Wellington Weekly
Wednesday Market Note (Incl. An ECM Update)
November 20, 2024
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“Cycles will never stop occurring. If there were such a thing as a completely efficient market, and if people really made decisions in a calculating and unemotional manner, perhaps cycles (or at least their extremes) would be banished. But that'll never be the case.” —Howard Marks, The Most Important Thing
At the start of the week I was fearful I would not have much to report on. My notes for the upcoming Weekly included topics such as Canadian ETF fund flows and Canadian ETFs ranked by expense ratio. Boring. As the week progressed, Bitcoin reached new highs and High Yield spreads tightened, activity picked-up. So let’s dive right in.
Yesterday morning the Bank of Canada released October CPI numbers, printing Core Median at 2.5% year-over-year (above 2.4% estimates), and broad CPI at 2.0%. Recall in June 2022, CPI touched a high just above 8.0%. Friday morning U.S. jobless claims are released. The North American bond market is vying with whether Central banks pause or continue their easing policies. The 10-year U.S Treasury Note closed the day at 4.418% - roughly 15 basis points higher than when Donald Trump was elected. The fear: stimulus and inflation.
Groupe Dynamite, Canada’s first notable IPO in 2-years is expected to begin trading tomorrow morning on the TSX. The deal is messaged to be well oversubscribed, and has priced at $21 - the midpoint of price talk. Typically, when a deal is “well oversubscribed” pricing moves to the higher end of price talk - someone isn’t telling the truth. Recall the deal is being led by Goldman Sachs. Unfortunately for Groupe Dynamite, NVDA earnings’ release is not a “market moving” event shaded on the IPO process calendar timeline. An event that should be added going forward - side-by-side with Fed rate decisions.
My writing notes from the start of the dull week had me mentioning Newmont selling its Canadian gold mine for $850 million; Silver Point closing a fresh $8.5 billion special situations direct lending; Choice Properties REIT announcing a normal course issuer bid; and WestJet launching a $1.5 billion term loan B, but the cryptocurrency convertible debt market will be stealing their thunder this week - and Graham Rosenberg’s Dentalcorp will be stealing their lightning.
Three cryptocurrency companies announced convertible debt offerings this week, raising a total of $3.7 billion off the back of Bitcoin reaching all-time-highs.
MicroStrategy Inc. hit the tape with a $2.6 billion senior unsecured convertible bond priced with a 0% coupon, and conversion 55% premium. MARA Holdings tapped the arbitrage market for an $850 million senior unsecured convertible bond priced with a 0% coupon and a 42.5% conversion premium. Galaxy Digital is in the process of pricing its $300 million senior unsecured convertible bond expected to price around 2.5-3% and a conversion premium of approximately 33%. Lastly, SOL Global Investments is calling investors on a $3.6 million LIFE offering of units, with the use of proceeds to purchase Solana coin - whether anyone answers the phones, is to be determined.
Given this is a Canadian markets publication, and most, if not all of my reader-base is Canadian market participants, you may be wondering, Gary, why are the coupons so low and the conversion premiums so high. You may be wondering, Gary, how are these companies issuing convertible bonds in such large offering sizes. You may also be wondering, Gary, why would an investor purchase a convertible bond - are they not for companies in distress? Allow me to explain:
As briefly highlighted in my 2021 Weekly, Convertible bonds are an elegant way for seasoned companies to issue alternative forms of capital. Given the nature and style of the above crypto-converts, I will focus on U.S. “style” convertible bond offerings.
A convertible bond is a beautiful blend of fixed income and equity, packaged into one security. These bonds are comprised of several components, namely:
a) coupon;
b) duration;
c) security; and
d) equity call option.
For fixed income investors, convertible bonds enhance traditional fixed income returns through exposure to equity-drive price increases. Separately, the impact of interest rate risk or convexity is reduced due to increased potential return from the equity component of the bond. For fixed income investors, who are typically risk-averse or relative value seekers, convertible bonds offer asymmetric return profiles given their structure/security/rank feature.
For equity investors, convertible bonds provide income and protection against market volatility, and create equity investment opportunity with downside protection. Equity investors still receive their beloved accretion.
But the above is too simple for such a misunderstood and under-owned product. Which leads us to the last investor - convertible bond arbitrageurs. Delta neutral hedgers. Gamma scalpers.
Simply put, convertible bond arbitrageurs make money by going “long” the convertible bond, and shorting the underlying stock until there is effectively neutral delta. The arbitrageur is estimating that implied volatility is too low, and is therefore going “long” volatility. These investors will require stock borrow, liquidity, and observable volatility of the convertible bond they are underwriting and underlying equity.
Let’s answer the next two questions: 1) why are the coupons so low and the premiums so high relative to convertible offerings we typically see in Canada; and 2) how are the offering sizes so large.
In Canada we typically see convertible “debenture” offerings where coupons average in the 6-8% range, with premiums falling within the bookends of 25-35%. In the U.S. we typically see convertible bond or note offerings where coupons are in the low single digits, with premiums in the 40-50% area. There are several drivers behind the difference.
For starters, the Canadian convertible debenture market is substantially more “retail” investor driven - meaning there is far less arbitrageurs at work, and no need for hedging the security. The impact: retail investors require higher coupon compensation, and lower premium i.e. greater overall required rate of return. Institutions who hedge the convertible debenture will require a lower cash coupon because their implied risk is lower, and their return is generated through other means. Given their ability to hedge out their risk, they are effectively getting paid in cash coupon to hold the convert through it’s horizon. A nice bonus chip.
U.S. convertible bonds are offered and priced different to Canadian convertible bonds. In the U.S., management teams are far more sophisticated when it comes to financing their capital structures. They are more willing to take risk. As a result, management teams understand their stock price will decline on the announcement of a convertible bond offering (result of potential dilution, and hedging impact). Companies will announce the convertible bond offering, the stock price will decline, and the conversion premium for the bond will be fixed/referenced to the reduced stock price. The hedges for the bond are set-out prior to the investor taking ownership of their bonds.
Here is an example:
U.S.:
Company A’s stock is trading at $100. The company announces a convertible bond offering, the stock trades down to $85 dollars, with a conversion premium of 50%. The strike price of the convertible bond is $127.5.
Canada:
Company B’s stock is trading at $100. The company announces a convertible debenture offering with a reference price of $100, and a conversion premium of 27.5%. The strike price of the convertible bond is $127.5. Hedgers place their hedges post-offering announcement. The stock is likely to decline post announcement - in anticipation of this, Canadian convertible debenture buyers require a lower conversion premium as the result is a conversion premium greater than 27.5%.
Net, net, the same. The differences are far more qualitative than quantitative.
Lastly, offering sizes are significantly larger in the U.S. for a number of reasons. The most obvious being the size of the markets. The second reason being the types of buyers - as mentioned, in Canada they are far more “retail” driven, meaning hedging is less common. In the U.S., given buyers are typically hedge funds, liquidity is a core investment decision factor.
Moving on, Graham Rosenberg’s Dentalcorp tapped the market on Monday with a $100 million bought deal of subordinate voting shares. The deal was priced at a tight 5% discount, and includes a secondary offering. 50% of the deal is fresh treasury stock, 50% is Graham selling down. The deal is led by TD and RBC. To not much surprise, the deal remains 60% covered - a hung deal do kick off the week!
Why no buyers? Recall in June of this year, the company announced Graham’s conversion of multi-voting stock, and effective restructuring of his margin loan. I shall summarize:
Rosenberg is expected to remain a Director until 2029, provided he continues to own more than 2.5% of outstanding stock
An accelerated conversion of the multi-voting stock at the earliest of: U.S. exchange listing or Rosenberg owning less than 2.5% of stock
The margin loan owed by Rosenberg totaling $52 million will be exchanged for the same notional value of preferred shares
The margin loan shall be 50% forgivable if the stock price exceeds $28/sh, and matures on 2026 with limited recourse to 8.1 million shares
The margin loan will be transferred to HoldCo, issuing preferred stock of the same notional value - of which, $14.7 million is Class B prefs and $37.6 million is Class C prefs
Under the Class B prefs, HoldCo may redeem $6.4 million face amount on January 1, 2025, $3.2 million face amount on Jan 1, 2026 and $3.2 million face amount on Jan 1, 2027 - if the stock price exceeds $7.35/sh at anytime, HoldCo may redeem the shares
Under the Class C prefs, HoldCo must redeem all of the prefs at the earlier of January 2029, certain change of control events, Rosenberg’s termination or resignation - in each case, Rosenberg must pay $10.65 per pref
To summarize the summary, through this week’s offering, Rosenberg intended on selling down $50 million worth of stock. In January, another $6.4 million of stock will be redeemed. That is a lot of stock to sell at levels 30% below IPO price - and to no surprise, a hung deal.
Lastly, the multi-billion dollar question across the North American office real estate market - where do we go from here? What do we do in markets with occupancy rates peaking at 70% and bottoming at 30% depending on the work-day. It seems in Toronto, real estate developer, Fitzrovia, is taking a $1 billion swing at the answer. The real estate developer, with backing from pension funds, made a $1.1 billion investment to redevelop a 24 storey office tower at St. Clair Ave into a 600 unit residential building.
Unfortunately, there were not enough notable transactions to include in this week’s ECM world.
ECM World
Top 5 Notable Transactions
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Cheers, G.G.
Excellent note. Thank-you.