Preaching the zero coupon converted bonds

Preaching the zero coupon converted bonds

Troubled travel stocks, including Webjet and Flight Centre in Australia and Carnival offshore, raised funds in this form to avoid hefty dilution when their share prices were on the nose.

But tech darlings such as Afterpay and Xero have also taken advantage of low interest rates and elevated share prices to raise cheap capital.

If a company has issued a convertible bond, it’s going to have a permanent pool of shares sold short.

Convertible bonds involve a company raising a finite amount of funding, paying an interest rate until a conversion date, at which point the funds morph into shares at an agreed price.

They’re complicated, but also highly mathematical, which means the pricing terms can be agreed to by the market immediately and deals executed within hours.

Afterpay’s deal caught the market’s attention because it appeared to have been done on such wildly attractive terms. The bonds pay a zero coupon and the price at which the bonds convert to shares in five years’ time was a 45 per cent premium to the share price at the time of the deal.

But zero coupons are in fact quite common of late. Twitter, Airbnb, Dropbox, Beyond Meat and Ford have all issued zero coupon bonds with conversion prices of between 40 and 70 per cent above the share price within the past six weeks.

Delta hedging

While the coupon may be zero, it doesn’t mean the financing is free. It simply means the value of the embedded equity option (and potential dilution) is baked into the price. In the case of the convertible bond, the sum of the yield over the life of the bond is the value of the option to convert into shares at the agreed price.

The other new trend is that companies have become wiser to the challenge of the delta hedges.

Delta hedging sounds way more exciting that it actually is. It’s a cohort of investors, usually hedge funds, buying the bonds not in the hope that the share price will go up and they’ll make a lot of money, but to eke out the implied yield, like a normal bond.

To lock in that yield they short the precise amount of shares required to protect them from any capital loss that would arise from a share price fall. In the past, hedge funds used to do the delta hedging themselves.

But now the banks that manage these bond deals find buyers to take the shorted shares. This ensures the process is a little more orderly than it was in the past.

Goldman Sachs’ Chris Champion and Jared Baker explain that about half the buyers in any deal are technical convertible funds that will delta hedge, while the other half are actual convertible bond funds buying outright and predominantly based offshore.

Goldman has had a role in six of the nine convertible deals done by Australian companies since 2018.

The reality is that if a company has issued a convertible bond, it’s going to have a permanent pool of shares sold short.

But Champion and Baker say delta hedging actually reduces share price volatility: these technical managers will reduce their hedges, and sell when the share price is going up, and cover, or reduce shorts, when the share price is falling.

This has happened with Tesla.

Last year analysts at Markit explained that convertible bond funds may have accounted for half the short interest in the stock, shorting more even as Tesla surged in price.

This means that short interest in Afterpay, if it is used as a measure of sentiment, needs to adjust for the fact a large proportion of shorts are true hedges that have no view on the stock.

As for Afterpay, since it issued its convertible bond, bond yields have spiked, and as a result, Afterpay’s share price has slid. The 45 per cent premium conversion price of $194.82 is now a 62.5 per cent premium, which means the implied option value has declined.

That’s bad for convertible bond funds that haven’t hedged. The $100 notes have lost more than 10 per cent of their value.

Published at Thu, 25 Mar 2021 02:42:28 +0000