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Convertible Bonds Controversy


Goldman Sachs recently put out a piece on convertible bonds, basically stating that prices should recover given the level of relevant markets: stocks, government and corporate bonds, and current levels of volatility. We disagree.

Current levels of supply is very high, but not abnormally so. Companies have been issuing convertible bonds at very high rates for several quarters. So why should this supply begin to cripple general prices when new supply hasn't changed much?

The reason is that there is an accumulation effect. First, the rate of issuance has not decreased, causing a higher notional amount of bonds outstanding. Second, and more importantly, existing convertible bonds are not going away like they used to and when they do go away, it is a negative event for the bond holders. Because stock prices are not appreciating substantially (over the last few years), many convertible bonds that were issued with premiums of say 30% are not "in the money" enough to force conversion. So they are still out there. When they are converted, they are being called for parity (say 102) when they are currently trading at 112. The reason this is happening is kind of like mortgage refinancing: rates are so low that companies can call their existing bonds in exchange for a lower coupon and higher premium. So the same process that is hurting the mortgage holders (lenders) is hurting the convertible bond holders (hidden negative convexity).

So things are going on that are and will hurt convertible bond hedge fund returns. This has the effect of causing redemptions at the margin. So we have accumulating supply with on the margin shrinking demand. This is not a recipe for a healthy market.
No positions in stocks mentioned.

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