ANALYSIS: Convertible bonds yield win-win for issuers and investors

Europe's listed real estate sector has taken the lead in issuing convertible bonds as a way of expanding their financial legroom.

As the closing bell of the Frankfurt Stock Exchange rang on 13 May this year, the faces of Gagfah’s board of directors broke into beaming smiles. The company - one of Germany's largest listed residential companies with a portfolio of 145,000 apartments - had not only successfully issued a €375 mln convertible bond with a coupon of just 1.5%. Contrary to the usual stock market reaction to such an issuance, the price of Gagfah shares had not fallen on this day but instead had climbed slightly to close at €12.02.

'We had done everything right,' boasted CFO Gerald Klinck in an interview with PropertyEU. The resi giant had not just persuaded institutional investors to sign up to the bond issuance; it had also managed to convince existing shareholders to stay the course, despite the fact that convertible bonds may at a future date be turned into shares and thus dilute the share of profit and dividends of the original holders.

However, in this instance, the shareholders had good reason to feel upbeat. Gagfah had issued the convertible bond to refinance a loan carrying an interest rate of 4.91%, more than three times the coupon rate the company will pay in the coming five years on the convertible bond.

By tapping the capital markets, Gagfah has thus generated savings of €12.79 mln in the first year alone. And over the life of the five-year paper, which matures in May 2019, the savings add up to more than €60 mln. 'The bond gives us leeway for further growth,' said Klinck.

Other property companies in Europe have also done their math and come to the same conclusion. Indeed, in the first half of this year, listed real estate companies across the continent have issued convertible bonds with a total volume of €1.5 bn, according to a study by Société Générale.

'The volume has doubled compared to the same period last year,' Ralf Darpe, head of equity capital markets at the French bank, told PropertyEU. Société Générale is Europe's leading player in the placement of convertible bonds with a market share of 11.3%.

German REITs take the lead
Some of the most active players include listed German companies. In November, Deutsche Wohnen placed a €250 mln convertible bond to finance the takeover of its Berlin-based competitor GSW. And in April, LEG Immobilien generated €300 mln with a bond carrying a coupon of between 0.125% and 0.875% in a move aimed at diversifying the company’s financial base.

But the largest convertible issuance by a property company so far this year in Europe was a €500 mln bond due to mature in 2021 issued by Franco-Dutch retail specialist Unibail-Rodamco.

In all cases, the bonds were snapped up by institutional investors looking for higher returns than the current yields of triple-A rated government bonds without running the normal stock market risks. 'Convertible bonds offer the best of the two worlds of bonds and stocks,' noted Darpe.

Just like a common bond, these hybrid securities yield a fixed annual return via their coupon rate and also guarantee the return of principal upon maturity. In addition, convertible bonds include a call option which offers investors the opportunity to profit from potential upward movements in the underlying share. If the share price reaches a predefined threshold, the hybrid paper may be converted into equity by the issuer which generates a gain for the investor based on the difference between that threshold and the share price on the issuance date of the convertible bond.

Since convertible bonds are traded on the stock market, investors can also cash in on upward movements in valuations long before the maturity date. 'Prices of convertible bonds move up with prices of the underlying equity since this makes conversion more likely,' explained Paul Hoffmann, senior portfolio manager of Convertinvest. The Vienna-based investment company launched a fund last year which invests solely in convertible bonds of real estate companies.

'With convertible bonds, investors can profit directly from the rising share price of the issuer without running the full downside risks of the stock market,' noted Fredy Hasenmaile, head of real estate research at Credit Suisse in Zurich. When the stock market goes south, convertible bonds react more like bonds and less like shares due to the interest coupon and the guaranteed return of the principal.

‘In a market downturn, convertible bonds offer far better protection for investors than shares,' added Dieter Thomaschowski, owner and founder of Thomaschowski Research & Analysis in Erkrath. A prime example is IVG. When the Bonn-based property company headed for insolvency last year, its share price was virtually wiped out after a fall of 99.9%. However, its convertible bonds due to mature in March 2017 currently trade at 49% of the price of issuance.

Gift from heaven
The yield crunch in triple-A rated government bonds has been something of a gift from heaven for listed real estate companies issuing convertible bonds. Not only have they been able to slash their interest coupons; they have also been able to raise the threshold for conversions which has soothed shareholders’ fears that their shares will be watered down. 'The current conditions on the bond market are forcing convertible bond investors to accept less favourable conditions compared to the same period last year,' said Thomaschowski.

When Alstria Office issued a €79.4 mln convertible bond in June last year, the German office specialist had to offer a coupon with an interest rate of 2.75% and a conversion rate only 15% above the share price on the date of the convertible bond issue. But since then, conditions have changed dramatically.

When Gagfah issued its convertible bond just under a year later in May this year, it managed to obtain a coupon of only 1.5% and set the conversion rate 30% above the share price on the issuance date. Unibail-Rodamco managed to issue its latest €500 mln convertible bond with a zero-interest coupon and a conversion rate 37.5% above the share price on the issuance date. But investors are betting that the share price of the Franco-Dutch office and shopping-centre giant will rise from €209 to €288 within the next seven years.

For real estate companies these conditions are near-idyllic. 'The low coupon rate makes convertible bonds ideal financing instruments for listed property companies,' argued Darpe. 'They can obtain this financing at far lower interest rates than banks can offer,' agreed Thomaschowski. At the same time, the low coupons make it more likely that the share price of the issuer will rise in the future and reach the conversion threshold. 'When a company can lower the cost on its borrowed capital, it can increase its profit and its dividends which make its shares more attractive to investors,' said Thomaschowski.

Not surprisingly given the favourable conditions, Europe's listed real estate sector has taken a lead position in the convertible bond market. According to Société Générale, property companies accounted for 16% of all convertible bonds issued in Europe since 2011 with a total volume of €71.7 bn. Oil companies came second with a market share of 11%, followed by technology companies with a market share of 8%.

Switzerland bucks the trend
Market watchers believe that listed real estate companies in most parts of Europe will continue to issue more convertible bonds in the future. With one exception: Switzerland. The Alpine country was a forerunner among the listed property companies in 2010 when Swiss Prime Site became one of the first to issue a convertible bond after the onset of the financial crisis just two years earlier. But there have been no new bond issuances since the beginning of 2013. Instead, Swiss real estate companies have moved to classical bonds and bank loans to meet their financing needs.

There are two reasons for this, according to Credit Suisse’s head of real estate research Fredy Hasenmaile. For one, as yields of Swiss government bonds have reached all-time lows, the coupon rates of classical bonds and the interest rates of normal bank loans have also fallen dramatically. As a result, it has not been worth the trouble for real estate companies to issue convertible bonds. Whether investors would have signed up to such offerings, had they been available, is another question. 'The share prices of listed Swiss property companies have risen so strongly during the last couple of years that many investors don't see much potential for further upside,' explained Hasenmaile.

Prospects for further share price rises elsewhere in Europe appear to be brighter. 'Even though share prices have risen considerably in the last couple years, listed real estate companies still offer very attractive dividend yields,' noted Thomaschowski. 'As long as interest rates stay low, those shares will remain very attractive.'

Richard Haimann
German correspondent