As a relatively small and often overlooked asset class, convertible securities rarely make headlines. However, the asset class has received a great deal of attention from financial publications in recent months. Convertibles have been making the news for two primary reasons – record-setting new issuance and strong absolute and relative performance.
COVID-19 spurred a wave of convertible issuance early this year
A convertible security is a corporate bond that has the ability to be converted into a fixed number of shares of the issuer’s common stock. New US convertible issuance has been strong this year, currently standing at about $81 billion according to Bank of America. That’s higher than all of 2019, which was in itself a very strong year with about $53 billion.1 This is highest level of issuance since before the financial crisis, when issuance totaled $95 million in 2007. 1 Additionally, with this surge in new issuance, the US convertibles market is now expanding versus shrinking, having recently crossed over the $300 billion threshold for total market value compared to around $200 billion just two years ago. 1
In the early days of the pandemic, new issuance was largely generated from “rescue names” – cash-strapped companies in sectors like retail, travel and restaurants that were looking for capital to help weather the downturn. That was different than the issuance that we saw over the past few years, which tended to be from companies (primarily within tech and health care) that were seeking growth capital. Some of the rescue names that have recently issued convertibles are household names like Carnival Cruise Lines, Southwest Airlines, Callaway Golf and American Eagle Outfitters.2 All saw huge revenue declines when COVID-19 hit, and the new issues were offered at very attractive terms, in my view.
Domestic convertibles: Historical new issuance
Issuance year-to-date is at the highest level since before the financial crisis in 2008
The potential benefits of converts may keep them in the spotlight
Now, with a return to credit market stability and a strong equity rally since March, we have been seeing less rescue issuance. So what may be driving new convertible issues now?
- Even amid the low interest rate environment, higher spreads can still make converts more compelling than other types of debt or equity issuance in terms of cost of capital, in our view.
- Also, high stock prices are also an incentive for companies to issue converts. Companies are using converts for potential merger and acquisition funding, and are pushing out maturities by refinancing existing debt (including existing converts).
- Companies have been seeking diversification of capital sources, with many issuers that previously relied on bank capital, investment grade, and high yield issuance now turning to converts.
Why have companies been looking at converts rather than the high yield market or equity? In my view, the asset class makes a lot of sense for high growth companies. For one thing, convertible coupons are generally lower than those attached to non-convertible debt. Also, the convert market allows unrated issuers to issue unsecured debt. Indeed, some companies don’t want to get rated given the time lag and the chance for an inaccurate rating. Converts can also be issued with a call spread,3 so initial premiums palatable to convert buyers can be moved higher, lessening the impact of earnings dilution to the issuer and making the financing more debt-like. And we have seen some companies look to converts earlier in their life cycles, since there is no collateral and usually no covenants. Upcoming accounting treatment changes may also benefit the asset class.4
Convert performance has been strong
Performance from the asset class has also captured investors’ attention this year, in our view. Convertibles have characteristics of both equities and fixed income, and this has helped the asset class weather the downturn and participate in the rally. The asset class, as represented by the ICE BofAML US Convertible Index, had a 24.88% return as of Aug. 31, according to Lipper, outperforming the S&P 500 Index return of 9.74% and several other equity and fixed income indexes. Performance is being driven partly by the unique make-up of the asset class, which is skewed to the technology, health care and consumer discretionary sectors. The asset class has also benefitted from a rebound in credit as the US Federal Reserve has provided support.
Going forward, we expect the issuance calendar to remain healthy, but the pace will likely be a bit more modest than what we’ve seen this year so far given a probable pullback on the part of companies that were most impacted when the pandemic hit. Nevertheless, I believe technology, media and telecom are once again likely to be active sectors in terms of issuance as their share prices have moved higher during the year, significantly so in some cases. Health care may be a big source of issuance as well, including some COVID-19 beneficiaries in areas like drug development and telemedicine, for instance.
We expect the current environment to continue to be favorable for convertibles. For one thing, while convertible valuations have improved in recent weeks, they are still below where they were at the start of the year, according to data from Barclays as of Aug. 26, 2020. Additionally, if equities continue to climb, converts may be well-positioned given the asset class’s exposure to tech, health care and now consumer discretionary, sectors that have performed well thus far. If, however, equities pull back from their recent all-time highs, we expect converts may do what they are designed to do and post relative outperformance due to their fixed income attributes – high income stream relative to underlying stocks and bond floors.
Learn more about Invesco Convertible Securities Fund
1 Source: Bank of America, data as of Aug. 30, 2020
2 As of Aug. 31, 2020, the following were holdings in Invesco Convertible Securities fund: Southwest Airlines: 1.44% and Callaway Golf: 0.41%. Carnival Cruise Lines and American Eagle Outfitters were not held in the fund as of that date.
3 For an upfront cost, issuers may choose to overlay a “call spread” to effectively increase the conversion premium from the issuer’s perspective. This entails buying call options with a strike equal to the conversion price and selling further out-of-the-money call options.
4 The Financial Accounting Standards Board (FASB) issued an accounting standards update in August that changes the tax treatment of convertibles to simplify reporting for issuers. We expect the effect to likely reduce reported interest expenses, which would be a positive for issuers. The rule also changes the way converts are treated for calculating earnings per share (eliminating the treasury stock method), which may increase share dilution. The rules will go into effect for the fiscal years after Dec. 15, 2021, with early adoption permitted for the fiscal years after Dec. 15, 2020. For more details, please read the full FASB update on their website.
Blog header image: Jayden Staines / Unsplash
The ICE BofAML US Convertible Index tracks the performance of US-dollar-denominated convertible securities that are not currently in bankruptcy and have total market values of more than $50 million at issuance.
The S&P 500® Index is an unmanaged index considered representative of the US stock market.
An investment cannot be made directly in an index.
Convertible securities may be affected by market interest rates, the risk of issuer default, the value of the underlying stock or the issuer’s right to buy back the convertible securities.
An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.
Derivatives may be more volatile and less liquid than traditional investments and are subject to market, interest rate, credit, leverage, counterparty and management risks. An investment in a derivative could lose more than the cash amount invested.
The risks of investing in securities of foreign issuers, including emerging markets, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
Junk bonds involve a greater risk of default or price changes due to changes in the issuer’s credit quality. The values of junk bonds fluctuate more than those of high quality bonds and can decline significantly over short time periods.
Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa.
Preferred securities may include provisions that permit the issuer to defer or omit distributions for a certain period of time, and reporting the distribution for tax purposes may be required, even though the income may not have been received. Further, preferred securities may lose substantial value due to the omission or deferment of dividend payments.
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The opinions referenced above are those of the author as of Sept. 22, 2020. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.
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