Last year the supply of new convertible debt climbed to levels not seen in a decade or more. In the US and Asia, US$84 billion came to the market, which more than outweighed softer levels in Europe.
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At this stage it is hard to know how long this increase in supply will persist for. Driven in the US by a combination of rising interest rates and a change in tax policy that limits the deductibility of interest expense from companies’ tax bills – the net result of the latter being the increased attraction of the (typically) lower coupons available via the convertible market.
A further driver of increased issuance was rising volatility in the stock market. The interest rate a company must pay is to some degree inversely correlated with the volatility of its stock price. Other things being equal, more volatile stock prices enable companies to issue convertibles with lower coupons.
Increased supply has mixed implications for investors. On the one hand, with the value of new issues exceeding the flow of new money into the asset class, the price of existing issues came under downward pressure in the secondary market. However, new bonds tended to be priced competitively to entice sufficient numbers of investors to buy them. That, in turn, offers plenty of profitable investment opportunities.
Looking further ahead, once this supply/demand imbalance has been rectified, the expansion of the number of issues in the market should be viewed positively. It will provide a wider range of investment options and we are already seeing a more diverse range of companies in different sectors, of different sizes and with different credit ratings, issuing convertibles. Further, as the amount of convertible paper outstanding grows new investors are likely to enter the market which should improve liquidity and drive up valuations over the long run.
The normalization of monetary policy occurring globally, albeit at a slow pace, will continue to drive bond yields higher and encourage companies to look at convertibles as a low-cost alternative to conventional debt financing. Over the longer term, we expect demand to be well supported by an increasing recognition of the unique risk/return characteristics convertible bonds offer, along with their broadening diversity.