Rush to convertible bonds makes sense

Elon Musk’s Twitter habits may not make him much of a role model on corporate governance. But in corporate finance he is a trendsetter. Tesla and SolarCity (the clean energy company he cofounded) have been prolific issuers of convertible bonds — debt instruments that can convert into equity.

Issuance of convertible bonds has exploded in the US in 2018 for good reason. Companies like Netflix, which has big financing needs, should consider eschewing sales of equity and debt for a combination of the two.

Convertible bonds can be cheap, often paying annual coupons of below 1%. Twitter priced $1bn of convertibles in 2018 with a coupon of just 0.25%. The rub is that convertible bondholders get a call option that lets them swap the bond into equity if the company’s share price rises by some preset amount, say 30% to 50%.

In the first half of 2018, US companies issued $58bn of convertible debt, the highest level since the crisis. The convertible bond index is up 6% even as high-grade and junk benchmarks are negative.

The rush makes sense. If interest rates are rising, low coupon convertibles seem more attractive.

For buyers, the embedded call option looks juicier as equity values keep rising. However, the ultimate catalyst is the jump in stock market volatility. Volatility is a key input in call option valuation.

So far in 2018 tech companies have dominated convertible issuance. Twitter, Western Digital, Atlassian, Akamai and Palo Alto Networks have all sold more than $1bn.

Netflix has previously said it would continue to rely on high-yield debt to raise the billions it needs to create new shows. But instead of paying interest at 3% to 4% after tax, it could pay a tenth of that in exchange for the small possibility that it owes shares down the road. London, August 15