Super Micro Computer recently accomplished an unprecedented feat by securing a $1.7 billion capital raise with a 0% interest rate using convertible bonds. This marks a resurgence in the market for such bonds, driven by investors adapting to the Federal Reserve’s decision to maintain higher rates and a favorable growth environment boosting stocks.
In the last fortnight alone, eight U.S. companies, including Global Payments, NextEra Energy, Lyft, and Sunrun, raised nearly $7 billion through convertible bonds, making it the most active period for these hybrid securities in over two years.
To enhance the appeal of convertibles for companies, banks are offering insurance and other services to mitigate the risk of issuing shares at a discount to the market price. Despite the additional costs, the interest savings are substantial, with companies potentially saving 3% to 4% on average in interest costs, as noted by an investor and analyst.
Santosh Sreenivasan, the head of the equity-linked and private capital markets business in the Americas at JPMorgan, the leading underwriter of such bonds, emphasized the significant coupon savings achievable through convertible bonds compared to regular bonds.
BofA Global analysts anticipate a global convertible bond issuance of $90 billion to $100 billion this year, reflecting a 20% increase from the previous year, with $60 billion to $65 billion expected in the United States. David Clott, a portfolio manager at Wellesley Asset Management, predicts a surge in volumes as companies seek to refinance upcoming maturities in the coming years.
Lowering dilution through convertible bond
Convertible bonds, similar to regular bonds, provide coupon payments, and their yields are influenced by interest rate changes. However, their value is also tied to the company’s stock price, as they have the potential to convert into shares.
Historically, the fear of diluting existing shareholders through convertible bonds has deterred many companies. To address this concern, bankers are introducing alternative products to minimize the impact of share dilution.
Recent deals in the past two weeks have often included a feature known as net share settlement. This option enables companies to settle bonds converting to stock primarily in cash, with only a portion in stock.
Additionally, companies are opting for capped calls, a derivative that boosts the share price at which the bonds can be converted into stock. In recent transactions, companies have been purchasing capped calls to mitigate the risk of dilution.
For instance, in Global Payments’ $1.75 billion bond issuance, the bonds were set to convert into shares at a 20% premium to the current share price. However, by acquiring a capped call, Global Payments increased the conversion premium to 75%, spending $222.3 million on the derivative.
Super Micro also utilized a similar strategy, raising the conversion premium on its deal from 37.5% to 100% through the purchase of the derivative.
Typically, companies allocate around 10% of their issuance proceeds to acquire capped calls, according to Santosh Sreenivasan, head of the equity-linked and private capital markets business in the Americas at JPMorgan.
Hedging against risks
Investors in convertible bonds often employ a strategy known as hedging, where they simultaneously make bets that the company’s stock will decline. In a short bet, they borrow stock and sell it, aiming to repurchase it later at a lower price.
This strategy of short bets can create downward pressure on the stock. To counteract this effect in recent transactions, many issuers have utilized the proceeds from convertible bond offerings to repurchase their own stock from bond buyers engaging in such short bets.
A notable example is Global Payments, which concurrently bought back $185 million of stock along with its convertible bond issuance.
While methods to mitigate dilution risk have existed for years, more companies are now demonstrating a commitment to employing them, as highlighted by JPMorgan’s Santosh Sreenivasan. He emphasized that companies aim to signal to their shareholders that, despite choosing a product with some dilutive impact, they are effectively managing and mitigating the associated risks.
According to Reuters.
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