US companies turned to convertible bonds as fundraising on Wall Street’s main equity market hit the lowest level in three decades.
December was the busiest month last year for convertible issuance by the number of deals according to Refinitiv data, as activity increased in the second half of 2022. The number of US-based companies increased more than twice in the second half of the previous six months, after a clear slowdown earlier.
Michael Zeidel, head of the Americas in the capital markets division of the law firm Skadden Arps, said that “more than 80 percent of the year, [convertibles] the market is basically dead” but it has “opened up” in the last two months of 2022 “and now we are seeing activity”.
Extreme volatility and rising interest rates make 2022 the worst year for traditional US stock market listings since 1990. Most experts think it will take at least another quarter for IPOs – the most profitable and highest-grossing part of the equity capital market business – to take off.
But regularly new valuations and encouraging inflation data have prompted an explosion of activity in offers considered less risky, especially the sale of convertible bonds – debt that includes an equity component.
“Conversion has always been a market that tends to be attractive to various companies when other markets are experiencing difficulties,” said Craig McCracken, head of equity capital markets at Wells Fargo, “due to greater certainty of execution”.
Convertibles start out like other corporate bonds, but include an option that allows investors to exchange their debt for equity if the company’s stock rises to a certain price. They can allow businesses to borrow at lower interest rates than traditional bonds, without directly diluting existing shareholders’ equity through the sale of new shares.
Like other forms of capital raising, convertible sales are down in spring 2022 as inflation rises – fueled by Russia’s invasion of Ukraine – and monetary policy tightens. Issuance by US-domiciled companies fell by almost two-thirds last year, according to Refinitiv data, to just under $27bn.
“This past year has been very difficult for investors . . . in line with other risk assets,” said Michael Youngworth, a convertible bond strategist at Bank of America Global Research.
In an environment where interest rates are expected to remain elevated, as this year, “convertible financing becomes more attractive”, according to Youngworth, because it can help companies reduce the cost of debt relative to the ordinary bond market.
Concert giant Live Nation hit the market this week with a sale of convertible bonds that eventually increased its size from $850 million to $900 million, meaning it was stronger than expected. Some of the proceeds from the sale have been earmarked for repurchasing old instruments.
“I think we’re going to see more traditional businesses . . . come into the convertible market to continue to keep interest costs at a reasonable level,” said John McClain, portfolio manager at Brandywine Global Investment Management.
This year, “predicated companies must finance their business [ . . . ] will have the ability to access a litany of different sources of capital that I do not give credit to”, McClain added.
Conversion deals can also be completed quickly, which is especially useful when the market is volatile and the window of opportunity is short.
“It’s good for issuers because you can [quickly] in and out of the market,” said Lizzie Reed, head of equity syndicates at Goldman Sachs. “I think it will be active in the first and second quarters because the macro picture is stable.”
But convertibles are not without risk, and in recent years have been associated with high-flying growth stocks whose valuations tumbled as the Federal Reserve jacked up the cost of debt.
The convertible number notes are currently trading at a “busted” level according to BofA, meaning the stock may not reach the conversion price. Globally, about two-thirds of convertibles are currently trading below par.
In 2021, “we see a lot of very aggressive issuers coming into the convertible bond space”, Youngworth said. “A high-growth name that is taking advantage of equity prices at all-time highs and the frenzy in the equity markets to raise opportunistically low-cost convertible bond capital.”
The next spike in interest rates “doesn’t just hurt the value of the bonds being converted”, Youngworth said, “but it also hurts the equity component, so converters are hit on both sides of the structure.”
This “resulted in a fairly meaningful selloff in the asset class,” he said, “and also helped moderate the primary market.”
Youngworth’s team is “more optimistic” about 2023. They expect $70bn-80bn of issuance globally, with $45bn-48bn coming from the US.
Brighter performance in the convertible market could also prompt more companies to consider IPOs, lawyers and bankers said.
“You have to see . . . more Converts that are successfully priced and successfully traded,” said Wells Fargo’s McCracken. Then, “we will only continue to decrease the risk continuously,” he added, noting that the IPO “is at the riskier end of the market overall equity”.