US borrowers have turned to convertible bonds in recent months as mainstream debt and equity markets have stumbled in the face of inflationary and interest rate headwinds. Combined leveraged loan and high yield bond deal volume in the US was down 26% in Q1 2023, year-on-year, reaching 396 deals. Leveraged finance value was similarly down by 24% year-on-year, reaching US$240.5 billion.
As a result, US convertible bonds, which can be converted into shares at pre-agreed price thresholds, have surged as the pool of available liquidity has contracted. According to Dealogic, the overall issuance of US convertible bonds was just under US$12 billion in Q1 2023, nearly double the US$6.2 billion recorded in Q1 2022. Except for the unusually high level recorded in Q1 2021 (US$39.9 billion), Q1 2023 issuances track closely to the first quarter figures recorded over the past few years, with total US convertible bond issuance for Q1s averaging around US$12.9 billion between 2017 and 2020.
As financing costs have climbed, convertible bonds have proven to be popular with issuers as they offer lower interest rates than plain “vanilla” bonds and do not contain financial covenants or require ratings.
Convertible bond interest rates are lower because investors have exposure to the equity upside if the issuer’s share price reaches an agreed threshold and the bonds are converted into equity. In most cases, investors have the option to convert their bonds into shares when the issuer’s stock reaches a premium of 20% to 30% over the share price at the time the bonds were issued.
In the early 2000s, the convertible and high yield bond volumes were roughly the same, but a prolonged period of low interest rates saw issuers pivot to high yield debt. However, due to climbing interest rates (in May the US Federal Reserve increased benchmark interest rates for the tenth time in 14 months to between 5% and 5.25%, the highest levels in 16 years), some traditional debt issuers have turned to the convertible bond market to reduce their interest expense.
Broader set of issuers spur activity
Convertible bonds have traditionally been issued by growth-oriented companies and can include companies that are either not yet mature or profitable enough to tap mainstream debt markets, or do not have big enough market capitalizations to raise sufficient capital from equity offerings. In most years, a significant proportion of convertible bond issuances involve borrowers that do not have credit ratings.
Meanwhile, investment grade issuers that can access standard bond and loan markets have historically avoided convertible bonds because the structures raise the risk of issuing shares at a discount and diluting existing shareholders. However, thus far in 2023, a number of investment grade and high yield issuers have entered the convertible bond market to take advantage of the lower interest rates on offer.
In February of this year, for example, investment grade utility companies PPL and Southern issued convertible bonds with a combined value of US$2.4 billion, becoming the first US investment grade utility companies to do so in two decades. Medical devices manufacturer Integer Holdings also successfully closed a convertible bond offering in February, securing US$500 million. All three companies were able to issue the bonds at lower interest rates than available in the mainstream bond market. Other investment grade issuers have followed suit, including power company Duke Energy, which announced a US$1.5 billion convertible bond offering in April, and Ventas Realty, which secured a US$750 million convertible bond deal in June.
According to Bank of America figures, investment grade issuers accounted for more than a quarter of Q1 2023 convertible bond issuance, up from 7% in Q1 2022 and the highest level recorded in more than a decade, Bloomberg reports.
For non-investment grade companies, convertible bonds also remain an option. Companies that face challenges raising capital in tighter markets have been able to agree to highly negotiated deals that include terms typically not seen in traditional markets. In these circumstances, terms have included conversion rate resets (which reset the price at which bonds convert into equity if the issuer’s stock price underperforms), adjustments in conversion terms (which change the conversion price to reflect a change in the value of the bond) and restrictive covenants.
Changes to US accounting rules have also helped to draw more issuers to the convertible bond space. Accounting for convertible bonds, which at one point could have up to five different accounting treatments, has been simplified. Rules mandating that companies issuing convertible bonds add a hypothetical interest expense on the bonds in their accounts (thereby, increasing the cost of issuance) have also been dropped. These changes to the accounting treatment have given convertible bonds issuance levels an additional boost.
Because convertible bonds are hybrid securities with an equity component, issuers sometimes use derivatives such as capped calls and call spreads (which are entered into with banks) to manage the dilution risk to existing shareholders when convertible bonds convert into equity and/or to synthetically increase the effective conversion premium of the bonds.
These complex derivative instruments allow the issuer to buy and sell options on its stock to provide a more predictable outcome when bonds convert into shares and to strike a balance between offering bondholders with equity upside and limiting dilution for the issuer. Through the end of June 2023, approximately 40% of convertible bond deals in 2023 have included capped call or call spread options. Subject to an initial payment by the issuer, these hedge instruments entitle the issuer to receive shares (or their equivalent in cash) when bondholders convert into equity, which mitigates part or all of the dilution effect of such conversions. Although these derivative trades are private transactions between the issuers and the banks, the existence of these trades is an important factor for existing shareholders and the bond investors, and issuers will disclose their existence and material terms.
Meanwhile investors who want to focus on interest rate returns will take out short positions (where an investor will receive a return if a company’s share price goes down) on the issuer’s underlying shares to hedge exposure to the risk of the bond issuer’s share price falling, which would typically have a negative drag on the convertible bond price as well.
Busy period ahead
According to Bank of America’s forecast reported by Bloomberg, further activity in the convertible bond space is anticipated in the coming months as issuers continue to explore their options in a volatile market.
Lower interest rate costs remain a big draw and, although mainstream loan and high yield bond markets have seen a slight uptick in recent months, we expect borrowers will continue to turn to convertibles until such markets fully reopen to refinance existing borrowings and push out maturities.
Entertainment and ticketing business Live Nation was one of the first issuers to tap convertible bond markets for refinancing in 2023, securing a US$1 billion convertible bond deal, priced at 3.125% and maturing in 2029, to refinance existing borrowings due in 2023.
A flurry of other issuers recently followed suit, including Ionis Pharmaceuticals, which has placed US$500 million of convertible notes, Bread Financial offering a US$275 million convertible bond and Tilray issuing a US$150 million convertible bond.
The steady increase in convertible bond activity observed since the middle of 2022 is showing little sign of slowing down.