Investment grade-rated companies and those with lower ratings that finally warmed to convertible bonds in 2023 after years of shunning them are set to keep the relationship going, even as investors grow increasingly convinced that central bank rate cuts are just around the corner.
The Federal Reserve is likely to take away some of the attractiveness of issuing convertible bonds, whose equity-like properties allow companies to offer investors smaller coupons than in conventional debt instruments. With borrowing costs for non-convertibles highest in at least a decade, the instruments proved alluring last year to household names like Uber Technologies Inc., which raised $1.7 billion at a 0.875% coupon.
“The interest cost savings alone are enough to overcome any of the hesitancy from corporates,” said David Clott, portfolio manager at convertible bond specialist Wellesley Asset Management. “So, if we see some rate cuts, even 75 basis points, that’s not going to really change the dynamics there.”
The convertible bond market was a bright spot in U.S. equity capital markets last year, seeing an influx of interest from investment grade and lower-rated issuers like utility companies and real estate investment trusts looking to blunt the impact of rising borrowing costs for straight debt. Investors are willing to take smaller coupon payments on the expectation that if companies’ share prices rise, they stand to benefit.
Even if the Fed cuts rates as expected, narrowing the interest rate spread between straight debt and convertibles, observers say the change would have to be drastic to undermine that appeal.
“If we do fall into a harder landing and a deeper type of recession situation and the Fed is forced to cut aggressively, then that would turn the table on the convert market,” Wellesley’s Clott said.
Household Names
Convertible bonds have once again become a staple financing tool for rated companies, after years when rock-bottom borrowing costs reduced their appeal.
Offerings in 2023 by rated issuers such as Evergy Inc. and Southern Co. represented an average of about 63% of total annual convertible bond deal volume, ICR Capital said, citing its own convertible database and data compiled by Bloomberg. That figure sank to about 22% in the five years between 2017 and 2022, as the near-zero interest rate regime made rated convertible bonds almost obsolete.
From 2000 to 2007, 71% of deal volume was by rated issuers, with household names like Ford Motor Co., Berkshire Hathaway Inc. and American Express Co. among them, data compiled by ICR Capital show.
Many convertibles last year offered companies substantial interest savings versus straight debt. California utility PG&E Corp.’s $2.2 billion December issue bore a 4.25% coupon, nearly half of the cost of the 8.44% term loan it took out in 2020. That translates to about $75 million in interest savings annually.