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LONDON (Reuters) - Rising European stock markets tempted companies to issue record numbers of convertible bonds in January, as investors worried about how long the rally will last sought to reduce their level of risk.
Investors' concerns about the outlook for stock markets, coupled with the attraction of convertible bond returns of around 16 percent in 2012, have led to strong inflows into funds specialising in bonds convertible into shares.
The European convertibles market saw its busiest start to the year for new issues in at least a decade with around $5 billion raised in January, almost half the volume issued globally, according to Thomson Reuters data.
Although new issues are expected to take a temporary dip as companies enter pre-earnings blackout periods, continued market uncertainty is likely to fuel demand over the year, with forecasts of between 30 and 40 percent growth relative to 2012.
ArcelorMittal's ISPA.AS $2.25 billion issue in mandatory convertible notes is 2013's biggest offer so far. Spain's Abengoa (ABG.MC) has sold 250 million euros of convertibles, while Italy's Eni (ENI.MI) sold 1.25 billion euros of bonds convertible into shares of gas grid operator Snam (SRG.MI).
Convertible bonds pay interest and are usually redeemed at par when they mature. If a company's share price rises to a predetermined level, investors have an option to exchange the bond for a predetermined number of shares.
If the value of the stock falls over the life of the investment, investors will continue to collect a steady income, and get their principal back at maturity.
For money managers starved of bond market yields, convertibles offer the opportunity to profit from the robust stock market gains seen in 2012 without the risk of buying shares outright.
Europe's debt woes, questions over a lasting U.S. fiscal deal, Middle East unrest and sluggish global growth make for an unpredictable backdrop for investors.
"If you are not completely sure how any of these very big issues are going to be resolved, whether short-term or long-term, or how the market will react to it, then you need to be in converts," said Maxime Perrin, convertible product specialist at Lombard Odier Investment Managers.
The degree of uncertainty is apparent in the Credit Suisse Fear Barometer, which tracks investors' worries about stock market direction. It hit a record high of 33.3 percent late last month.
"We are entering another period of uncertainty, and uncertainty generally breeds volatility. This is the asset class which behaves best in times of uncertainty," Perrin said.
Their flexibility makes convertible bonds especially attractive in an uncertain environments like now, when investors need a halfway house between defending existing gains and chasing more.
The FTSEurofirst 300 .FTEU3 ended down 1.5 percent on Monday at 1,150.91 points, its lowest close since December 31, having hit a near two-year peak towards the end of January in a rally that raised it nearly 8 percent above a November trough.
"All other things being equal, convertible investors should be able to capture progressively more of the rise if the underlying equity moves up and progressively less of the downside," said Lee Manzi, Jupiter Fixed Interest and Multi Asset Team fund manager.
European stocks snapped out of an extended depression last July when European Central Bank Chief Mario Draghi promised unlimited financial support to euro zone governments who were struggling to keep their borrowing costs under control.
The move, dubbed the Draghi Put, buried fears of a collapse of the currency bloc and sparked a "risk-on" trade that saw yield-starved investors clamour for historically cheap shares.
But anaemic GDP forecasts and record unemployment rates mean even the most optimistic investors are struggling to argue the case for continued share buys.
For convertible issuance to prosper the stars need to be aligned for both issuers and investors. The bonds typically allow companies to raise debt more cheaply than issuing straight bonds because investors are willing to accept lower coupons for the option to convert.
Firms can also issue shares at large premiums to their current stock price, often 20 to 30 percent. As a result, most run shy of issuing convertibles when shares are depressed but with markets at multi-year highs, and crash worries stalking investors, convertibles issuance has rarely looked so appealing.
At the same time, a shortage of supply over much of the previous year has enabled many companies to pay very low coupon.
"The terms are eye-catching," said Steven Halperin, Co-Head of EMEA Equity-linked Origination at Barclays. "Demand is there for those terms and that's encouraging people to market."
Dedicated convertible funds have lapped up the offers and remain hungry for more, bankers say.
"In the first week of January, we estimate they were sitting on cash positions representing 15-20 percent of their portfolios which is very high on a historic basis," said Yacine Amor, Head of EMEA Equity Linked at Bank of America Merrill Lynch.
While the bonds offer refuge for those with no idea what tomorrow holds, Diana Monteith, convertibles head at Loomis Sayles & Co, also sees investors diversifying from Treasuries, Gilts and Bunds -- sensitive to sudden rate rises and inflation -- into convertibles.
"Investors shouldn't get too carried away with equities and should bear in mind that there will be volatility ... We need to see economic data reflect the bullish sentiment that the markets have priced," said James Butterfill, Coutts Equity Strategist.
Editing by Alexander Smith and Giles Elgood