June 29, 2022

Capital Markets: Converts Hit the Skids

During the early days of the pandemic, many companies opted to meet their capital needs by issuing convertible debt.  Fueled by continuing low interest rates, convertible debt remained attractive to investors through 2021, but as this WSJ article indicates, higher interest rates & the pullback in tech stocks have resulted in the convert market cratering in 2022:

Few investments have delivered positive returns this year, as investors have struggled with the implications of stubbornly high inflation and rapidly rising interest rates. But the performance of convertible bonds, in some respects, “is still a little bit shocking,” said Michael Youngworth, convertible bonds strategist at BofA Global Research. The reason for the surprise isn’t just the magnitude of convertible bonds’ losses but how they have fallen short of their promise. A major selling point has long been that convertible bonds offer investors the potential gains from stocks, with bonds’ downside protection.

One issue is that stock declines this year have been particularly concentrated in the type of high-growth technology companies that make up a large portion of convertible bond issuers. But that is only part of the story.

This year, convertible bonds have captured 46% of their underlying stocks’ performance when the stocks have climbed but 49% of their performance when they have declined. That puts them on track for the worst upside-to-downside capture ratio in records going back to 1995 and only the second year when the ratio has been less than one, according to BofA Global Research data.

Nature abhors a vacuum, so just as the smart money rushes out of converts, it looks like a golden opportunity has emerged for the dumb money to rush in. Behold, the crypto folks have discovered convertible debt!

John Jenkins