As the era of free money comes to an end thanks to rising interest rates the world over, companies have been forced to seek new, less expensive ways to raise credit, and convertible bonds appear an attractive alternative.
Convertible bonds, which offer investors the chance to convert to equity when the stock reaches a certain price, give companies the chance to raise money without facing double-digit interest costs.
Research from Man Institute released in March this year reveals issuance activity started to pick up towards the end of the 2022 just when interest rates were at their highest. Thirty per cent of the entire year’s convertible bond volume came in the last two months.
And issuance continues apace this year as interest rate continue to climb. In the first quarter of 2023 US utility companies PPL Corp and Southern Co became the first two in their sector to use convertible bonds in 20 years, raising a total of USD2.4 billion between them.
Tracy Maitland, President and Chief Investment Officer at convertible bond manager Advent Capital Management, says: “We have come to the end of decades of what amounted to free money through low or even negative interest rates. That’s clearly not the case anymore.”
At the same time, severe market volatility also plays to the convertible bond market since when a stock is unpredictable the option to convert a bond to equity when it reaches a requisite point becomes more valuable. For equity investors especially, this is notable as they capture the upside, but minimise the downside. For example in 2022, convertibles only captured 52 per cent of equities’ negative return.
Meanwhile, rates look attractive for convertible bond issuers. According to Barclays research, a firm considering issuing a straight bond yielding 6 per cent could alternatively issue a five-year convertible bond at 1.67 per cent, saving 433 basis points on the coupon size.
Man Institute says that investment-grade issuers, who have pulled back from the convertible space in recent years, might also return to the market as rates remain elevated.
Maitland says: “It’s a win-win situation because the issuer is saving money and they also have a defensive equity strategy.”
Despite the uptick in issuance and in investor interest, Maitland concedes the convertible bond space is largely undiscovered.
“It’s not omnipresent, but that’s both good and bad. On the good side it’s not an overcrowded space, and there is positive asymmetry which is the ability to capture a majority of the upside, while only be subject to a portion of downside risk. On the downside, convertible bonds are a unique asset class that most people just do not know about.”
While Maitland says he wants to keep the convertible bond club exclusive, he would like to see more investors allocate to the asset class, particularly as a means of managing capital reserve requirements.
“If US insurance companies invest in stocks, they have to prove a reserve of 30 cents on the dollar, but if they buy investment grade convertible bonds, it is one to three cents on the dollar. Convertible bonds are the most capital efficient investment that they can make, but a lot of [investors] don’t know that.”
