The convertible bond market hums to life​

By Jake Rickman​

What do you need to know this week?

Convertible bond issuances are on the rise on both sides of the Atlantic. This reflects the continuing erosion of investor confidence in the public equity markets, as companies shy away from initial public offerings (IPOs) due to changes in investor appetite. Accordingly, investors view the equities market as fundamentally riskier compared to other securities like convertible bonds.

Moreover, it is a welcome sign for legal and financial advisers working in debt capital markets. As the Financial Times notes, until quite recently, the convertible bond market has been “essentially dead”. This reflects market volatility and its impact on convertible bonds in particular because, as we will see below, they behave like both equity and debt securities.

Market analysts interviewed by the FT suspect that between $70bn and $80bn of convertible bonds will be issued in 2023, with more than half coming from the US alone.

Why is this important for your interviews?

If nothing else, this gives us an insight into an interesting asset class traded by parties in debt capital markets (DCM). If you are interested in DCM or corporate finance more generally, this development will help signal your commercial understanding of this asset class to your interviewers.

Convertible bonds are hybrid securities that combine aspects of debt securities (loans and traditional bonds) with equity securities (i.e. company shares). Under the right set of circumstances, investors can trade convertible bonds and obtain the benefits of both equity and debt instruments while minimising certain disadvantages associated with each.

Likewise, from the issuing company’s perspective, the convertible bond market may offer a source of capital that is harder to access in other markets (such as IPOs).

Convertible bonds start their life as traditional corporate bonds. That is, in exchange for upfront cash, a company issues IOUs to investors, the terms of which usually obligate the borrower to make quarterly interest payments throughout the lifecycle of the bond. From this perspective, convertible bonds behave like debt securities.

But baked into the investors’ rights in the convertible bond is the option — but not the obligation — to swap the debt for equity in the company if the company’s share price hits a minimum price. If investors exercise this option, rather than hold the bond until it matures (upon which, the company typically repays the face value of the bond), they become shareholders and obtain a certain number of shares at a price pre-determined in the issuance documentation.

Convertible bonds give investors “downside protection” while also allowing them a path to participate in the company’s profits (i.e., as traditional equity shares do). The downside protection exists in the fact that, until the convertible rights are exercised, the investors are treated as creditors and therefore obtain stronger rights in the company in the event the company faces financial distress.

From the company’s perspective, they can issue convertible bonds at lower interest rates compensated by the equity rights associated with the bonds. This means the company pays less to service the debt than if it had borrowed through a traditional bond.

How is this topic relevant to law firms?

Surging activity in the convertible bond market means DCM teams will generate more fees. The top-rated DCM firms in London include Clifford Chance, Linklaters, White & Case, and Allen & Overy.