Convertible Bonds Could be the Answer if Interest Rates Continue to Rise
After 2 years of historically low interest rates that encouraged borrowing and spending, many companies are scrambling to change their strategies ahead of the planned rise in interest rates over the next year. While organizations are trying all different forms of strategies- from hurriedly borrowing and locking in rates before they rise, to investing in cash rich companies, some may turn to convertible bonds as an alternative.
Convertible bonds have been long thought of as toxic debt, due to their close association with risky startups and troubled companies, but they are not always worthy of this title. In many cases, convertible bonds can be a great answer to rising interest rates and help diversify a company’s portfolio.
Benefits of Convertible Bonds for Companies
Companies benefit from convertible bonds because it's a great way to raise capital without immediately diluting their shares. This is particularly attractive to young companies, as the immediate benefits can outweigh other options of raising capital in the early stages of a business.
As a result of shares not being diluted, it avoids negative investor sentiment that typically surrounds equity issuance. Convertible bonds then become more attractive, potentially allowing them to raise more funds than they would in normal circumstances.
Companies may pay lower interest rates on their debt compared to using traditional bonds.
Benefits of Convertible Bonds for Investors
Although convertible bonds carry risk just like any investment, investors get some default risk security since bondholders are paid before common stockholders.
Convertible bonds provide an extra layer of protection that is rare in other types of investments, and essentially allows investors to benefit from the best of both worlds. A convertible bond protects the investors’ principal on the downside, but also allows them to gain from the upside if the company succeeds.
The last level of flexibility allows investors to do a call option. This allows the option buyer to convert it into a stock or bond at a specified price. Convertible bonds are essentially a bond with a stock option.
Downsides of Convertible Bonds for Both Parties
Although there are many advantages to convertible bonds, there are always downsides and risks as well:
To begin with, not all companies offer convertible bonds which means that it’s less known and common from both the company side and investors.
Most convertible bonds are considered to be more volatile than typical fixed-income instruments, due to the nature of the type of companies who typically use them (young companies that need capital with little to no earnings). Many investors specifically buy bonds to balance out their portfolios with a less risky investment, therefore, even if convertible bonds are an option, many investors will opt for more conservative bonds instead.
Although shares aren’t immediately diluted in convertible bonds, share dilution does happen if buyers exercise the option of converting bonds to stock shares. This can potentially depress the share price and lower the earnings per share.
Lastly, due to the option to convert the bond into common stock, convertible bonds offer a lower coupon rate which can be unattractive to investors.
The Right Environment for Convertible Bonds
The rise in interest rates that is expected throughout this year combined with a wider credit spread, indicates that there is more potential for coupon savings. In addition, convertible bonds tend to come in waves and currently the biggest issuers are tech companies. The sheer number of young tech companies who need cash and are willing to take risk keeps growing, providing a good environment for convertible bonds to multiply in number.
Issuing convertible bonds are particularly attractive to companies now, specifically because of the convertible abilities of the bonds. This option allows firms to pay a lower interest rate than with regular bonds when there is no conversion privilege. The firm can issue bonds that are convertible into common stock at a higher price than the going stock market rate, to go along with the lower interest rate provided in comparison with regular bonds. All of this allows the company to raise equity while simultaneously lowering its financing costs in the short- run.
Martin Kuehl, investment director for convertible bonds at Schroders explains that convertible bonds offer companies many positive things such as savings on coupons, selling volatility, selling equity at a premium, not having to refinance debt when conversions are triggered, and the ability to tap into a highly liquid market when straight bonds turn illiquid, which happened early last year. Overall there are plenty of reasons for CFOs to look into convertible bonds.
CFOs' Caution when it comes to Convertible Bonds
Despite all of the benefits in regards to convertible bonds, many people are cautious with them for a few reasons. The biggest reason is due to the type of companies that typically use them- namely young tech companies. With most tech companies reaching big bear market territory in the beginning of the year, many investors are cautious about getting involved in the slightly more risky convertible bonds.
In addition, the overall market volatility tends to scare people off from convertible bonds, and investors seem to prefer other forms of investing. If more conservative, inflation- friendly companies such as energy and raw materials would issue convertible bonds it might become more popular with businesses and investors. However, there are still many benefits to convertible bonds and we may see the amount of transactions grow especially if interest rates continue to rise as planned.