Hot New Convertible

What’s going on?

Top US companies are turning to an unexpected source to borrow, diving into the convertible bond market – typically the stomping ground for junk-rated firms.

What does this mean?

Think of a convertible bond as the asset you’d get if a stock and a bond had a baby. Like any bond, a convertible pays interest to its holder, but unlike the old-school versions, it can be swapped for stock at a later date. Now, because of that sweetener, these convertible bonds pay less in interest – and that allows firms to borrow more cheaply without immediately watering down the value of their stock, as issuing brand-new shares would. 

If this sounds familiar, that’s because these kinds of bonds have been around for a while, but have been mostly issued by lower-quality firms. However, with interest rates so much higher now, these bonds are becoming popular among the high-quality, investment-grade set. In fact, those companies have sold $12 billion in convertible bonds this year, or more than 30% of the total. That’s triple the usual rate.

Why should I care?

Zooming in: Cheaper, not cheap.

The average yield on investment-grade corporate bonds has nearly tripled over the past two years to 6%. And, sure, companies can save 2 to 3 percentage points on their interest rates by issuing a convertible instead of a traditional bond. But, any boost to their stock prices from those savings might be offset by the dilution that occurs if the bonds are converted into shares.

The bigger picture: Fond of the bond.

About $2.3 trillion of corporate debt is set to mature each year between 2024 and 2026. A lot of it will have to be refinanced. And even if firms lean more heavily toward cheaper convertible bonds, they’re still going to feel the impact of higher rates on their bottom lines – and it won’t bode well for their stock values.

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Originally Posted September 27, 2023 – Hot New Convertible