Note Rate
5.20%
5.38%
5.50%
5.60%
5.68%
5.82%
11
Debt Issuance
•
In a currency swap, the two legs are fixed and there are two principals, each denominated
in a different currency. The principals may be notional only, or they may be real. When
real, the principals are exchanged at the inception of the swap at then re-exchanged at swap
maturity. Real principal currency swaps tend to accompany new issues, whereas notional
principal currency swaps tend to relate to outstanding issues. Example: 5-year Yen-dollar
real principal swap with annual periodicity, $10 million 6% p.a. and Y1.1 billion:
$10 million (at time 0)
Y1.1 billion (at time 0)
Goldman
Sachs
Swap
Desk
6% p.a. ($) (annual for five years)
3% p.a. (Y) (annual for five years)
Swap
Counter party
$10 million (at the end of 5 years)
Y1.1 billion (at the end of 5 years)
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Debt Issuance
•
09/01/01
With a cross-currency interest rate swap, one swap leg is fixed and
denominated in one currency while the other swap leg is floating and
denominated in a second currency. Thus a cross-currency interest rate
swap is simply a combination of an interest rate swap and a currency
swap. For example, the swap dealer pays s.a. $LIBOR on $10 million
for 3 years, and the counter party pay 3% on Y1.1 billion for three
years where both principals are notional.
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Debt Issuance
Building Structured Securities:
Consider the following scenario. A corporation decides that it needs to
issue $1 billion of four-year fixed-rate debt. It would like to do it through a
private placement.
The private placement desk discusses the matter with institutional sales and
trading. They identify three investors who would be willing to hold the
corporation’s debt. One investor is willing to hold $500 million of fixedrate debt and another is willing to hold $300 million of fixed-rate debt. The
fixed rate debt would pay a coupon of 9.00%. The third is willing to take
$200 million, but requires floating-rate debt in the form of a floating rate
note that pays LIBOR + 100 bps.
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Debt Issuance
Corp.
Issuer
9.00%
Corp.
Issuer
9.00%
Corp.
Issuer
fixed
?
9.00%
09/01/01
9.00%
floating
Investor 1
Investor 2
Investor 3
$500 mm
$300 mm
$200 mm
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Debt Issuance
Corp.
Issuer
Corp.
Issuer
8.75%
fixed
7.75%
Note
?
LIBOR
floating
09/01/01
Goldman
Sachs
DPG
LIBOR +100 bps
Investor 3
Investor 3
$200 mm
$200 mm
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Debt Issuance
Summary of Corporate Finance and its Relationships to Other Areas of the Firm
Syndicate
Public Offerings
ECGS
DCGS
Corporation
GS
Corporate
Finance
Private
Placements
Inst/Retail
Investors
Inst. S&T
PCS
Inst/Retail
Investors
Inst. S&T
Institutional
Investors
Private Placements
GS DPG
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Debt Issuance
Case Study I: Goldman Sachs-Skopbank
•
•
•
•
•
•
•
•
09/01/01
December 1989
Japanese life insurance companies seeking enhanced interest income
Skopbank AAA rated
Skopbank traditional funding in US dollars and at $LIBOR flat
Nikkei 225 at about 38,200
Seasoned 1-year AAA-rated Euro-Yen bonds yielding 6.10%
Yen-dollar rate at about Y144/US$1
Annualized vol of Nikkei about 13% (in Yen)
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Debt Issuance
•
Terms of Issuance:
Issuer:
Size:
Coupon:
Maturity:
Issue Price:
Call Options:
Denomination:
Commissions:
Redemption:
Skopbank
Y6.7 billion
7%
1 Year
101-1/8
None
Y100 million
1-1/8
If at maturity, Nikkei > 31,870.04, then
redemption at par. If Nikkei < 23,902.53, then
redemption is zero. If in between, then
redemption is
Y100 million x {1 - [(4)(31,870.04 - Nikkei)/(31,870.04)]}
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Debt Issuance
•
•
•
•
09/01/01
Skopbank issues a plain-vanilla 1-year, fixed-rate Euro-Yen bond and
buys an embedded, European-style, out-of-the-money capped put on
the Nikkei 225.
A capped put is a combination of two puts, short one put with a higher
exercise price and long an otherwise identical put with a lower
exercise price. Here the two strike prices are 31,870.04 and 23,902.53.
The capped put precludes the investor (Japanese life insurance
companies) from having to pay the issuer (negative redemption)
should the Nikkei fall below 23,902.53 at expiration. The capped put
is out-of-the-money because the two strikes are well below the current
level of the Nikkei at issuance (38,200).
The instrument is coupon guaranteed by not principal guaranteed. The
principal component has four times leverage.
The investor picks up 90 basis points in enhanced coupon for writing
the capped put.
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Debt Issuance
•
Graphically, the redemption formula looks like the following:
% Redemption
100%
Slope = 4
0%
23,902.53
09/01/01
31,870.04
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Nikkei 225 at Maturity
21
Debt Issuance
•
Skopbank will seek to “reverse engineer” the issue and, economically
speaking, get back to floating dollar funding at sub-LIBOR. Skopbank
will need to achieve a sub-LIBOR funding rate because (a) otherwise
it would just issue floating dollar funding in the first place, and (b) it
will assume some counter party credit risk with Goldman.
•
Specifically, Skopbank will look to sell off its embedded capped put to
Goldman (enter Goldman’s equity derivatives desk) and to convert the
Yen-denominated fixed coupon obligation to a floating dollar
obligation (enter Goldman’s cross-currency interest rate swap desk).
Skopbank will convert the Yen proceeds from the issue into dollars,
and reconvert dollars back to Yen via the real principals on the swap.
•
Note that I do not have the exact terms of the swap done in this deal,
so the figures appearing on the next page are just representative.
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Debt Issuance
•
We have:
Skopbank
Capped Put on Nikkei
1-1/8% Commission (or
about $525,000)
Yen 6.7 billion (today)
100% + $LIBOR - 20 bps (in
one year on $46.5278 million)
Goldman
Sachs
$46.5278 million (today)
107% (in one year on
Yen 6.7 billion)
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Debt Issuance
•
In this case, at the end of the day, Skopbank has issued about $46.5278
million at an all-in cost of 20 basis points below $LIBOR.
•
How much money Goldman makes all-in depends critically on what it
will fetch for the capped put. (In addition, Goldman will have to
hedge the risks occasioned by the cross-currency interest rate swap
transaction.) In this case, Goldman refashioned the Nikkei puts and
resold them to retail investors as Nikkei Put Warrants listed on the
Amex. (One might say that Goldman could profit if the implied vol of
the embedded put was lower than that of the listed put it in turn sold.)
•
On a forensic note, the Nikkei closed at around 23,000 at the maturity
of the Skopbank issue.
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Debt Issuance
Case Study II: Goldman-Disney
•
•
•
•
09/01/01
In 1985, Disney acquired Arvida (real estate inventories) and paid
greenmail to Saul Steinberg
As a result, Disney had a substantially more levered balance sheet and
had a significant debt maturity profile problem. It had $862 million in
debt ($215 million to acquire Arvida and $328 million to repurchase
4.2 million shares from Steinberg). TD/TA rose from to 43% from
about 20% just one year earlier. Two-thirds of the total debt consisted
of short-term bank loans and CP.
Disney was rated a weak single A.
Since 1983, Disney had a licensing agreement with a Japanese
company related to Disney Tokyo. Gate receipts were rising and so
were Disney’s Yen-denominated royalties, but the dollar had been
depreciating, occasioning losses on the exchange component.
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Debt Issuance
•
•
•
Thus Disney’s treasury officers sought to solve both problems by, in
part, issuing long-term debt in Yen, converting the proceeds to dollars
and paying down some of the short-term bank loans and CP, and using
the Yen-denominated gate receipts to service the debt.
Being a weak single A, a Euro-yen issue by Disney could not float in
the Eurobond marketplace.
Disney could obtain a 10-year Yen term loan from a consortium of
Japanese banks. The loan would be fixed rate with a s.a. coupon of
3.75% and up front fees of 75 basis points. The principal would be
Yen 15 billion or, at an exchange rate at the time of about Y250/US$1,
about $60 million. Thus the all-in cost of the loan, in Yen, would be
7.75% p.a. (r = IRR = 3.804% s.a. or 7.75% p.a.):
100.00 - 0.75 = 3.75/(1 + r) + 3.75/(1 + r)^2 + … + 103.75/(1 + r)^20.
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Debt Issuance
•
Goldman suggested an alternative strategy to Disney whereby it would issue a
10-year Euro-ECU bond and then swap to Yen. The ECU proceeds would be
exchanged in the spot market for dollars and used to pay down some of
Disney’s short-term debt, thus restructuring its debt maturity profile. The
Disney Tokyo Yen-denominated royalties would be used to service the swap
payments. (The ECU was a trade-weighted basket of Common Market
currencies and the forerunner of today’s euro. At the time, the ECU was the
second leading European currency behind the then West German mark.)
•
Goldman had identified a AAA-rated French utility with an already outstanding
Euro-Yen bond that had about 10 years to maturity and was yielding about
6.83% p.a. It also had a 10-year outstanding Euro-ECU bond that was yielding
about 9.37%.
•
So the question was, Could Disney issue Euro-ECU and swap to Yen at an allin funding cost that was lower than the 7.75% p.a. rate on the Japanese term
loan? And could Goldman and the French utility profit too?
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27
Debt Issuance
•
The terms of the Euro-ECU bond were:
Par:
ECU 80 million (also about $60 million at the time)
Price:
100.250%
Coupon:
9.125% p.a.
Fees:
2%
Expenses:
$75,000
Sinking Fund: 5-year straight line beginning in Year 6
Dollar/ECU: $0.7420
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Debt Issuance
•
Given these terms, the cash flows on the Euro-ECU issue occasioned
an all-in funding cost to Disney of just 9.47% (the IRR from the cash
flow stream below):
Year
0
1
2
3
4
5
09/01/01
Cash Flow (million ECU)
78.499
(7.300)
(7.300)
(7.300)
(7.300)
(7.300)
Year Cash Flow (million ECU)
6
(23.300)
7
(21.840)
8
(20.380)
9
(18.920)
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Debt Issuance
•
At this point we can readily see an arbitrage opportunity. Call it
“relative credit spread arbitrage”. As the table below indicates,
whereas the French utility being rated AAA has an absolute advantage
in issuing in both ECU and Yen, Disney has a comparative advantage
in issuing in ECU. Disney’s relative credit spread in ECU is just 10
basis points, whereas it is 92 basis points in Yen. Buyers of the EuroECU issue appear to be overpricing the issue. The difference between
the two relative credit spreads is 82 basis points and represents the
“pie” that can be sliced up among Disney, the French utility, and a
swap dealer (presumably Goldman at first thought).
Fr. Utility (AAA)
Disney (A-)
Spread
09/01/01
ECU
9.37% p.a.
9.47% p.a.
10 bps
Yen
6.83% p.a.
7.75% p.a.
92 bps
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Debt Issuance
•
So Disney should issue in ECU and swap to Yen, the result of which is
for Disney to service the French utilities outstanding Euro-Yen debt
and the French utility to service Disney’s Euro-ECU debt:
Yen Payments (A)
Disney
ECU Payments (B)
Yen Payments(C)
Swap
Dealer
ECU Payments (D)
ECU78.5 million (from Euro-ECU issue)
$60 million (to service short-term debt)
Yen (from Disney Tokyo royalties)
ECU Payments (to service Euro-ECU bond)
ECU (from operating cash flows)
09/01/01
French
Utility
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Yen (to
service
Euro-Yen
bond)
31
Debt Issuance
•
•
•
•
•
09/01/01
The next slide shows the actual cash flows on the swap. The swap
dealer in this case turned out to be the Industrial Bank of Japan (IBJ),
which was then AAA rated. (It could have been that the French utility
demanded a better-credited counter party than Goldman on the 10-year
swap.)
The columns are labeled A, B, C and D and comport to the arrows
labeled similarly in the previous slide.
When one computes the IRRs using the cash flows in the columns, one
sees that Disney’s all-in funding cost in Yen (from issuing the EuroECU bond and swapping to Yen) was just 7.01%. That is a savings of
74 bps versus using the Yen term loan (7.75%). IBJ took 6 bps and
therefore the French utility saved 2 bps (giving a total of 82 bps).
Conclusion: Disney funds in Yen at just 18 bps above a AAA despite
being a weak single A.
Discuss IBJ’s “hari kari” swap.
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32
Debt Issuance
•
•
Note that the swap cash flows ignore any fees baid to either IBJ or Goldman. The
dollar/ECU was $0.7420 and the Yen/dollar was Y248. The initial Yen principal received
by Disney from IBJ is relevant only to the swap transaction and the calculation of an all-in
Yen financing cost. By exchanging the initial Yen for dollars in the spot market, Disney
would obtain new dollar funding. The principal amounts for the French utility are strictly
notional as no net new funding is obtained by the utility as a result of the swap.
ECU/Yen Swap Flows (Million)
Disney Swap Flows:
Fr. Utility Swap Flows:
(Paid to)/received from IBJ
Received from/(paid to) IBJ
Year
Yen (A)
ECU (B) Yen (C)
ECU (D)
0
14,445.153
(78.499) (14,445.153)
80.000
0.5
(483.226)
483.226
1
(483.226)
7.300
483.226
(7.350)
1.5
(483.266)
483.266
2
(483.266)
7.300
483.266
(7.350)
2.5
(483.266)
483.266
3
(483.266)
7.300
483.266
(7.350)
(table continued on next slide)
09/01/01
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33
Debt Issuance
Year
3.5
4
4.5
5
5.5
6
6.5
7
7.5
8
8.5
9
9.5
10
09/01/01
Disney Swap Flows:
Paid to/(received from) IBJ
Yen (A)
ECU (B)
(483.266)
(483.266)
7.300
(483.266)
(1,808.141)
7.300
(1,764.650)
(1,721.160)
23.300
(1,677.670)
(1,634.179)
21.840
(1,590.689)
(1,547.199)
20.380
(1,503.708)
(1,460.218)
18.920
(1,416.728)
(1,520.450)
17.460
Fr. Utility Swap Flows:
Received from/(paid to) IBJ
Yen (C)
ECU (D)
483.266
483.266
(7.350)
483.266
1,808.141
(7.350)
1,764.650
1,721.160
(23.350)
1,677.670
1,634.179
(21.880)
1,590.689
1,547.199
(20.410)
1,503.708
1,460.218
(18.940)
1,416.728
1,520.450
(17.470)
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Debt Issuance
More Modern Applications:
During the second half of the 1980s and first half of the 1990s, interest
rate derivative desks discovered that the call option embedded in a
callable bond could be replicated by a swaption. As a result,
underwriters, working with their interest rate derivative desks,
schooled corporate treasury officers on how to issue a callable bond
and then sell-off (economically speaking) the embedded call by
writing a swaption. If the embedded call could be purchased cheaply
by the corporate issuer, that is, the added coupon was small compared
to a straight-bond alternative, then the corporation’s overall funding
cost would be lower (than the straight-debt alternative) after selling off
the call by writing the swaption. At the end of the day, the embedded
call was cheaper if its implied vol was lower than that of the swaption.
We have:
09/01/01
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Debt Issuance
Issue callable bond
+ Write a swaption
Issue straight debt
(issue straight debt and buy back a call)
(sell off embedded call)
(lower coupon than issuing straight debt
directly if the implied vol of the swaption is
greater than that of the embedded call)
Of course, the investment bank could help discover (or create) value
for the buy-side under this same process. If the implied vol of the
embedded call is greater than that of the swaption, then the investor say a hedge fund that buys the debt issue under a 144A offering - could
buy the bond (possibly financing the purchase in the repo market) and
buy the swaption. To isolate the value more precisely, the buyer could
hedge the credit risk of the bond with a credit derivative.
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Goldman Sachs: Debt Issuance Copyright (c)
1998-99, Marshall, Tucker & Associates, LLC.
All rights reserved
36
Debt Issuance
Convertible Bond Arbitrage:
This process is essentially being rehashed today in the convertible
bond arbitrage game. The following attachment demonstrates how an
investor can engage in volatility arbitrage related to differences in
values between the embedded option in the convertible and an actual
or synthetic option on the stock. (See attachment.)
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Goldman Sachs: Debt Issuance Copyright (c)
1998-99, Marshall, Tucker & Associates, LLC.
All rights reserved
37
Debt Issuance
•
•
09/01/01
The issuance of convertible debt through 144A offerings has been
growing substantially over the last two years. In 1999, convertibles
accounted for about 17% of the total equity issuance market, which
was $186 billion. In 2000, convertibles accounted for about 25% of a
$216 billion market. And through May of 2001, convertibles claimed
about 53% of a $90 billion equity issuance market. (Follow-on’s were
33% and IPO’s just 14%.)
Reasons for the rise in convertibles include (a) demand by investors
occasioned by convertible arbitrage plays as just described; (b) a
growing recognition that convertibles offer some balance sheet
benefits (e.g., firms do not need to report fully diluted EPS as they
would under a straight equity offering); (c) an unwillingness to issue
straight equity as firms view their common stock as “expensive
currency” following the NASDAQ market crash; and (d) a willingness
among better credits to issue convertibles (just 22% investment grade
issues in 1999 as compared to 63% in 2001 to date).
Goldman Sachs: Debt Issuance Copyright (c)
1998-99, Marshall, Tucker & Associates, LLC.
All rights reserved
38
Debt Issuance
•
09/01/01
Indeed, some now argue that the flood of embedded stock options
accompanying these convertible issues has created a “volatility crush”
or “volatility overhang” in the equity market. It is a fact that the
market has been “taking out” time value from options, perhaps
because of an excessive supply of vol. Volatility traders who have
been delta and gamma neutral but carrying negative vegas have
generally profited in 2001 (whereas such a strategy was generally a
loser for the preceding five years).
Goldman Sachs: Debt Issuance Copyright (c)
1998-99, Marshall, Tucker & Associates, LLC.
All rights reserved
39