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IN THE MIDDLE March of last year, as the coronavirus pandemic was setting in, a U.S. private equity boss was asked how his industry would cope with the shock. Companies owned by buyout companies would first seek to get into debt wherever and whenever they could. Raising equity from private equity investors would be a last resort. “I think you’ll see the same thing in government markets – a lot of convertible issues,†he said. Sure enough, there was soon a wave of massive sales of convertible bonds by cruise lines, airlines and retailers.
A convertible is a bond with an option to exchange for common stock. Last year, $ 159 billion was issued worldwide, according to figures compiled by Calamos Investments, an asset manager. This was roughly double the value of convertibles issued in 2019. So far this year around $ 100 billion has been issued. An asset class that has gone out of fashion is making a comeback. This is because convertibles are well suited to rapidly changing conditions.
To understand why, start with a few basics. A convertible bond has the usual characteristics of a garden-variety bond: a principal to be repaid at maturity, an interest coupon paid once or twice a year and so on. In addition, the issuer grants the bondholder the right to convert the principal into a fixed number of shares. This number, known as the conversion rate, is usually set in such a way that it is only worth exercising the option if the share price increases by 30-40%. The option is therefore “out of the money†when the convertible is issued. A company with a share price of, say, $ 15 could set the conversion rate for a $ 1,000 bond at 50. At that rate, it would make economic sense to exchange the bond for stocks. only if the stock price reached $ 20 (that is, $ 1,000 divided by 50). In exchange for the stock option, convertibles pay a lower interest rate. Typically, they have a coupon about half that of a regular bond.
Convertibles can be complex securities, but in some circumstances they have clear advantages over debt or equity securities for issuers and investors. This is the case for unproven businesses in capital-hungry businesses. (Until recently, Tesla was a large issuer of convertibles, for example.) The founders of such companies are often reluctant to issue shares because it dilutes their ownership. They would rather issue debt. But bond investors could charge a high interest rate to offset the risk of default. Convertible bonds can be an ideal compromise. Investors are prepared to accept a lower interest rate in return for part of the rise in stocks. For business owners, convertibles are less dilutive than common stocks. New shares are issued later at a much higher price, if at all.
About 60% of the volume of issues so far this year has come from companies listed for less than three years, explains Joseph Wysocki of Calamos. But the cyclical companies of the old economy are also emitters. Some, like Carnival Cruises and Southwest Airlines, used convertibles last year to raise “bailout” funds at lower interest rates and without immediate dilution. Others use them to fund investments: Ford Motor sold $ 2 billion in convertible bonds in March, for example.
This wave of broadcasts is quite a change. The convertible market was previously rather moribund, even as high yield bonds and leveraged loans boomed. The absence of significant inflation has resulted in a steady decline in long-term interest rates. Bond investors benefited from healthy capital gains. At the aggregate level, the trend in US corporate finance was to swap equity for debt, not the other way around.
Today’s challenges are different. A big concern is that inflation and interest rates are at the start of an uptrend. In a world where inflation is high, it would be more difficult to raise capital by issuing corporate bonds. The face value of the bond upon redemption would be much lower in real terms. Conversely, convertible bonds offer some protection. They are “nominal assets with a call option embedded on a real asset,” writes Dylan Grice of Calderwood Capital, an alternative investment boutique. The option to convert to shares offers the bondholder some indexation to rising consumer prices.
Convertibles have already proven themselves. They were almost tailor-made for the circumstances of spring 2020. Big changes require flexible forms of capital. And it’s easy to imagine further economic dislocations on the horizon. Convertibles are the asset class of the time.
This article appeared in the Finance & economics section of the print edition under the title “Classic convertible”
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