After the March sell-off sent both equity and bond markets into turmoil, companies have turned to the convertible bond market to raise money and created a “fantastic” investment opportunity in the process, according to RWC Partners.
Around $25bn in bonds have been issued so far this year, reaching levels not seen since 2009, as companies rush to cash amid the uncertain environment caused by the coronavirus pandemic.
However, Justin Craib-Cox, portfolio manager at RWC Partners, pointed out that the majority of the market before the crisis was occupied by growth companies.
“Growth companies like convertibles because they allow the company to raise money when the equity price is going up. They can get money in today, and just convert it,” he explained.
Craib-Cox said that some of the companies coming to the convertible bond market this year “may just need liquidity now, but it's not rescue financing”.
“These companies might be good companies but they might be in tough industries,” he added. “Not all companies want to go and issue more debt or issue high yield bonds. They might just want to raise funding which might be kind of equity-like if they believe their stock price has been beaten down too much and has room to come back.
“In future they can repay simply by converting it into equity. So it's diluting shareholders today a little bit, but that's opposed to taking on a lot of debt.”
From an investor’s point of view, “all this new issuance has created a fantastic level of investment opportunities”, said Davide Basile, head of global convertibles at RWC Partners.
“The convertible is a very attractive investment for an investor because you tend to have the inherently more capital preservation aspects than if you were just to buy the equity, but the recovery on the stock can be quite substantial,” he said.
Convertible bonds come with a fixed coupon payment and an inherent call option that allows the investor to convert the debt into equity at a premium to when it was issued.
Basile, who manages the €515.5m RWC Global Convertibles fund with Craib-Cox, explained that the 20 to 30 per cent premium which typically comes with convertible bonds “is comparatively quite small to where some of these companies were trading”.
Convertibles are usually long-dated calls, with four to five years to maturity, and Basile suggested that because of this, a recovery does not have to take place in a short period of time for investors to be rewarded.
He added: “Usually a lot of these convertibles are coming with interesting coupons, so we’re getting paid to wait”.
Comparing convertible bonds to ‘straight’ corporate bonds, Basile said: “When you have a difficult situation as we’re in now, you have some certainty and some protection on the downside - the same as a corporate bond.
“But if you see that markets are recovering, many times corporate bonds don't do a lot. You’re not going get anywhere close to the return you’re going get from equity markets.
“With a convertible you are still getting a coupon, maybe lower than a straight, and you have a downside which is mitigated because you do have a bond dynamic, but if things go well you’re almost participating as much as an equity holder. It’s that risk reward ratio that is very attractive.”
Taking the view of an equity investor, Basile said: “Assuming you make the same judgement and buy a travel stock, once you make that purchase you can have full upside. But you also have full downside - you don’t really have any incremental benefit.”
Conversely, he noted that bond investors “aren’t going to share much on the upside”. “Bond investors may get a good coupon at 4 to 5 percent, but within the context of the return potential of this underlying name, I don’t think it's a sufficient kind of return profile for buying an industry which is struggling,” he said.
Craib-Cox takes this a step further and said: “For credit investors, are you going to go with the name that lets you sleep at night but it's not going to pay you very much yield? Or are you going take out a lot more risk that these companies might not work out but if they do you’ll earn pretty good money?
“In the case of equities, for growth stocks it's often a good story, but how good of a story is it really? Or if its value, maybe the company is cheap, but maybe it’s cheap for a reason.”
However Craib-Cox said with convertible bonds an investor can construct portfolios with dynamics that sit very well.
Looking at the recent $4bn convertible bond offering by Southwest Airlines, the manager said; “The airline industry has had experience with these kinds of issues before, certainly in 2008 and 2009.
“Southwest has a relatively good balance sheet, they have a low cost product, they revolutionized short-haul travel in the US and you know that in time we will get back to travelling.”
Retailers and apparel brands caught up in the crisis have also rushed to the convertible bond market, including names like Retailers Burlington Stores, Dick’s Sporting Goods and American Eagle Outfitters.
Slack Technologies and Snap Inc, companies much more typical of the convertible bond market, have also came out with convertible bond offerings this year.