Alternatives: Are convertible bonds back on the menu?

Back in September 2022, we gave our thoughts on the market for convertibles in Opportunities in the aftermath. The primary market for convertible bonds dried up in the first half of 2022, a consequence of falling equity prices, rising rates, and widening credit spreads. It was one of the worst starts to a calendar year on record, with only US$11bn in convertibles issued globally in the first half of the year. The existing universe of convertibles also performed poorly, with smaller coupons relative to the rising rate environment and the embedded call options moving further out of the money (OTM). With equity markets selling off, these bonds offered little appeal for investors seeking to offset inflation.

At that point, we saw two potential directions for the market, both of which we thought were directionally positive. The first – a rise in new issuance – saw the prospect of companies returning to the market to refinance, as existing convertibles reached maturity, meeting demand for new paper from convertible investors.

The second was the risk of significant outflows from funds in this space, leading to a period similar to that which followed the 2008 global financial crisis, where we saw some convertible bonds trading at yields close to or just below their straight peers. That would have been a huge opportunity for investors with sufficient cash to purchase options for pennies (potentially even for free).

Are good times back for convertible bonds?

With 2022 marked by such low levels of activity, it has been encouraging to see global market stabilisation feed through to a pick-up in convertible bond issuance, which reached over US$19bn in notes for the first quarter of 2023 (Exhibit 1). This was almost half the total issuance seen across the whole of 2022 (US$39.5bn), with some interesting names taking advantage of the convertible market’s thirst for new paper.

Exhibit 1: Primary markets are once again open for business

Source:  Bank of America, 31 March 2007 to 30 April 2023.

We saw cruise operator Carnival[i] bringing another US$1bn deal to the market in November, to cover principal payments on debt due to mature in 2024. Korean semiconductor manufacturer SK hynix[ii], a leading supplier of memory chips, raised a massive US$1.7bn in April 2023, securing cash for operations in response to sluggish chip demand.

Elsewhere, German food delivery service Delivery Hero[iii], no stranger to the convertibles market, launched a €1bn issue of senior, unsecured debt in February 2023 (maturing in 2030), alongside a buy-back of some of its OTM, shorter-dated bonds, extending its maturity profile. The convertibles were issued with an annual interest rate north of 3.0%; that higher coupon (unsurprising, given the path of interest rates) and a reasonable conversion premium helped to fuel strong demand.

Higher issuance was also used to fund some merger and acquisition activity, with German defence industry supplier Rheinmetall^[iv] raising €1bn via two convertible notes in January 2023, primarily to help fund the acquisition of Expal Systems.

Some markets have been slow to wake

While we have seen a rise in issuance in Europe, Japan has been notably absent from the party, with just US$0.3bn of new paper thus far in 2023. The region has yet to buck 2022’s trend of closed primary markets – a far cry from the huge convertible bond issuances we saw from Mitsubishi Chemical and Kyushu Electric Power back in 2017[v]. Given the low level of Japanese convertibles that have redeemed so far this year, there has been a lesser need for refinancing.

Outside Japan, the broader recovery in global convertible issuance and bounce back of equity markets has helped the delta profile (which indicates how sensitive a convertible bond is to a price change in the underlying share) of the convertible bond universe. Average deltas have moved from recent lows slightly above 30% – the level where convertibles become ‘busted’ and start to behave more like straight bonds. We are now closer to 40%, where we would expect to see a more balanced profile, and where the market has at least a little bit more of the desired convexity (Exhibit 2).

Exhibit 2: Convertibles no longer look ‘busted’

Source: Bank of America, 31 March 2012 to 30 April 2023. Shows the average delta for convertible bonds in the ICE BofA 300 Convertible Index. The long-term average here covers the period between 31 January 2000 and 30 April 2023. Past performance does not predict future returns.

Renewed demand for assets that combine equity and debt

Looking ahead, one potential boost to convertible issuance could stem from the current environment of higher interest rates. While higher coupons are undeniably attractive to investors, companies worried about the cost of debt can find convertibles and their comparatively lower coupons a more appealing alternative when considering financing options. This has not been particularly relevant for much of the post-financial crisis era, given the persistency of ‘ultra-low’ interest rates.

The value of a convertible bond comes partly from the cash flows and partly from the optionality of the bond to convert to common stock. The appeal of the embedded call option means that issuers can offer lower coupons than they would need to if issuing straight debt. In the case of South African energy company Sasol^[vi], for example, which launched an offering of US$750 million in November 2022, the convertible bond offered an attractive coupon of 4.0%–4.5% per annum (paid semi-annually), with an initial conversion price offering a premium of 30%-35%.

On these terms, given where interest rates now stand, convertible bonds currently seem to offer a source of reasonably priced funding for companies affected by rising costs, as well as those looking for cash to fuel growth. For investors, adding an allocation to these hybrid securities can provide some downside support should market volatility pick up, with potential return coming through the convertible’s equity option. And given the higher yields on offer, investors are getting well rewarded to wait.

Delta – A measure of how sensitive a financial instrument is to a price change in the underlying share.

Convexity – This is a measure of the curvature in the relationship between convertible bond prices and interest rates, reflecting the rate at which the duration of a bond changes in response to interest rate movements. The right level of convexity gives convertible bonds an asymmetrical risk-reward profile, meaning they should share a portion of any increase in the underlying share price and provide a degree of downside support if the underlying equity falls in value.

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Important information:

Past performance does not predict future performance. The value of your investment may go down as well as up and you may not get back the amount originally invested. Examples used here are purely for illustrative purposes and should not be considered as a recommendation to buy or sell any security.

Equity securities are subject to risks including market risk. Returns will fluctuate in response to issuer, political and economic developments.

Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments, or its credit strength weakens.

High-yield or “junk” bonds involve a greater risk of default and price volatility and can experience sudden and sharp price swings.

Credit Spread is the difference in yield between securities with similar maturity but different credit quality. Widening spreads generally indicate deteriorating creditworthiness of corporate borrowers and narrowing indicate improving.

[i] Carnival issuance.

[ii] SK hynix issuance.

[iii] Delivery Hero issuance.

[iv] Rheinmetall issuance.

[v] Mitsubishi Chemical and Kyushu Electric Power issuance.

[vi] Sasol issuance.