Convertible bonds make a comeback

Originally Posted, 25 April 2024 – Convertible bonds make a comeback

• Unlikely monetary easing in 2024 to support convertible issuance
• Pick up in corporate activities 
• Convertible bonds presenting an opportunity for investors

With the US economy remaining strong and interest rates likely to stay higher than expected this year, convertible bonds are once again becoming a hot investment vehicle and an appealing debt instrument for companies following the post-pandemic collapse. 

Convertible bonds, with their hybrid nature, gained increasing popularity after 2016, alongside gradual monetary tightening before the pandemic. However, the trend reversed in 2022, because falling equity prices reduced the appeal for convertible investors seeking potential equity growth and led the primary market for convertible bonds to dry up. Convertible issuance was also affected, as origination plummeted by more than 70% compared to the previous year.

Signs of recovery 

Amid rising interest rates in 2023, convertible bond issuance picked up, and continues to surge in 2024. Global issuance of the asset class in 2023 totaled around $90 billion, while the US market alone topped $57 billion. The trend has continued upward in Q1 2024, with more than $20 billion issued in this sector in the US and $26 billion globally. Issuers span a broad spectrum of industries, including AI firms like MicroStrategy and Super Micro Computer, ride-share company Lyft, fintech firm SoFi Technologies, and energy producers NextEra Energy and Kosmos Energy. LSEG estimates between $100 and $110 billion of global issuance will occur this year.

Past performance is not indicative of future results

Convertible issuers typically benefit from the lower coupon rate compared to straight coupon-paying bonds, thanks to the compensating potential of equity growth that attracts investors and reduces interest payments. In February, Super Micro Computer raised capital through convertibles with an interest rate down to 0%. Other convertible issuances might not have the luxury of such a low interest rate, however the spread that results in the cost savings remains enticing in this relatively high-rate environment.  

Investors that desire the soaring stock price are often willing to accept lower coupon payments. This speculation carries both pros and cons. If the stock price surpasses the conversion price, investors stand to gain upon potential conversion into equity shares. However, if the company underperforms, investors may be left with a suboptimal investment choice. Therefore, prudent analytics- and data-driven judgement, which considers both equity price dynamics and convertible clauses, is necessary to navigate the dual aspects of convertible bonds.

Versatile and complex investment options

Priced into the bond’s value, equity plays an essential role in boosting the potential upside of convertibles.  When the stock price is low, the convertible price is supported by the bond floor; while as the stock price surges, the convertible behaves like equities, resulting in a delta of one. The conversion premium normally ranges from 10% to 40% when convertibles are at-the-money, evidencing the enhanced cash value added above the parity price. The hybrid nature offers convertibles the balance between fixed-income stability and equity-like returns, which helps to increase their Sharpe ratio. In the economic environment where overall credit risk is minimal, investing in convertible bonds can effectively improve portfolio diversification and elevate the efficient frontier.

Figure 2: Efficient frontiers of investment portfolios mixing FTSE All World Index, FTSE World BIG Index and FTSE Convertible Bond Index 

Past performance is not indicative of future results

As complex derivatives of equities, convertibles are also leveraged to hedge movements in stocks. A typical strategy involves going long the convertible and shorting the stock. In either case of upward or downward stock price moves, the portfolio values are well protected with limited downside. Short selling stocks comes with extra costs of stock borrowing, though, which inevitably puts slight downward pressure on the value of the hedging convertible, out of the impact of dynamic hedging.

Furthermore, the objectives of issuers and investors are often in conflict. When the stock price rises, issuers may prefer to continue lower coupon payments, while investors anticipate immediate conversion. Conversely, when the stock price remains low, issuers may opt for forced conversion to increase their capital ratio, while investors may still prefer receiving coupon payments. This rich dynamic of a two-player game, which necessitates a sound analytic formulation, complicates the valuation of convertible bonds, and influences all market activities such as trading, investment, and risk management further down the road.

Opportunities abound 

Looking ahead, we believe convertible bonds are well positioned to be an attractive investment opportunity throughout 2024 and beyond with a growing level of issuance. Convertible bonds offer a unique feature of lower coupon cashflows and equity growth, making them attractive to both issuers and investors and a valuable inclusion in investment portfolios. Moreover, convertible valuation models are instrumental in the market, serving not only as tools driven by market conditions and requirements but also an indispensable element that provides market insights and impact.