The recent rally in the US stock market, with a particular focus on technology shares, has prompted several companies to tap the market for additional funding. These funds have been raised using convertible bonds, a hybrid of equity and corporate bonds. Why is interest in convertible bonds so strong, and what could this indicate about market valuations?
February saw some massive fundraisings
Recent market data shows that US companies raised $7.4 billion in convertible bonds in February alone, the highest figure since August. A staggering 75% of funds raised came from technology and FinTech companies, which are enjoying a strong market revival. At first glance, it may seem strange raising funds with bonds (upon which interest is paid) just before an expected reduction in both US and global interest rates.
The critical difference between convertible bonds and traditional bonds is that companies do not have to pay as much interest because they are convertible into equity on predefined ratios or share prices. In many cases, this also offers an additional hedge because bondholders are generally treated as company creditors in the event of financial trouble. Therefore, they would stand ahead of equity holders in a worst-case scenario.
Are we experiencing a degree of market over-exuberance?
Aside from the fact that we have seen substantial convertible bond issuances in February, it's essential to look at the companies raising funds. These include:-
· Super Micro Computer raising $1.7 billion with a zero interest rate convertible bond despite having no credit rating
· Ride-hailing company Lyft also raised $460 million after a significant rise in the share price following well-received results
Several market observers are already comparing the current trend in convertible bonds (and the companies raising funds) to the "frothy" markets of 2020/21. History shows that many technology companies will look to the convertible bond market after a period of outperformance, to raise additional funds. These could fund future expansion, enhance existing cash flow, or bolster the company's balance sheet. It will be interesting to see how the companies raising funds utilise this additional liquidity.
Impact on existing shareholders
In what many see as a win-win situation, it's essential to recognise the limited impact on existing shareholders when it comes to dilution. These convertible bonds have been issued after a strong rally in the technology sector and individual company share prices. When checking the fine print, you will also notice that the conversion ratio/conversion price will likely be significantly higher than the current share price.
Many companies currently taking advantage of demand for convertible bonds might struggle to secure finance through traditional routes, or at best, the interest rate charged would be significantly higher than the bond rate. This highlights the huge benefits of convertible bonds to companies in potentially high-risk/high-growth sectors and the power of investor sentiment.
How long will the demand for convertible bonds last?
Despite the enormous amounts raised in February, many recent convertible bond issues were oversubscribed. This suggests that investors are willing to pay up for new convertible bonds, some of which will pay a relatively modest interest rate but also offer direct exposure to the underlying share price. Unfortunately, as we have seen on many occasions in the past, investor sentiment can change in an instant!
Summary
The vast number of convertible bonds issued by US technology companies in February is indicative of current investor sentiment, focused on potentially high-risk/high-growth companies. Even though the American markets are taking the headlines, we have seen increased interest in technology shares in the UK and around the world. Whether this will be maintained in the short to medium term remains to be seen as there are economic challenges ahead, and interest rates have yet to start to move downwards.
Sometimes an indicator of the top of the market, a period of over-exuberance or perhaps misplaced confidence, keep an eye on the convertible bond market in the weeks and months ahead for indications of fluctuating investor sentiment.