Corporate Bonds in Germany: Market and Valuation

Table of Contents

Table of Graphs

Table of Abbreviations

Table of Symbols

1 Introduction
1.1 Nature of the Problem and Objectives of the Study
1.2 Methodology and Structure

2 The German Corporate Bond Market
2.1 Historical Development of the German Corporate Bond Market
2.2 Recent Trends in the German Corporate Bond Market

3 Convertible Bonds: Alternative for Asset Managers?
3.1 The Main Characteristics and Functionality of Convertible Bonds
3.2 The Valuation of Convertible Bonds
3.3 Convertibles as an Asset Class for Portfolio Managers

4 Case Study 1: The Mandatory of Deutsche Telekom AG
4.1 Background and Conditions of the Issue
4.2 The Mandatory Convertible from the Issuer’s perspective
4.3 The Mandatory Convertible from the Investor’s perspective

5 Case Study 2: The Exchangeable of KfW
5.1 Key Facts of the Issue
5.2 Reasoning behind the Deal
5.3 Benefits for the Investor
5.4 Market Reaction on Announcement

6 Conclusion and Outlook

Appendix

Bibliography

Table of Graphs

Graph 1: Outstanding Corporate Bonds in Germany (in $bn)

Graph 2: Outstanding Corporate Bonds (in $bn) and as percentage of GDP

Graph 3: Equity vs. Equity-Linked Issues in Germany

Graph 4: Pay-Off Structure of the Deutsche Telekom Mandatory

Graph 5: Price reaction of share price due to announcement of convertible issue

Graph 6: Trading volume of underlying stock before and after announcement of the convertible issue

Graph 7: Deutsche Telekom: Share Price vs. Mandatory Convertible Bond Price

Graph 8: Daily price change (in %) of Telekom share and Telekom mandatory

Graph 9: Pay-Off Structure of the KfW/Deutsche Telekom Exchangeable

Table of Abbreviations

Abbildung in dieser Leseprobe nicht enthalten

Table of Symbols

Abbildung in dieser Leseprobe nicht enthalten

1 Introduction

1.1 Nature of the Problem and Objectives of the Study

The German corporate bond market is, like many other markets, subject to a constant development: New external conditions and changes in our economic environment al-ways trigger new trends that can be observed when analysing the structure of capital markets. Particularly during the last months, a new significant tendency could be ob-served in Germany: As market statistics indicate, more and more German corporations decide to issue equity-linked securities such as convertible bonds instead of raising capital using straight corporate bonds or equity. Consequently, investors are now faced with a new asset class beyond debt, cash or equity. This implies more opportunities but also bears some risks, problems and pitfalls as each convertible has specific characteris-tics and covenants which have to be taken into account by the investor.

The purpose of this study is to reveal the reasoning behind the growing popularity of convertibles within the German corporate bond landscape. In this context, the conse-quences and opportunities for the investor are emphasized as the paper shows how asset managers can benefit from the particular characteristics of convertibles. Moreover, the price reaction of the underlying share price on an announcement of a convertible issue will be analysed. In order to avoid a too theoretical approach, two extraordinary equity-linked issues that took place in Germany in 2003 are discussed and compared.

1.2 Methodology and Structure

After having analysed the characteristics and recent trends of the German corporate bond market, the growing importance of convertible bonds in Germany is presented. Chapter 3 explains the functionality and the basic features of convertible securities as this is important to understand the following two case studies.

These examples present and analyse two specific forms of convertibles using real cases concerning a mandatory convertible issued by Deutsche Telekom and an exchangeable bond sold by KfW which can be exchanged into shares of Deutsche Telekom AG. The purpose of these case studies is to illustrate the deeper reasoning behind a convertible issuance both from an issuer’s as well as from an investor’s point of view. The paper concludes with a summary of the main findings and gives an outlook on the future expected development of the German corporate bond market.

2 The German Corporate Bond Market

2.1 Historical Development of the German Corporate Bond Market

In Germany, corporate bonds still play a subordinated role compared to other ways of debt financing. Although the amount of issued bonds increased drastically during the last years, the total volume of outstanding debt issued as corporate bonds is fairly low compared to other economies.¹ In Germany, corporations still prefer borrowing capital in the traditional way, i.e. directly from their house bank instead of raising funds through capital markets. Several reasons justify this typical German behaviour and tra-dition: Firstly, companies often fear the relatively high costs and efforts that are con-nected with the issuance of bonds, such as legal advisory, commissions for the under-writing syndicate, costs for rating-agencies and disclosure requirements. This high amount of fixed costs discourages many companies issuing bonds instead of refinancing themselves through the banking system.² More importantly, the German economy is dominated by the broad “Mittelstand” which means that there is a large base of medium sized companies, whose scale and capital demand is too small to make a public issuance reasonable. This general lack of marketability was and still is the main reason of the relatively low importance of corporate bonds in Germany.

2.2 Recent Trends in the German Corporate Bond Market

However, especially during the last years, a new trend towards issuing corporate bonds in Germany can be observed: The introduction of the Euro paved the way for offering bonds to a larger investor basis. European capital markets grew together which implies that corporations can now address their capital needs to a larger investor community offering more possibilities and opportunities.³

Besides, banks have shown a more and more restrictive attitude towards granting loans: The rules of Basle II have a major impact and will accelerate this development towards raising funds through capital markets in Germany.⁴

Within the rising popularity of corporate bonds in Germany, equity-linked securities such as convertible bonds get increasingly important and can be considered as an interesting alternative and investment opportunity for asset managers.

3 Convertible Bonds: Alternative for Asset Managers?

Current market statistics illustrate that particularly during the last months the amount of issued convertible securities increased dramatically in Germany.⁵ Obviously, the current market situation and investors’ demand benefit the issuance of those hybrid capital structures. In this chapter, the basic characteristics and features of convertible bonds are presented before analysing and comparing two specific convertible bonds that have recently been issued in Germany.

3.1 The Main Characteristics and Functionality of Convertible Bonds

In general, convertibles are bonds with an embedded option which gives the investor the right to convert the bond into a pre-specified amount of shares of the issuing company. Consequently, debt can be converted into equity by the investor which makes sense if the underlying share price is higher than the contracted “conversion price” which is comparable to the strike price of a normal option. Thus, a convertible is an ordinary straight bond plus a call option to exchange the bond into shares. Investors typically “pay” for this right by accepting a lower coupon compared to straight bonds of the same issuer or risk class respectively. This is the most important advantage and a common argument for the issuer, who benefits from significant lower interest costs of the con-vertible. Besides, normally the debt agreements or “covenants” are less restrictive rela-tive to a non-convertible bond issue which finally offers more possibilities and a higher flexibility to the issuer.⁶ Moreover, because of the conversion, temporarily granted debt might be changed into equity which is not redeemed.⁷ On the other hand, the issuer of a convertible is confronted with “capital structure uncertainty”⁸ due to the mezzanine and hybrid character of convertible securities: If the future business prospects deteriorate, bankruptcy risk increases and the issue of a convertible rather than straight equity has been a bad decision after the event. If the business booms and the stock price increases drastically, debt will be converted into equity which dilutes the (existing) shareholders’ share of the growth and earnings which means that issuing straight debt would have been the better decision in that case.⁹ This high grade of uncertainty and the complexity of capital structure decision might be a reason why managers have been reluctant to issuing convertibles so far. Another general disadvantage of convertibles is the dilution effect of the existing shareholders because of the increased amount of outstanding shares. That is among other things (particularly hedge fund activities as explained later) a reason why market participants nearly always respond negatively to an announcement of a convertible issuance.¹⁰

Apart from the “plain-vanilla” convertible just described, there exists a broad range of other versions and variations with specific covenants and characteristics which take into account the particular needs of both, investors and issuers. Two of these innovative convertibles, mandatories and exchangeables, are explained in detail in the following chapters by using real case studies concerning Deutsche Telekom AG.

3.2 The Valuation of Convertible Bonds

Since convertibles contain one or even more embedded options, the valuation of those securities is more complex than that of a simple straight bond. Due to the limited scope of this paper, only the most important aspects concerning valuation methodology will be explained now.

Generally, a convertible bond can be valued by splitting it into the main two components: the bond and the call option. The bond value without the conversion feature is called the “straight value” and is calculated by simply discounting the future cash flows, i.e. the interest revenues and principal, at a YTM of an equivalent nonconvertible bond.¹¹ Ideally, one takes an already outstanding bond of the same company with a similar maturity in order to match the same risk and duration profile.

Valuing the price of the call option is a more sophisticated exercise but has been manageable thanks to the BLACK/SCHOLES approach¹² and the further development of the option pricing theory during the preceding three decades.

Due to the embedded option, convertibles have, compared to straight bonds, a broader range of value drivers which influence the convertible’s pricing: Apart from the general factors that are related to the bond component (coupon, maturity, credit risk, duration), the warrant implies additional value drivers that have to be taken into account, such as the conversion price, the dividend assumption of the underlying share, the borrow rate and the implied volatility.¹³ This higher degree of complexity and sensitivity due to the option indicates that investing in convertibles requires more attention by the investor and is more sophisticated compared to straight bonds.

3.3 Convertibles as an Asset Class for Portfolio Managers

Generally, convertibles provide a certain risk/return-profile, which lies in between eq-uity and debt. As a result of the bond-attached call option, the payoff is highly asym-metric: After an increase of the stock price, the option becomes deeper in the money and the convertible’s return becomes more and more equity-like. If the stock price decreases, the convertible bond price falls at a progressively slower rate and is finally limited by the bond floor.¹⁴ This hybrid character can be an attractive opportunity and alternative for risk-averse, defensive asset managers, as those securities offer an upside participa-tion in the equity and a downside protection through the debt component.¹⁵ Moreover, those instruments provide a balanced risk/return-profile that surpasses those of straight equity or debt in the long run.¹⁶ In fact, statistics reveal that on average, European con-vertibles achieved a yearly return of 14.8% with an annualized volatility of 11.1%. Compared to Equities (return p.a.: 11.9%; ı = 20.3%) and Corporate Bonds (return p.a.: 5.1%; ı = 2.7%) this is an impressive and convincing characteristic of convertibles.¹⁷ These figures indicate that convertibles are a useful vehicle for an investor to enhance and influence the return and volatility of a portfolio. They can be used to obtain equity exposure in the portfolio with a lower volatility compared to common stock. Besides, the use of convertibles as an “equity-kicker”¹⁸ is an attractive possibility for institutional asset managers, whose ability to take equity-risk is legally constrained (for instance pension funds, insurances etc.) and who desire more equity exposure in their portfolio. In that case, convertibles are considered as a fixed income instrument (because of the downside protection through the floor and the constant interest cash flows) with an eq-uity element, as the convertible directly participates in the upside potential of the under-lying stock.

Beyond these typical asset managers just described, arbitrageurs and hedge funds use convertibles to benefit from market inefficiencies by pursuing the following strategies:

Arbitrageurs try to obtain risk less profits (“free lunch”) by trading over- or undervalued convertibles and therefore benefiting from market inefficiencies.¹⁹ These situations can often be enforced because of the relatively low liquidity in the convertible markets creating a mispricing. These market inefficiencies often result in convertibles “trading at a discount to their fair value”²⁰ which can provide additional income and further return enhancement opportunities.

Hedge Funds are the most important convertible bond investors and are estimated to act as a buyer of 80% of total issued volume.²¹ They usually sell short the underlying share and buy the convertible bond (long position) hoping to repurchase the stock at a lower level through the conversion of the bond. This common strategy of short-selling and repurchasing is one explanation for the sharp decrease of the stock price due to the announcement of a convertible issuance.

To sum up, convertibles offer several interesting characteristics for various types of investors which might be useful to enhance the risk/return-profile in a portfolio. In the next two chapters, two case studies are presented which illustrate the significance and possibilities of convertible bonds for both the issuer and the investor.

4 Case Study 1: The Mandatory of Deutsche Telekom AG

4.1 Background and Conditions of the Issue

On February 19th, 2003 Deutsche Telekom announced within the scope of its debt re-duction programme the issue of a €2.3bn mandatory convertible, the largest-ever man-datory convertible in Europe and the US.²² Unlike traditional convertible bonds, this mandatory will definitely be converted into common stock at maturity, irrespective of the price of the underlying Telekom share. Thus, this bond does not offer full downside protection as described in Chapter 3. In order to compensate for this disadvantage, the bond offers a high coupon of 6.5%. The bond was issued at 100% and has a mandatory-typical short maturity as it will already expire in 2006.²³ The extremely high face value of the bond (€50,000) already indicates that Telekom primarily intends distributing the bond among institutional investors rather than on a retail base. Due to the fairly attractive pricing the demand surpassed supply strongly - the bond was “three-times oversubscribed”²⁴, completely placed within only a few hours and traded in the “grey market” already at 101.75% before the issue.²⁵ Concerning the redemption, the mandatory has several characteristics which differ from traditional convertibles:

At maturity, investors will receive common stock to an extent that depends on the underlying Telekom share price. Here, three different scenarios have to be taken into account by the investor:

1) If the “maturity share price”²⁶ is below €11.80 (the “initial share price”), the conversion ratio is 4,237.2881 (=the “maximum conversion ratio”). In that case, the investor receives 4,237 shares at the current share price for each nominal €50,000 bond.
2) If the underlying Telekom share price has increased and trades above the conversion price of €14.632 the conversion ratio equals 3,417.1679 (=the “minimum conversion ratio”).
3) If the maturity share price lies in between the range just described (€11.80 - €14.63), the conversion ratio is not fixed but is equal to the principal amount of the bond (€50,000) divided by the maturity share price.

Graph 4 visualizes the pay-off structure of the mandatory and clearly indicates the dif-ferent ranges just described that define the value of the redemption amount at maturity.

4.2 The Mandatory Convertible from the Issuer’s perspective

Although the focus of this paper is concentrated on the benefits and risks of convertibles for asset managers in Germany, the characteristics of a mandatory from the issuer’s perspective are discussed now, because issuers’ and investors’ goals will finally have to be balanced with regard to the structure and pricing of the new convertible issue. Among the issuers from the technology and telecommunications sector, mandatories get more and more popular because those companies strongly benefit from the specific characteristics and features of mandatory convertibles.²⁷

It is now interesting to figure out and to explain the reasons and motivation for Deutsche Telekom to issue a mandatory instead of a straight bond or an ordinary con-vertible bond:

[...]

¹ See: Graphs 1 and 2 (Appendix).

² See: DEUTSCHE BUNDESBANK (2000), p. 37.

³ See: GEBAUER (2000), p. 12.

⁴ See: RETTBERG (2002).

⁵ See: Graph 3 (Appendix).

⁶ See: DIALYNAS / DURN / RITCHIE (2000), p. 1106.

⁷ See: SCHÄFER (2002), p. 514.

⁸ DIALYNAS / DURN / RITCHIE (2000), p. 1108.

⁹ See: DIALYNAS / DURN / RITCHIE (2000), p. 1108.

¹⁰ The market reaction of a convertible issue will be discussed in detail in the following chapters.

¹¹ See: DIALYNAS / DURN / RITCHIE (2000), p. 1123.

¹² See: BLACK / SCHOLES (1973), pp. 637-659.

¹³ See: DIALYNAS / DURN / RITCHIE (2000), p. 1104.

¹⁴ See: MACKIE et al. (2001), p. 4.

¹⁵ See: BHATTACHARYA (2000), p. 1145.

¹⁶ See: SCHÄFER (2002), p. 523.

¹⁷ See: WEISSENEGGER (2002), p. 18. The underlying indices of the statistics are: Dow Jones Euro Stoxx; Merrill Lynch EMU Corporate; UBS Warburg Eurozone Convertible Bond. Time frame of the study: 1996 - June 2002.

¹⁸ DIALYNAS / DURN / RITCHIE (2000), p. 1109.

¹⁹ See: SCHÄFER (2002), p. 522.

²⁰ MACKIE et al. (2001), p. 4.

²¹ See: WEISSENEGGER (2002), p. 11.

²² See: TULLY (2003), p. 26.

²³ See: DEUTSCHE TELEKOM AG (2003a), pp. 6-12 for further details.

²⁴ EVANS (2003), p. 8.

²⁵ See: RÖDER (2003), p. 240.

²⁶ DEUTSCHE TELEKOM AG (2003a), p. 7. The maturity share price is defined as “the arithmetic average of the daily closing prices of the shares on the twenty consecutive trading days ending on the third trading day immediately preceding the final conversion date.”

²⁷ See: KEATING (2002), p. 88.