Some highly rated US companies take unusual funding route as rates rise
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[February 27, 2023] By
Shankar Ramakrishnan
(Reuters) - Some highly rated U.S. companies have issued bonds that
convert to shares to raise several billion dollars so far this year, in
what bankers said signals a shift in a market that has long been
dominated by companies with few other options to raise money.
Investment-grade-rated companies have traditionally avoided such
convertible securities because they risk giving away shares at a
discount to the market price, lowering the value of their stock.
Credit-worthy companies have found in the past that they can raise funds
more cheaply in investment-grade bond markets.
But in the past week alone, two highly rated utility companies -- PPL
Corp and Southern Co -- raised a total of $2.4 billion through
convertible bonds, making them the first investment-grade utilities in
20 years to do so. They were able to issue the securities at much lower
interest rates than what they would have had to pay on a bond.
So far this year, investment-grade companies have helped boost
convertible bond issuance volumes to $8.5 billion, putting the market on
pace to reach $65 billion to $70 billion this year, or more than double
the amount raised in 2022 and returning to the levels of previous years,
one banker said.
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Craig McCracken, co-head of equity capital markets at Wells Fargo, said
more investment-grade companies were showing interest, promising to make
2023 "a breakout year relative to 2022" for convertible bond issuance.
CHEAP FINANCING
The entry of some investment-grade companies in the convertible bond
market shows how the U.S. Federal Reserve’s rapid interest rate hikes to
stamp out inflation have created anomalies in the marketplace. In recent
weeks, economic resilience in the face of the Fed’s campaign has added
to uncertainty about the path of the stock market and interest rates in
the coming months.
In interviews, two bankers and an investor said that uncertainty has
made convertible bonds an attractive option to raise money for some
investment-grade companies. That is supported by an accounting rule
change last year that made it less expensive for companies to issue
convertible bonds and by steady demand from funds dedicated to investing
in these securities, they said.
"Convertibles are the cheapest available financing for both high-yield
and high-grade issuers right now," said Josh Schaeffer, managing
director at accounting firm Equity Methods.
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HYBRID SECURITIES
Convertible bonds are hybrid securities. Like a regular bond, they
pay a coupon and their yields change with interest rates. But their
value also depends on the company's stock price, as they can convert
to shares. The hybrid nature can limit the risk but also add to it.
Earlier this week, for example, investors bought PPL’s convertible
bond at 100 cents on the dollar, or at par. The bond was trading at
101 cents on Friday.
Investors were betting on an appreciation in the shares of the
company, according to Howard Needle, portfolio manager at Wellesley
Asset Management, which bought the bond.
PPL’s stock is up 19% from a low of $23.28 in October last year.
Because defensive stocks such as utilities like PPl could benefit if
interest rates keep rising, potential returns for investors in
convertible bonds could be boosted. That environment would make
convertible bonds attractive to such companies because it would
instill confidence that their offerings would successfully raise
money.
On the flip side, investment-grade companies in other sectors whose
stock prices suffer when rates rise would likely shy away from the
convertible bond market because their product would be less
attractive to investors.
For PPL, these factors have meant it was able to raise $900 million
through a five-year convertible bond that paid a 2.875% coupon.
Southern's 2.75-year bonds pay 3.875%. Both are much lower than the
average investment-grade corporate bond yield of 5.48%.
Wells Fargo's McCracken said that in addition to the lure of cost
savings, convertibles have become more palatable to higher-rated
companies because of an accounting change in 2022.
A U.S. accounting rule had required that companies issuing
convertibles add in a hypothetical interest expense on the bond,
adding to the cost of issuance. That rule was eliminated last year.
(Reporting by Shankar Ramakrishnan; editing by Paritosh Bansal and
Leslie Adler)
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