More Convertible Bond Issuers Are Saying No to Hedging Their Bets

More convertible bond issuers this year are saying no to hedging their bets.

(Bloomberg) — More convertible bond issuers this year are saying no to hedging their bets.

So-called capped-call transactions — options that automatically sell a stock if the price goes beyond a predetermined price — are often put in place in conjunction with convertible bond deals. The overlay prevents actual dilution to the shareholding base, even when a share price rises and triggers a conversion of the bonds into equities. 

Only a third of the issuers in 2023 have used the structure versus about 50% over the last three years, according to Santosh Sreenivasan, head of JPMorgan Chase & Co.’s equity-linked and private capital markets in the Americas. JPMorgan, together with Bank of America Corp. and Morgan Stanley, are the top three banks handling the 64 convertible issues so far this year, based on data compiled by Bloomberg.  

Companies have been more prudent about using hedges partly because of a shift in issuer type from high-growth companies to investment-grade utilities, which generally enjoy slower, but steady growth. And their main concern isn’t share-price increases triggering a dilution.  

“Issuers have been more focused on preserving cash and maximizing the coupon savings versus debt this year,” Sreenivasan said.  

And while the S&P 500 Index had risen almost 20% this year through July, before paring gains, industry participants have said that rally centered on just a handful of large-cap stocks.

The capped-call premium has long been a gauge of how bullish a convertible bond issuer is about its stock. The share price level at which such options are set is often deemed a reflection of management expectations on the trajectory of its shares, as it costs to put the options in place. And the higher the premium, the more it costs. 

Fitness company Peloton Interactive Inc., which benefited from a boom in at-home fitness equipment sales during the pandemic, famously placed a 150% capped-call premium on its already 65% conversion premium — versus a typical 25% to 35% — for its $1 billion, zero-coupon convertible bond in February 2021. Peloton shares have lost 95% since the convertible issue, and the convertible bonds currently trade at around 76 cents on the dollar.

Outside of the utility and real estate investment trust sectors, most convertible bond issuers are using capped call transactions, according to Eric Coghlin, an Americas co-head of strategic equity solutions at Bank of America Corp.

When Shockwave Medical Inc. priced its upsized $650 million convertible bond issue on Aug. 10, it entered into capped call transactions of up to 100% of its share price on the day of issuance. Granite Construction Inc. went even further in its May issue of $325 million worth of five-year notes, setting it at a 125% premium. Shockwave’s shares have risen about 7% this year, while Granite Construction gained over 16%.

Market participants expect the capped-call strategy to return as a common feature of convertible bonds as the mix of issuers diversifies beyond investment-grade utilities.   

“There will be more growth issuances going forward, and other sectors should also take a greater interest in convertibles, including industrials, consumer and real estate,” said Michael Voris, global head of structured equity group at Goldman Sachs Group Inc. 

Nicolas Gortzounian, an equity-linked advisor at HudsonWest LLC, said his firm is having conversations with industrial and consumer companies about refinancing past term loans or bond offerings.  

“If they refinance in the bond market today, they will likely pay a higher coupon than what they currently are paying, which is dilutive to earnings,” he said. “So as an alternative, they can tap the convertible market and issue with coupons of typically under 4% so long as they are comfortable with the equity option they are selling.” 

Utilities and financial companies drove over 40% of the $34.8 billion deal flow so far this year, while industrial and consumer issuances made up a combined 8%. 

“The real question is when does the cost of capital become more expensive in the future? And what to do to mitigate that equity dilution? And should they start looking at call spreads? We are having those conversations at the moment,” said Goldman’s Voris. 

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