By Caitlin Ostroff and Paul J. Davies
Companies hit hard by the coronavirus pandemic flooded the
market this year with the most convertible bonds since 2007.
Investors who scooped up these securities have been rewarded with
strong returns.
Travel and hospitality companies including Carnival Corp.,
Southwest Airlines Co. and Royal Caribbean Group raised $147
billion through Oct. 30 globally from the sale of bonds that can be
exchanged for stocks, using them as a cheap way to stay afloat
through the pandemic. That compared with issuance of only $108
billion of such bonds by the same point in 2019.
Almost a third of the roughly $450 billion convertible bonds
outstanding were issued this year. Companies began stepping up the
pace of such sales in April, following a tumultuous month that saw
investors pull money out of even the safest assets. Travel, tourism
and hospitality companies, whose stocks were among the most beaten
up, turned to these securities in the months through June.
Convertible bonds are a hybrid between a bond and a stock. Like
bonds, they have a coupon that pays a set interest rate for a
period, providing a steady return. But unlike a bond, if the
company's stock price rises above a certain threshold, the holder
can convert the bond to stock, scooping up a tidy profit.
The interest rates that companies need to pay on convertible
bonds tend to be lower than on regular bonds, since the investor
gets a chance to profit if the share price rises. That has made
them attractive for companies that became strapped for cash as the
pandemic halted flights and cruises and closed shops and
restaurants.
"In hindsight, the best way to play the [convertibles] market
was to buy everything that came out because of the stock market's
V-shape recovery, " said Maxime Perrin, client portfolio manager at
Lombard Odier Investment Management.
Convertible bonds in the Reuters Qualified Global Convertible
Index are up almost 22% this year.
A $2 billion convertible bond issued by Carnival in early April
with a 5.75% coupon now trades at more than 155% of its face value,
according to FactSet, after shares in the cruise-line operator
rebounded strongly from their lows. In the same month, Carnival
issued $4 billion of regular corporate bonds with a coupon of
11.5%, twice the cost of the convertible.
The terms of Carnival's convertible-bond sale gave investors the
option to swap each security for 100 shares at $10 apiece, at a
time when the stock was trading near its lowest this year. Four
months later, after the stock price approached $15, Carnival
redeemed nearly $900 million of these bonds early by offering
investors 112 shares priced at $14.02 apiece for each note, which
have a $1,000 face value.
That allowed holders of the convertible notes to book some
profits, even if it meant giving up on some of the potential
upside.
Hedge funds and investment bank's proprietary-trading desks used
to dominate the market. They would buy convertible bonds, then
trade the equity and credit risks linked with them separately,
often using derivatives and leverage to exploit small differences
in values.
Nowadays, longer-term buy-and-hold investors have become more
important. Investment bank proprietary-trading desks are gone and
leverage for risky trades is much harder to get for hedge
funds.
Mr. Perrin is a long-term holder looking for deals that will do
well over many years, rather than a short-term trader or arbitrage
specialist hunting for quick profits. That means this year he has
missed out on some sharp, quick returns, but he isn't convinced all
the deals will still look as attractive in a few years.
"I don't think cruise companies are out of the woods," Mr.
Perrin said. "I don't see bookings picking up substantially."
He has favored companies like Southwest Airlines, French
aerospace group Safran SA, and Booking.com, a younger,
higher-growth tourism company.
"The issuance has been enormous, historic in nature," said Kevin
Russell, chief investment officer at UBS's hedge-fund unit,
O'Connor. "We saw this rush of issuance, and we ramped up our
exposure to take advantage of that."
Mr. Russell said he put some spare cash into the market and
wound down some junk-bond exposure to add more convertibles. He has
sold some positions lately to cement gains, but is optimistic for
further strong performance as markets remain volatile.
Volatility is important because it directly influences the
likelihood that a bond will convert into shares when it matures.
This works exactly like stock options do: Higher volatility makes
the conversion option more valuable because it improves the chances
that the shares will rise above the price at which the bond can be
converted into stocks.
"We're expecting a supportive and positive environment for
credit and volatility will remain elevated, so we'll remain
invested in the market for some time ahead," Mr. Russell said.
Write to Caitlin Ostroff at caitlin.ostroff@wsj.com and Paul J.
Davies at paul.davies@wsj.com
(END) Dow Jones Newswires
November 02, 2020 09:02 ET (14:02 GMT)
Copyright (c) 2020 Dow Jones & Company, Inc.
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