Convertible bonds coming to market in 2023 have a feature that has been absent for many years: A meaningful coupon. Since early 2022, many central banks have resorted to interest rate hikes to fight inflation, forcing up borrowing costs for corporate issuers that are raising new bonds. We believe that these higher coupons on convertible bonds provide a more positive dynamic for investors.
2023 has marked a respite from the previous era of low interest rates. While this period was great for borrowers, it was a less pleasant time for fixed-income investors, who had to accept greater risks from duration, credit, and liquidity to earn a meaningful return. Over 2022, in a battle to curb inflation, the Fed hiked interest rates more than 400 basis points, which caused major pain to bondholders. But the effect of higher rates and yields on primary market is clear: there is far more income to be earned from new bond issues.
Our review of 2023 convertible bond issuance shows that the (non-weighted, source Bloomberg as of 13/04/2023) average coupon for a new convertible deal in USD was 3.56%. In 2021, that average coupon was only 1.27%. By comparison, that same analysis for all USD corporate bonds raised in 2023 shows that the average coupon paid was 5.28%, with an average of 3.4% for 2021.
As an example, compare two convertibles raised by the same issuer, Marriott Vacations Worldwide (ticker VAC US), which is a US-based company that operates resorts and timeshares that was spun out from parent hotel chain Marriott International in 2011. The company has two convertible bonds outstanding; one issued in early 2021, and the second issued at the end of 2022. The pickup in coupon is clearly substantial; prevailing market conditions led the more-recent bond to be issued with a lower conversion premium, which is an additional benefit for investors. [1]
Pricing date | Issue size | Coupon | Maturity | Conversion Premium at issue |
|---|---|---|---|---|
28 Jan 21 | $575 mm | 0.00% | 15 Jan 2026 | 40.
00% |
6 Dec 22 | $575mm | 3.25% | 14 Dec 2027 | 32.50% |
In general, the higher coupons available for convertible bonds mean that investors are getting paid more to wait while waiting for equity optionality to play out. Compared with straight bonds, which receive little if any upside from rising stock prices, the income received from convertibles is still meaningful. And because primary market issues are calibrated around secondary market valuations, which are currently screening as cheap to theoretical valuation, we see a strong possibility that new convertible bonds coming to market will be also set at these inexpensive levels.
Now that higher rates and yields have caused prices to reset, there remain open questions about whether they will cause a recession (and possibly rate cuts) and if they will be effective at dealing with inflation. As a result, inflation and credit risk remain major potential stumbling blocks for straight corporate bond investors. In a scenario where rate cuts cause bond prices to rise, the implication is that income levels must fall as well, which would make straight bond yields look comparatively unattractive.
Of course, convertible bonds are a different investment to straight corporate bonds. We are willing to accept lower coupons than straight bonds because the embedded option to convert into stock can become valuable with rising stock prices. Furthermore, not all underlying issuers are affected the same way by inflation or the other factors that influence straight bond prices; they may even see their stock prices rise. Finally, embedded optionality becomes more interesting with markets that are more volatile, where investors can use convertibles for multi-asset class exposure without committing to a tactical asset allocation decision. That explains the diversification that convertible bonds can provide when compared with straight corporate debt, or as a lower-risk means of accessing equity optionality.
We are expecting to see more issuance of convertible bonds as higher rates start to make convertibles look appealing to issuers who face rising borrowing costs from refinancing or issuing new straight bonds. In contrast to the low-rate and low-volatility paradigm over much of the 2010s, getting paid to wait looks much more attractive.
Sources:
[1] Bloomberg, as at 26 March 2023
Key Information
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