C&B Notes

Yield Chasing: Convertible Bond Edition

Issuers are selling convertible bonds at the highest clip since 2007 and early 2008.  In the current depressed interest rate environment, coupons are predictably low on the new issues.  Nonetheless, buyers are not just willing to accept low interest rates but are also swallowing meaningfully higher conversion premiums.

Summer may be over, but top-down, hit-the-accelerator time has arrived for companies selling convertible bonds.  The bonds get their name from the feature that separates them from conventional debt: They can be converted into the issuer’s stock at a specified price, often at the buyer’s option.  They are popular among companies looking to raise money at rates lower than those on ordinary bonds.  Investors like them because, at a time of low interest rates, they can book extra profit if the issuer’s stock price rises.

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Some investors question whether buyers of convertible debt are being appropriately compensated for the securities’ risks. Prices are already high, and like those of other fixed-income assets, they could fall if interest rates rise, these people say.  Higher rates could drag on stock prices, further weighing down convertibles.  The average yield on a new convertible note this year is 2.7%, down from 3.8% in 2011, reflecting strong investor demand and a decline in U.S. interest rates.  The so-called conversion premium — the share-price gain needed to make it worthwhile for investors to turn bonds into shares — has risen to an average of 33.7% this year from 24.8% in 2011, according to Barclays.

Some companies have offered even larger premiums.  In August, the online travel company Priceline sold $1 billion of notes with a conversion premium of around 60%. Twitter, the social-media company, sold $1.8 billion of debt in September with a conversion premium of nearly 50%.  “There’s just a lot of desperation for yield,” said George Cipolloni, who helps oversee the $2.7 billion Berwyn Income Fund, which has halved its convertible notes holdings since last year, to about 15% of the portfolio.  “The convertible market is no different.”