Lost among record levels of issuance of both investment grade and high yield bonds, activity is starting to percolate in a quieter corner of the capital markets: the convertible bond market. Convertible bonds are hybrid financing vehicles. They’re issued as a bond, but they include an option for the bondholder to convert them into a specified number of shares of common stock in the issuing company. This embedded option, sold by the issuer to the investor, enables the issuer to lock in a lower coupon than it could for equivalent straight debt, and it enables investors to receive current income in the form of cash coupons while potentially participating in the upside of the underlying shares.
Over the past few years, historically low interest rates have made traditional bonds very attractive to issuers. Many have opted to lock in low coupons in the straight debt markets, rather than issue convertible bonds that would potentially result in future dilution of their common stock. Corporate America’s focus on more traditional bonds has limited the supply of new convertible offerings. Recently, however, favorable market conditions have led to a surge in new convertible offerings, and the trend may be just getting started.
From the issuer’s perspective, investors’ willingness to accept a wide array of coupon and conversion premium combinations provides flexibility to target a specific cash coupon or conversion premium.
But issuers need to understand that cash coupons and conversion premiums are closely correlated. A company seeking to lock in the highest possible conversion price can do so by offering investors a higher coupon.
Getting Under the Hood