Convertible bonds, an esoteric corner of the capital markets, have rapidly risen to prominence as a financing vehicle not only for growth sectors, but as a bridge for highly rated companies seeking to weather the economic downturn caused by the Covid-19 pandemic.
Since the beginning of April, 46 US-listed companies have raised US$23bn from CBs, including US$6.6bn raised last week alone.
If issuance continues at this pace, the asset class would see total issuance in 2020 of US$99.9bn, eclipsing the all-time high of US$98.7bn raised in 2001.
Teladoc Health, a provider of virtual healthcare services, was an obvious candidate for the US$850m seven-year CB it sold on Thursday – via JP Morgan and Goldman Sachs – at a coupon of 1.25% and conversion premium of 35%.
High demand for its services has seen its shares double this year putting its existing 3% CB so far in the money as to be problematic.
The banks also helped Teladoc negotiate the repurchase of US$228m principal of its 3% CB for roughly US$930m, the principal in cash and residual in 3.9m shares.
Teladoc shares fell 4.6% to US$179.54 over the one-day marketing period on Thursday.
Cloudflare, a cybersecurity specialist, took advantage of surging demand for its services with a US$500m five-year 0.75% CB offering last Tuesday, just eight months after going public.
The software company used part of the money raised on a derivative to offset dilution to a 100% premium, versus the 30% premium where investors are eligible to convert into the underlying. The deal was also led by Goldman and JP Morgan.
That derivative, known as a call spread, achieves fixed-income like outcomes through the repurchase of the embedded call option and sale of warrants at a higher strike price.
HIGHLY RATED
Most highly rated companies have shied away from CBs because of accounting complexities, particularly given their ability to fund with straight debt with no dilution at ultra-low interest rates during good times.
But times are not good and many companies that previously sold debt to buy back stock are now selling CBs to fortify their balance sheets.
Carnival Corp became one such company when it sold a US$2bn three-year 5.75% CB on April 1, shortly after suspending operations. The deal came alongside a larger US$4bn straight bond as the cruise ship operator sought to raise enough money to keep afloat for at least a year even under a worst-case scenario of no operations.
Priceline parent Booking Holdings (US$750m) and Southwest Airlines (US$2bn), the only IG-rated US carrier, are other travel-related companies that have issued CBs recently as part of broader funding initiatives to weather the pandemic.
Larger deal sizes and solid credits have led to broadening investor participation, with credit and equity income buyers joining traditional CB investors.
"If you look at my top 20 accounts, none are focused exclusively on convertible bonds," said an equity-linked banker involved in one of the aforementioned deals. "They are able to shift assets to where there are opportunities.
"In my view, we're not at the point of capacity constraint. Investors still have money to put to work."
There are nonetheless signs that the heavy deal flow is beginning to sap investor demand for new issues. Half of the 14 CBs sold last week came at the investor-friendly ends of price talk, including Teladoc's trade.
"You can see from how some of the converts traded that there is a bit of buyers' fatigue," said one trader. "Companies are going to have to re-think going for that marginal dollar."
There are also constraints caused by the small size of the asset class. As of May 1, equity-linked strategists at Barclays put the total market value of the US CB universe at US$237bn, of which just 16.4% was IG rated.
However, the equity downside protection provided by converts – clearly on display when markets tanked in mid-February – is continuing to attract new investors nervous about the robust performance of stocks in recent weeks amid the ongoing coronavirus crisis.
As measured by the Refinitiv US Convertible Bond Index, CBs fell 26.5% from mid-February to late March and have since rallied 27%, outperforming the S&P 500 on the downside (33.9%) and just underperforming the 28.3% recovery in the benchmark stock index.
The larger deals of late mean there is a greater focus on short-term performance, a particular concern because those issuers were motivated by Covid-19 operational exposure in the first place.
"My biggest concern is that there is a second wave of Covid-19 contaminations that causes a leg down," said a second equity-linked banker. "If all these new deals trade down, it would make it difficult to bring new issues."
CAN IT LAST?
It is also far from clear that the US new-issue converts market can maintain the pace that would see it hit the US$100bn mark in 2020.
For starters, interest rates are at historically low rates, and are likely to stay low for the foreseeable future. Under normal circumstances, that makes CBs a lot less compelling for highly rated companies with funding options tied to rates.
In the early 2000s, when the CB market was thriving, interest rates stood in the low single-digits – not sub 1% – and the asset class benefited from favourable accounting treatments that have since been eliminated.
Nonetheless, so long as corporates need vast sums of money in very short order the need to tap multiple markets at once will support issuance and that seems likely to last many more weeks yet.
