LONDON (Reuters) - The market for bonds that can be converted into stock looks set to grow in Europe over coming years, driven by a fall in bank lending to companies, the funding needs of cash-strapped governments and return-starved investors worried about volatility.
Many European companies, which have traditionally relied more heavily on bank finance, could be forced to try other methods of funding as banks rein in lending under pressure from regulators to beef up their capital requirements.
With bank loans hard to come by, particularly for more risky borrowers, companies are likely to turn to bonds.
The cheaper cost of issuing a convertible bond relative to straight debt, as investors are willing to accept a lower coupon in return for the equity option, makes it an attractive alternative.
While bankers and investors expect new convertible issuance, which has been low this year, to stay quiet while the euro zone debt crisis remains unresolved, they say that could change in the longer term.
"Many corporates are getting to the point of thinking about refinancing syndicated loans, and with the reduction in bank lending are likely to look at trying different products, especially those who are not yet investment grade," said Yacine Amor, head of EMEA convertible bond origination at Bank of America Merrill Lynch.
"In the medium to long term I expect substantial growth from the (convertible) market."
Many expect this shift towards bonds could prove a more permanent boost to the market's size. Once previously loan-reliant firms become comfortable with convertibles as a product and better known to investors, they may not look back.
Annual new issuance of convertible bonds has averaged around $24 billion in Europe over the last five years, according to Thomson Reuters data, but this year has so far seen only $7.5 billion as record low rates in the high-yield bond market in the first half of the year made straight bonds unusually cheap.
But those spreads have since shot up. The average yield on the Barclays Capital Pan-European High Yield ex-Financials index hit a multi-year low of 6.6 percent in February, but is now at 9.5 percent having reached 11.2 percent last month.
"The high-yield bond market could multiply in size over the coming years. In recent years, about a fifth of high yield bond issuance is convertible debt. But with credit spreads now so wide on high yield bonds, the lower coupon on convertibles may tempt more issuers," said Luke Olsen, head of convertibles research at Barclays Capital.
Buyers have got the capacity to absorb extra issuance.
While convertible arbitrage hedge funds suffered 34 percent losses in 2008, they are proving more resilient this year.
These funds are down 4.57 percent in the 10 months to October after losses in August and September, according to Hedge Fund Research, while the average hedge fund is down 3.5 percent.
"Hedge funds don't have all their chips on the table and aren't as leveraged as they could be. There is capacity among the existing hedge fund community to buy significantly more paper," said one convertible arbitrage hedge fund manager, who has seen net investor inflows this year.
Amidst such uncertain markets there are signs of growing demand for these funds, which aim to profit from volatility and mispricing in convertibles by buying the bond and then hedging equity exposure or default risk.
"If you're a convertible bond arbitrageur then you're not correlated (to markets) for next year, (whether) we go through a recession or not," said Jose Galeano, Head of Alternative Investments at fund of funds SYZ Asset Management.
"For us it's a very good trade. You can (make) 10-12 percent (next year), without counterparty risk and without leverage risk," added Galeano, who said he had 6 percent of a balanced, multi-strategy portfolio in convertible arbitrage funds, but planned to raise this to 10-15 percent by the end of the year.
Convertibles also offer the attraction of asymmetric returns, which could help tempt nervous investors.
Analysis by BarCap indicated a 25 percent rise in EMEA equity markets by the end of the year could see convertible returns at 9 percent, while a 25 percent fall in equities would result in only a 6.1 percent fall in convertible returns.
The need of European governments to boost state coffers by offloading assets is also expected to support the market.
Governments have in the past used exchangeable bonds, issued by one company and convertible in to the stock of another, which would allow them to receive income from assets without having to sell or float them at current depressed market valuations.
Last year Portugal's state holding company Parpublica issued 900 million euros of bonds convertible into shares of oil firm Galp (GALP.LS) as part of efforts to curb its budget deficit.
Structuring a sale this way gives governments the chance to access a more diverse set of investors, said James Taylor, a senior associate in the capital markets group at law firm Allen & Overy, and, as a more flexible product than straight equity or debt, can be better tailored to meet issuer and investor demands.
"Governments are turning fairly frequently to exchangeable bonds as a divestment tool," he said. "It allows them to do a forward sale of equity at a premium and retain, pre-exchange, income from their asset."
Editing by Erica Billingham