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Firms including Banco Santander and Toronto-Dominion Bank's U.S. investment banking arms have been adding to their convertible bond teams, anticipating that companies refinancing existing debt will be drawn to the asset class in the next several years.
Faced with widespread predictions that interest rates will remain higher for longer, convertible bonds' relatively low interest coupons could prove irresistible to U.S. junk-rated firms' $1.87 trillion in debt coming due between 2024 and 2028, according to Moody's Investors Service.
"If you believe in the thesis that the convertible market is going to be busy, banks hiring today are doing the smart thing," said Syed Raj Imteaz, head of convertible and equity derivatives advisory at ICR Capital LLC.
TD in June hired Carey Squires, who was previously a co-head of equity-linked capital markets for Bank of Montreal. More recently, it picked up 19-year Credit Suisse veteran Tucker Martin. The firm is already generating revenue after bulking up: Uber Technologies' offering Monday, which had been boosted to $1.5 billion, was led by Barclays Capital, and counted TD among the joint bookrunners, sharing the credit with stalwarts Goldman Sachs Group, Bank of America and JPMorgan Chase.
The case for convertible bonds is easy to make in this environment. Uber will use part of the proceeds from the new convertibles, which carry a 0.875% coupon, to redeem $1 billion in outstanding 2025 notes, which carry a 7.5% coupon.
In general, there's roughly a 400 to 500 basis-point difference in coupon between straight debt and convertible bond financings at current levels. That contrasts sharply with most of the past 15 years, when the Federal Reserve's zero interest rate regime after 2008 provided companies a broad choice of low-cost debt financing and eliminated convertibles' edge.
"To me, it feels like 2010 to 2018 was a lost decade for converts," said ICR's Imteaz.
The asset's lack of restrictive covenants has historically drawn high-growth technology and life sciences companies. With interest rates predicted to stay at elevated levels for most of next year, large cap companies' heavy interest payment burdens are forcing them to look twice.
"There are limited ways to reduce cost of capital, and the convertible market is the easiest way to accomplish that lower cost profile," said Richard Duffield, head of equity-linked capital markets at Citigroup. "We expect the convertible market balance of rated versus unrated issuance is going to stay more consistent with what we're seeing today, which is closer to a 50-50 split."
To be sure, central bank officials have consistently signaled that they won't be content with inflation above the 2% target. Though they're set to move cautiously, they have said they're willing to tolerate economic slowing to achieve their goal. That puts firms betting heavily on higher rates at risk of fighting the Fed.
For banks looking to strengthen their convertible bond capabilities, it helps that origination is a rather lean operation. Even bulge-bracket banks have only a handful of managing directors leading the practice, compared to initial public offering origination which often employs four to five times as many. And while IPOs typically have higher fee margins than convertibles, bond deals' larger sizes and relatively shorter development process more than make up for it.
Even if attempts to lure issuers away from straight debt prove disappointing, ICR forecast another $180 billion of convertible bonds are coming due in the next three years that will need to be refinanced.
"In the next 12 to 24 months, many banks will look to hire more convertible bankers," Imteaz said. "At that point, I don't know if as much convert banking talent will be available."
