Higher Interest Rates and Depressed Stock Prices Have the Convertible Bond Market Buzzing
Why issuance of bonds that turn into common stock is picking up and piquing investor interest.
The market for convertible bonds, the interest-paying securities that bondholders can choose to turn into common stock, is stirring again and attracting investors.
Convertible bonds typically mature in five years and are issued by less creditworthy companies — 76 percent of issuers don’t have a credit rating and most of the others have a BBB rating or lower from one of the major agencies, according to research by Calamos Investments. But higher interest rates are causing even the healthiest companies to use convertible bonds to raise capital. Through September of this year, companies across the globe sold $61 billion worth of convertible bonds and out of the $42 billion raised by U.S. companies, almost a third of them have investment grade ratings.
“That’s a bit of a change from the previous few years in that it was a much smaller percentage than before,” said David Hulme, managing director and portfolio manager at Advent Capital Management, which specializes in convertible bonds. “I think that’s been driven partially by a change in the way companies account for the issuance of convertibles.”
Companies are realizing two things, according to Hulme: the call options can be less dilutive based on how they are offered and convertible debt can be much cheaper. Right now, issuing convertibles can save companies approximately 3 percent on interest payments.
“As interest rates go up, the cost of a traditional corporate bond goes up, and the opportunity to perhaps issue a convertible [bond] and reduce debt payments becomes even more meaningful,” Scott Becker, senior vice president and head of portfolio specialists at Calamos Investments, added.
In 2022, falling stock and bond prices dramatically cooled convertible bond issuance and the lull in activity continued early this year while investors watched the Fed interest rate hikes and weighed the possibility of a recession. But as the Fed’s decisions and the economic impact felt more predictable, the convertible bond market has reawakened.
“Everyone’s kind of thinking higher-for-longer is a real thing,” Becker said about interest rates, and more companies are considering whether to recapitalize or refinance. They would rather do that now than risk doing those things during a recession and have to pay more.
Investors also like convertible bonds for their dynamism. It’s hard not to like the hybrid securities that can serve as either a fixed income or equity, depending on an issuer’s performance or the needs of an investor’s portfolio, Matt Kaufman, senior vice president and head of ETFs at Calamos, added. Calamos, the biggest convertible bond manager in the U.S. with $11 billion in assets, launched an actively managed ETF this month in part to capture new and returning interest in the securities.
It’s a good time to potentially take advantage of the options, according to Hulme. Most issuers are small and mid-size companies whose stocks have been under pressure in recent months, making their call option prices appealing to investors, he said.
“When you have a sharp rise in interest rates, that tends to put pressure on equity valuations. We’ve seen that this year, particularly higher growth equities,” Hulme said. “And many convertible issuers tend to have a higher growth profile than the broader market. So that makes the entry point that much more attractive.”
Investors also like the $340 billion convertible bond market because even though it is much smaller than the traditional high-yield corporate bond market (over $1.3 trillion), it tends to be more liquid. “You can put money to work in the convertible space a lot easier than you can in high yield,” Hulme said. “And more importantly, you can get it out as well.”
Convertible bonds were a favorite of hedge funds before the financial crisis. Now, fewer trade them, Hulme said. The list of traditional asset managers that have dedicated convertible bond strategies is relatively short.
Tracy Maitland, the founder, president, and chief investment officer of Advent, thought that 2021 might be the year when more institutional investors embraced convertible bonds.
Calamos counts some institutional investors as clients but Becker said convertible bonds are definitely an alternative asset. The market is also plenty big enough to provide good liquidity and grow a handsome asset management business. But it doesn’t have the scale to, for example, become an investment consultant’s recommendation for every pension or endowment portfolio.
“It doesn’t get talked about on CNBC or Bloomberg Television,” Becker said. “To us, that’s kind of nice. It allows people to see something a little bit more unique and think: ‘how can I put this alongside other things I already know? Maybe that can help with my risk budgeting, with my volatility, et cetera.’”