Let’s start by understanding why convertible bonds are issued. In a word, flexibility! Sitting between debt and equity, convertibles have proven highly useful for issuers in unusual conditions, such as ones created by the coronavirus pandemic.
Convertible bonds suit issuers in need of equity-like financing. Unlike an equity rights issue, which sells new shares at a discount, convertible bonds are launched at a premium to the prevailing share price. In early 2020, we saw issuers with businesses affected by lockdown restrictions—such as airlines, cruise lines, and retailers—use convertibles to shore up their balance sheets. And because holders may choose to convert their bonds into equity, the issuer might not need to repay at maturity with cash.
Convertible bonds can also help issuers that are looking to raise capital for growth. We saw many convertible bonds launched in 2020 by companies to finance expansion; for example, technology companies who benefited from remote working and learning conditions.
Finally, convertibles work well for issuers looking to raise money quickly. Many convertible bonds are unrated, and the sensitivity of the share price to the conversion option means that deals are usually announced and closed on the same day, compared with a much longer process of a roadshow and bond rating for straight debt.
Going back in time, we can see that this flexibility has been very useful to corporates. Convertible bonds have a long history, with the first issuance coming from a US railroad in the late 1800s. In today’s global convertible bond market, the issuer base is broad, with most corporate sectors and regions having representation. Growth-focused sectors tend to have higher representation than they would in the corporate bond markets.
How big is the market?
Record issuance in 2020 helped to push outstanding convertibles over the $600bn mark, according to Refinitiv. This is the largest that the market has been since the all-time high of $727bn reached in May 2008. As of early March 2021, the convertible market is more than $660bn in size.
Yet this recent pickup in activity follows a decade that was quiet for equity-linked issuance, with the market as small as $400bn at the end of 2016.
Two developments following the 2008-2009 financial crisis period explain much of the shrinkage in convertible issuance. First, the winddown of leverage extended to hedge funds led to losses and a sharp reduction in capital employed to convertible arbitrage strategies, which had represented the bulk of the investment in the asset class. Second, the easy money policies adopted by central banks both lowered headline interest rates and suppressed volatility, both of which caused a migration of issuance from convertibles to straight debt markets.
However, these conditions have now changed. Long-only, directional investors are now the main investor base for convertibles and realised volatility has been on the rise since the end of the last decade. Combined with the need for flexible financing during the pandemic, convertible issuance has been resurgent, and we expect that trend to continue.
Why invest in convertibles?
Second, convertibles can also provide a useful alternative for fixed income allocators. They are still bonds but can deliver equity-like returns with bond-like volatility. This can help returns under scenarios that might be positive for equities but bad for bonds; for example, if growth picks up and inflation expectations and central bank rate hike probabilities increase. Also, many convertible issuers do not have any other straight debt, so an allocation to convertibles brings credit diversification.
Third, within a multi-asset portfolio, convertibles bring convexity that cannot be replicated from combinations of stocks or bonds alone, which helps the allocator to push out the portfolio’s efficient frontier. That is, the convexity from convertibles helps to create a potential portfolio with better expected returns without having to accept higher risk, and therefore a higher Sharpe ratio.
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