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Convertibles thrive in pandemic but are no financial panacea

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By Aidan Gregory
11 Aug 2020

The convertible bond market has played a vital role during the Covid-19 global pandemic in funding corporates that were in urgent need of liquidity as the crisis took hold. Deals have performed for investors too, although they should be concerned about the potential for rising defaults.

Market veterans will tell you that equity-linked deals perform best in times of crisis. It is the last market to shut and the first to reopen. This has been proved to be the case during the pandemic.

Convertible bonds were one of the first markets to reopen following the global equity crash in March and they did so with a flood of issuance. More than $130.4bn of convertible bonds have now been issued globally this year, up from $86.6bn in the same period in 2019.

The Americas accounts for more than half of the volume, with $77bn issued in the region this year. As usual, EMEA lags behind other areas, but there has still been $20.2bn of issuance in the region so far this year, up 63% year-on-year.

From a funding perspective, convertible bonds have many attractive features for corporates, which have become more important during the pandemic.

You do not need a rating to issue a convertible bond and equity-linked investors are far more comfortable lending to companies with weak cash flows because they have the chance of equity upside.

This has provided a key lifeline to many companies that suddenly found their businesses impaired by Covid-19 and lockdowns. Convertible bond investors have thrown billions at firms from some of the most damaged sectors, such as cruise lines and airlines, as well as retail and energy businesses.

In volatile markets, the value of the embedded option in a convertible bond increases. The asset class also becomes more attractive to investors owing to its convexity.

Convertible bonds give investors equity-like returns on the upside while maintaining bond-like protections on the downside.


Finding alpha

The result has been that the asset class has generated big returns this year. The Refinitiv Qualified Global Convertible Index, one of the main benchmarks used by equity-linked investors, is up more than 14% year-to-date, outperforming the S&P 500, which is up 4.6%.

In Europe, where performance has lagged behind, the UK’s FTSE 100 is still down more than 17% this year.

Owing to the clear benefits of the asset class, market sources are confident that this will translate into greater investor demand, particularly if rates remain at or near zero.

Convertible bonds are expected to outperform further, particularly if the issuance boom in the technology and biotechnology sectors carries on as it has done this year.

But issuance volumes still pale in comparison with the size of the broader corporate bond market. An even bigger scaling up of the primary market is required to take the asset class permanently beyond niche status.

A bigger concern, and one that will hold the market back, is credit quality. The convertible bond market is now even more highly exposed to the technology sector, where companies often lack positive free cash flow. Any bursting of the bubble in tech stocks will be disastrous for the performance of convertible bonds.

Despite diversification, the influx of distressed credits during the pandemic also raises challenges, particularly if the economic fallout from the pandemic is worse, or drags on longer, than many people hope.

Some of the firms that have issued convertibles, such as the cruise lines, face serious environmental, social or governance challenges. Others, such as airlines, are also facing a long-term decline in their businesses.

Default rates in the US are lower than the long-term average of 1.36%, according to research by Barclays. Many of the defaults that have occurred are concentrated in the energy sector. This could easily change, though, if revenues in the corporate world do not pick up.

For now, convertible bonds are one of the brighter corners of the capital markets for those who are prepared to look; but for any investor chasing a quick buck, as so many are when yields are so low, they must be mindful of the extra risk they are taking on board.

By Aidan Gregory
11 Aug 2020