Convertible securities are somewhat complex instruments that are unfamiliar to most investors. Now could be a good time to learn about them.
Converts are bond/stock hybrids that can offer the security of bonds and the upside of stocks. They’ve historically generated strong returns—gaining about 50% in 2020.
But the $280 billion market has been stung this year and is now worth a look. The selloff has pushed yields to 10% or more on the convertible debt of former highfliers like
(RDFN). These unloved securities seem like an appealing alternative to the issuing company’s depressed common shares.
owner MicroStrategy, for instance, has a zero-coupon convertible bond due in 2027 that trades around 55 cents on the dollar with a yield-to-maturity of 13%. It looks like an attractive Bitcoin play. Beyond Meat has a $1.15 billion, zero-coupon convertible due in 2027 trading for 41 cents on the dollar and yielding 19.5%. Peloton’s $1 billion zero-coupon convert due in 2026 trades around 69 cents on the dollar and yields more than 10%.
Investing in these “busted” converts can be difficult for retail, or individual, investors. Convertible-bond mutual funds and exchange-traded funds don’t offer much exposure to busted converts, which make up about 20% of the convertible market, because they tend to focus on lower-risk convertibles with more current income and equity sensitivity.
And it can be tough for retail investors to purchase individual convertibles. Most were originally sold as rule 144A private placements to institutions. The securities listed in the accompanying table have “unrestricted” Cusip numbers—the identifiers for bonds—that should allow broader ownership. It may be easier to buy them from full-service brokerage firms with big bond trading desks than from pure online brokers.
There’s risk in these bonds. Most have junk credit ratings or none at all and most of the companies are losing money. At Goldman Sachs, there are investor suitability protocols that govern the purchase of high yield and unrated securities.
Investors can get bond pricing history by inputting the Cusip numbers on Trace—the Trade Reporting and Compliance Engine—which was developed by the Financial Industry Regulatory Authority to provide visibility into the opaque over-the-counter trading in bonds.
The market’s losses this year reflect a big selloff in convertibles issued during the frothy convertible market of late 2020 and 2021, when investor demand allowed hot growth companies to get interest rates as low as zero. The allure was that investors got an option to convert the debt into the issuer’s stock if it continued to rally and win big—as
(TSLA) convert holders did in 2020 when the stock rose eightfold.
But as the underlying stocks have cratered, the convertibles have been hit and many now trade anywhere from 40 to 80 cents on the dollar. They’re a rarity in financial markets because they now amount to low-interest or zero-coupon corporate bonds.
The chances of investors profiting from the equity conversion feature is remote since that would require huge gains in the stock. The Peloton convertible, for instance, is convertible into stock at more than $200 a share, versus the recent share price of $13.
“There is a limited appetite for zero-coupon with high conversion premiums from growth companies with little or no earnings,” says Michael Youngworth, head of convertibles strategy at BofA Securities. “There could be some defaults but also some great opportunities.” The conversion premium refers to the percentage gain in the stock needed for investors to realize value from the equity option in a convertible.
The good news for investors is that the convertible bond is often the only debt on company balance sheets and interest costs can be minimal. For investors to win, the companies simply need to survive and pay off debt. If that becomes an issue, companies often will reach deals with bondholders to extend maturities and boost interest rates, notes David King, a manager of the
Columbia Convertible Securities
With the market selloff, convertible issuance has slowed sharply this year. Through May, there was $6.6 billion of new deals, down 87% from the same period of 2021. For all of last year, issuance was $84 billion, following $106 billion in 2020. The $4 billion
SPDR Bloomberg Convertible Securities
(CWB), the largest convertible ETF, is down 17%.
Here’s a look at some converts:
The MicroStrategy issue now trading around 55 cents on the dollar amounts to a lower-risk Bitcoin play. The company owned over 129,000 Bitcoins on March 31 that are now worth about $3.9 billion, with Bitcoin around $30,000. It also has a software business that could be worth $1 billion.
The convertibles look like a good bet since MicroStrategy’s debt is $2.4 billion, half its estimated asset value. Bitcoin likely would have to fall below $15,000 to impair the debt, and that assumes a low $500 million value for the software business, which has about $500 million in annual revenue.
|Convertible||Cusip||Recent Price*||Yield to Maturity||YTD Price Change||Deal Size (mil)||Conversion Premium|
|Beyond Meat 0% due 2027||08862EAB5||$41||19.5%||-41%||$1,150||235%|
|Redfin 0% due 2025||75737FAC2||62||14.5||-30||661||364|
|MicroStrategy 0% due 2027||594972AE1||55||13.1||-27||1,050||232|
|2U 2.25% due 2025||90214JAB7||77||12.0||-28||380||147|
|Wayfair 5/8% due 2025||94419LAM3||72||11.0||-22||1,518||423|
|Peloton Interactive 0% due 2026||70614WAB6||69||10.4||-18**||1,000||1,175|
|1Life Healthcare 3% due 2025||68269GAB3||83||9.5||-9||316||375|
|Snap 0% due 2027||83304AAF3||74||6.2||-25||1,150||374|
|Block 0% due 2026||852234AJ2||85||4.2||-15||575||210|
*Face value is $100. **Price change from 3/23/22.
The Beyond Meat convertible looks like a good alternative to the company’s common shares. The $1.15 billion issue is the only debt on the company’s balance sheet, and there was over $500 million in cash and equivalents on March 31. The bonds trade for just 40 cents on the dollar.
Beyond Meat’s stock is down 80% in the past year to $27 and its losses have widened with eroding pricing. But it is a category leader in meatless alternatives with the Beyond Burger, and it could have strategic value. At the current convert price, investors essentially are buying the company for less than $500 million (0.4 times $1.15 billion), or around one times annual sales.
Peloton’s convertible also amounts to a lower-risk alternative to its common stock, which is down nearly 90% in the past year to $13. The bonds, at around 70, yield over 10%. The $1 billion convertible is its only debt outstanding. The company is losing money but has nearly three million subscribers, $4 billion of annualized revenue, and could become a takeover target.
King is partial to a convertible from
(TWOU), the education company that owns edX, which offers online courses from universities like Harvard and MIT. The 2U 2.25% converts due in 2025 trade around 77 for a yield of 11%. King also likes converts from
(ONEM), which operates the One Medical primary-care practices. Its 3% issue due in 2025 trades at 83 for a 9.5% yield.
“Both of these are growth companies that have generally been hitting their milestones but the stocks have declined sharply anyway,” King says. “Each company has a valuable franchise—cost-efficient medical care delivery and remote learning—with meaningful growth potential. Both companies are burning cash now but could become cash generative, in our view, merely by dialing back growth initiatives.”
Paul Latronica, a managing director at Advent Capital Management, likes lower-yielding convertibles from
(SQ), formerly Square.
The Snap zero-coupon issue due in 2027 is more of a bond proxy with the equity component out of the money. It trades around 74 for a 6.2% yield. The Block zero-coupon issue due in 2026 trades at 85 for a 4.2% yield. This issue has more equity sensitivity, with the conversion premium at about 200%.
Converts historically haven’t been mainstream investments, but the downdraft this year has created unusual opportunities.
Write to Andrew Bary at email@example.com