Convertible bonds can be a good way for companies to raise funds despite the stigma, say specialists in the field.
While some see convertibles as toxic because of the often-troubled companies that issue them, Calamos Investments in February called them the top performing asset class so far this year and in six of the last 10 years.
“We do not view convertible bonds as toxic debt,” Jon Vacko, Calamos senior vice president, told CFO Dive. “Convertible bonds are … attractive from an issuer perspective in that the coupons are generally lower than what would be required with non-convertible debt and issuers can typically raise capital quickly. As interest rates increase, convertible bonds actually become more attractive to issue.”
Convertible bonds are a form of hybrid security that companies issue as debt that investors can later exchange for equity if the business grows and the stock value goes up. The bonds are an especially viable option for companies, like many tech startups, that face short-term financing challenges but have strong growth prospects.
“We think today’s convertible market provides us with excellent opportunities for deploying capital to a range of businesses with compelling long-term fundamentals,” he said.
Vacko said many of the new companies which have broadened the convertible bond market during the 2020 and 2021 pandemic have included those whose cloud-based businesses have enabled people to do remotely what they used to do on-site, including work, learn, exercise and go to the doctor.
Credit analysis key
Because non-rated issues make up a significant percentage of the global convertible market, with many companies foregoing ratings to avoid the length and expense of the process, it’s mainly sophisticated investors who get involved in the market.
“For this reason coupled with the fact that convertible securities can be quite complex, active management and a thorough credit analysis process [from the investor perspective] is an important part of convertible evaluation and is a cornerstone of our investment philosophy,” Vacko said.
He added convertibles can be used in a multitude of ways – as defensive equity, as fixed income enhancement, and as a separate asset class. As a defensive tactic, many investors give up maximum upside in exchange for mitigating equity downside.
Delayed equity financing
Creighton University Finance Professor Robert Johnson said CFOs should think of the issuance of convertible bonds as delayed equity financing.
“That is, the firm issues bonds that are convertible into common stock at a price higher than the prevailing market stock price,” said Johnson, a former president of the American College of Financial Services. “The interest rate on the bonds is also lower than the firm would have to offer in the absence of the conversion right. This allows the company to lower its financing costs in the short-run.”
In his view, now is the perfect climate for companies to issue convertible bonds. Rates are expected to rise and when they do, the issuer benefits and convertibles allow firms to pay a lower rate of interest than in the absence of the conversion privilege.
To Johnson, the idea that convertible notes are toxic comes from the association with firms that issue convertible debt because they don't have other options – in essence, it’s the idiom that a "man is known by the company he keeps."
Martin Kuehl, investment director for convertible bonds at Schroders, a global investment management firm with nearly $1 trillion in assets under management, was upbeat about the prospects for the asset class in a recent email to CFO Dive.
“We look at CBs very much from an investor’s perspective – and here we look at balanced, outright, long-only CBs,” said the economist.
He calls people who call convertible bonds toxic wrong.
They are neither toxic for companies issuing the instruments nor for investors
Convertible bonds, said Kuehl, offer companies savings on coupons, selling volatility, selling equity at a premium, not having to refinance debt when conversions are triggered, and the ability to tap into a highly liquid market when straight bonds turn illiquid, which happened early last year.
“[There are] a lot of good reasons for CFOs to launch CBs,” Kuehl said.
Looking at the rise in interest rates expected this year, he said, higher rates and a bit wider credit spreads would indicate that there is more potential for coupon savings. Hence, the primary market should remain active.
Kuehl noted convertible bond issuance comes in waves. Most recently, the focus has been on tech startups.
While there are many regions in the world where businesses regularly tap convertible bonds for funds, there are some like Latin America where they’re hardly used.
He pointed out there are a lot of “repeat offenders,” companies regularly refinancing via CBs so there is a lot of knowledge with those CFOs who use the asset class.
Active, but not as much as before
Currently, many convertible bond issuers have had their stock hammered, along with broader market volatility, with many correcting more than 50%, said Kuehl.
“This is deep red bear market territory,” he said. “CBs now offer a great opportunity. As bond floors hold and company earnings are not even bad, this is not a falling knife situation. But I would understand if CFOs don’t launch new paper on these low equity prices.”
After two record years, his expectation is that the primary market for the issuance of convertibles will be less active.
“We would like to see higher issuance in material, energy, industrials, companies that generally benefit from an inflationary environment,” he said.