0% Convertible Notes: How Corporations are Raising Interest-Free Capital

Last year, the convertible bond market picked up enormous momentum, shattering the $100 billion issuance mark for the first time since 2007 and reversing the asset class’s stagnant growth. Convertible issuances surged in popularity during the pandemic due to an attractive pricing environment and found continued traction in 2021 with the unique rise of 0% notes. 

Convertible bonds, which give investors the right to exchange bonds for common stock, have a long history dating back to 1865, but only became established as a global asset class in the 1990s with a strong U.S. presence. The market gained traction in the decades before the 2008 financial crisis thanks to a combination of rising interest rates, market volatility, and strong economic growth, resulting in a $518 billion market by the end of 2007. However, this figure nearly halved the following year, as the financial crisis led to a flight to liquidity and to rising default rates. The ensuing years saw a low volatility, low interest rate environment that kept the convertible market suppressed in favor of high-yield debt — until recently.

The onset of the COVID-19 pandemic provided a strong catalyst for convertibles as large corporations with threatened business models (including Carnival Cruises, Southwest Airlines, and Expedia) rushed to raise billions using convertibles to deploy as emergency cash. The Federal Reserve’s decision to stimulate the economy through incentivized lending (which lowered interest rates from 1.58% to 0.05%) made it even more viable for corporations to raise debt. Issuing convertibles allows companies to raise capital quickly, cheaply, and without covenants, making it one of the most attractive financing options for issuers experiencing financial distress. Despite the pandemic, corporations easily raised significant funds using convertible debt and at lower interest rates of 1-4% compared to the standard 4-8% range. Accordingly, investor demand surged as the quick recovery, rallying equity markets, and strong liquidity in contrast to the 2008 financial crisis dramatically increases the equity upside potential for convertibles which far outweighs the lowered coupon payments. 

2021 ushered in even more extreme activity in the convertible space with $19.7 billion in convertible debt issued in just the first seven weeks of the year. Continued rock-bottom interest rates and a volatile tech sector have brought to life the 0% convertible, allowing corporations to raise significant capital completely interest-free. However, instead of issuing convertibles as a means to survive (as was the case with the first wave of convertible issuers), these recent offerings are more speculative in nature. Firms such as Airbnb, Twitter, Peloton, Spotify, and Beyond Meat have now raised over a billion dollars each in 0% notes in the last few months to take advantage of cheap financing. In addition, companies can get away with huge conversion premiums that prevent dilutions. Historically, convertible debt features 20-30% conversion premiums, but recent offerings such as Spotify and Peloton’s convertibles feature premiums of 70% and 65% respectively, meaning note-holders need to witness share price appreciations in excess of these figures to make converting to equity worthwhile. 

Investors would not favor these terms in normal times, but the low-rate environment (coupled with high valuations and elevated market volatility) makes investments in 0% notes attractive despite zero coupons and high conversion premiums. The volatility component is essential since convertibles act as a combination of a bond and call option, and high volatility causes call options to appreciate due to an increased chance of dramatic price appreciation. Investors are able to diversify through equity and debt exposure, which allows them to profit during extreme price rises, but also to suffer limited downside if the stock falls. 

 The current market situation has allowed for the rise in the novel 0% convertible bond, but such interest-free convertibles may not stay in vogue in the long-term. A multitude of structural changes in the macroeconomic environment can rapidly reverse issuances. For example, a rise in interest rates will force investors to demand attractive coupon payments, making the 0% rate unfeasible. Further, a bearish reversal in the tech sector (the industry in which a majority of 0% issuances originate) will reduce the likelihood of extreme increases in equity prices above convertible premiums, making the option component nearly worthless and dissuading investors. These concerns appear legitimate due to an overheated tech sector and economists projecting rate hikes within the next few years.

The 0% convertible bonds may appear attractive today, but their future looks to be short-lived. While 0% notes are likely a coronavirus-inspired anomaly, the overall convertibles market is poised for growth in the coming years. Rising rates will only make convertible securities more attractive to investors since they have historically outperformed during rate hikes compared to other fixed income instruments. They will also be preferred by issuers wishing to access low-cost debt quickly before rates increase. Both investors and issuers will undoubtedly require strong equity and fixed income analysis, as well as an understanding of macroeconomic trends, to succeed in the rapidly changing convertible bonds market.