Cruising in convertibles...

 

ref :- "Classic convertible", Buttonwood, The Economist

First up, apologies for the cheesy title but it's almost impossible to find a catchy tag line to a piece about convertible bonds without some lazy reference to soft-top motor cars… as the title of the Economist piece itself confirms. Perhaps we should also apologise for the fact that we first spotted this article in the weekly issue last Friday so it's hardly breaking news. But then again, the upsurge in issuance of convertible bonds was predicted (correctly) right at the start of the pandemic and so the piece is not exactly revelatory in that sense. But with the subsequent and continuing confirmation of the attraction of convertibles for both issuer and investor it's worth reminding ourselves just why this particular vehicle has regained its popularity in these strange times. 

And so, for newcomers and any others whom the world of convertible bonds has passed by, let's start with the basics. What are these things? 

Just like a traditional bond, a convertible features a principal amount to be repaid on maturity to the investor, who also receives regular coupon (interest) payments, usually once or twice per year. Unlike a traditional bond however, the investor can convert his bondholding into equity at a pre-determined number of shares per each $1,000 of the bond. This number - the conversion rate - is set so that it is only worthwhile for the investor to convert bonds into shares should the underlying share price of the issuing company rise significantly, say by 30 - 40%, from the level they stood at at the time the bond was issued.

In effect, the investor owns an out-of-the-money call option on the shares which he/she can exercise if the gains in the share price outweigh the returns available from continuing to hold the bond.

Why are they attractive?

For the investor, convertible bonds still offer a current and regular income, and (relative to equity) a good measure of security. But crucially, they also offer the chance to participate in any sharp uplifts in share price that they would otherwise miss out on. This is important when you consider the type of companies issuing convertibles, which are often young and unproven and at the same time cash-hungry. Investing in them sounds a bit speculative, but that's why one might want to buy the bond rather the equity, and if the company takes off... well, that's exactly why one would like the bond to be convertible into equity. The Economist points to Tesla, a frequent issuer of convertible bonds and as an example of how they can be profitable vehicles for investors, off the top of our head we can't think of a better one.

For the borrower/issuer, perhaps the most obvious benefit of convertible bonds is that the "granting" of an option to the bondholder to convert into equity allows them to borrow at a considerably cheaper rate than they would have to pay with a conventional bond. Since a substantial portion of those issuing convertibles are indeed young and unproven, that rate is likely to be pretty hefty without that all-important equity "option". And continuing with the young and unproven theme, much of the equity in those companies is quite likely to still be held by the founders and very early investors who would not be keen to see their shareholding diluted... at least not at the share price at the time of the bond issue. If a large rise in the price in the future should then prompt a dilution... well, that wouldn't be the end of the world. In a sense, unless they've sunk an unholy amount of money into their companies a convertible bond could be viewed as something of a no-lose tactic.

The Covid pandemic is also a big factor in the upsurge in convertible bond issuance, which doubled in 2020 from the previous year to roughly $159bn globally. This year, the tally already stands at about $100bn and it's no longer just those younger companies driving the numbers. Many well-established cyclical firms have been cruelly damaged by the events of the past 16 months, and the Economist mentions cruise lines (Carnival), airlines (South-west) and most high-profile of all Ford Motor Company as amongst those who've come to the convertible bond market. It's been termed "rescue finance" though those companies probably wouldn't want to call it that, but it does give them the chance to raise capital at a lower cost and without dilution of shares, at least until their shares rally.

There's one more factor to consider... and at its core it revolves around inflation. Yes we know... we can't get away from it.

Some years ago convertibles were popular and many portfolios would have at least a slice of them. In recent years though the absence of any meaningful inflation and the subsequent lowering of rates to near-zero levels meant that investors could make great capital gains out of traditional bonds, and corporates have been able to borrow at cheap and manageable interest levels. The spectre of inflation surging, higher and for longer than most central banks have been budgeting for, brings the possibility that in real terms investors would actually lose money on conventional corporate bond investments when they're redeemed at maturity. The "call option" element of a convertible bond does at least offer some protection, "an indexation to rising consumer prices", according to Dylan Grice of Calderwood Capital.

Of course, one could argue that assumes that rising prices will continue to be accompanied by resurging economies and consequently buoyant share prices. But then nothing's ever simple, is it? Apart perhaps from the fact that convertibles are back, and in the words of Buttonwood in the Economist, are "the asset of our times".