Europe's boom in convertible bonds feeds on unease of investors

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 specializing 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 US$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 US$2.25 billion issue in mandatory convertible notes is 2013's biggest offer so far. Spain's Abengoa has sold 250 million euros of convertibles, while Italy's Eni sold 1.25 billion euros of bonds convertible into shares of gas grid operator Snam.

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.

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.

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