Convertible bonds: the worst of both worlds

Tech stocks are being hammered. The threat of inflation is weighing on corporate bonds. One unlucky group of investors is feeling the effects of both misfortunes. Earlier this year, companies such as Twitter and Peloton issued billions of dollars of convertible bonds. They appear to have raised capital at the top of both the debt and equity markets. Holders of convertible debt must hope that at least one of those markets can rally.

Convertible bonds combine standard debt with an option to buy company stock at a premium price in the future. Earlier this year demand was so hot that some companies did not have to offer coupons. In February Peloton issued a $1bn convertible bond. Normally such a zero coupon bond, this one with an five-year maturity, would trade at a discount that allows the holder to achieve a positive yield to maturity. Yet investors decided the equity option embedded in the convertible feature was worth so much that the bond should trade at a sharp premium and above par.

The conversion price for the bond was set at $239, or a 65 per cent premium to where the company traded at the time. Today, the fitness equipment group’s shares change hands for just $110. As for the convertible, it trades at $95, even after rallying in recent weeks. At this price the bond portion implies a positive yield of just under 1 per cent.

Convertible bonds are typically purchased by hedge funds which employ complex hedging strategies to lock in returns regardless of how the underlying shares trade. The convertible bond market had been hot, not only because of low yields and high stock prices but also because of volatility. Volatility, all else equal, makes the call option more valuable. But that may not be enough to compensate for extended concerns about inflation and interest rates. If a convertible bond with a 75 basis point yield is what counts for a hedge, the sharp run up in growth stocks may finally be facing its reckoning.

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