Market sees rise in sale of convertible bonds by big companies
At $43bn, techno stocks including Twitter lead largest sale of the convertible securities since 2008 financial crisis
Companies are on pace this year to sell the most bonds that convert to equity since the financial crisis, an indication that investors still see potential for big gains in risky companies even as debate intensifies on the direction of the economy.
Companies including Twitter, Sempra Energy and Akamai Technologies had raised almost $43bn in convertible bonds by Friday. That figure is on pace to beat 2014’s $44.1bn ,which was the most since 2008, according to Dealogic.
The growth has been particularly acute among technology companies, one of the market’s hottest sectors until recently, and issuing $22.5bn, a fraction of the nearly $170bn raised in high-yield bonds or the roughly $430bn in leveraged loans.
Still, some analysts said the rise in convertible-bond sales shows the appeal of investments that give investors a way to benefit from gains in risky assets while mitigating the potential for losses.
Convertible bonds, which grant investors the right to swap their securities for equity at predetermined prices and offer the potential for much larger gains than typical high-yield debt. Investors can still get their money back if the borrower’s stock sputters, though defaults remain a risk. The debt is also appealing to companies because it carries lower interest rates than traditional bonds, and, unlike a traditional stock offering, doesn’t immediately dilute existing shareholders.
The surge in convertible-debt issuance worries some investors, however, because such issuance soared ahead of the financial crisis, and many have already grown concerned about the longevity of the bull market. Others believe conditions are still ripe for strong returns.
“It’s an interesting area, given the shift in financial conditions,” said Andy Cawker, head of specialist equities at Insight Investment, which has hired a team of experienced convertible-bond managers.
The team’s first task in coming months will be to add convertible bonds to the firm’s existing absolute return strategies, he said.
Convertible debt sales are rising at a time when analysts expect corporate profit growth to slow. While bond yields remain low by historical standards, the premiums above risk-free government debt that companies pay to borrow have been rising, along with concerns that overall economic growth could be decelerating.
Sales of convertible bonds declined after the crisis as the downturn cooled investor appetite for the riskiest securities. The average coupon for convertible debt has fallen almost by half during the expansion to 2.9% this year, the lowest on record, with tech companies on average paying just 1.4%, according to Dealogic data.
Some hedge funds buy the debt, betting on converting the bonds down the road, while others use the complexity of valuing the bond-stock hybrid to make money on misaligned shifts in prices, a strategy is known as convertible arbitrage.
Those investors buy convertibles while taking a short position in the stock of the issuing company. They then trade in and out of the two asset classes, seeking to balance their risk while capitalising on moments when one security is mispriced in relation to the other.
Because of this investment style, companies that sell convertible debt often see an increase in investors selling their stock short— borrowing shares and selling them, hoping to buy them back later at a lower price.
Earlier in the year, some investors said those strategies were a factor driving up the cost of shorting Tesla, which issued $3.9bn of convertible bonds since the start of 2013, according to Dealogic.
For now, the default rate for the debt reflects trends in the broader corporate market. Barclays estimates it will close the year at 0.9%, down from 2.6% in 2016. The default rate reached almost 5% in 2009, according to Calamos Investments. The rise in convertible debt typically occurs late in the business cycle, while stocks retain some of their allure even as growth shows signs of slowing, said Dave King, who manages a convertible-bond fund at Columbia Threadneedle Investments.
Like other markets for riskier borrowers, convertible debt has shown signs of strain in recent weeks. Ribbon Communications, which provides internet-based technologies to telecommunication companies, announced and then pulled a convertible deal on in mid-November, saying in a press release that “current market conditions are not conducive for an offering on terms that would be in the best interests of the company’s shareholders.”
Still, “while volatility shocks are not good for issuance as a backdrop”, they were part of a market environment that made the securities attractive for both borrowers and lenders, said Michael Youngworth, a convertible bond strategist at Bank of America Merrill Lynch.