Expert Commentary

Deflation: Surge in Convertibles a Sign of the Dash for Cash

Cash is king in deflation.

Developed Market Buybacks and Equity Fund Flows USD

What a difference a few months make. Last year, corporations around the world but particularly in the U.S., were using their cash balances to buy back their own stock as a way of returning cash to shareholders. The stock buyback craze was a sign of wild corporate optimism and a sneaky way of not having to continually increase dividends. This mania, which reduced the amount of shares in circulation, contributed hugely to the stock market bull run. Indeed, as the chart below from Bernstein Research shows, buybacks could have been the dominant source of Developed Market (DM) buying, with buybacks dwarfing flows into equity market funds since 2014.

Fast forward to now and not only are firms dismissing out of hand the idea of stock buybacks, they are so desperate for cash that they are issuing bonds that they would be happy to see convert into new common stock. Convertible bonds are notes issued by corporations that pay a coupon on principal just like normal corporate debt, but they carry with them the option to have them convert into ordinary shares given certain circumstances. That’s the basic gist but convertibles have many complicated plays for the rocket scientist quants to get involved with (I once worked on a trading floor next to a guy whose specialty was convertible bond arbitrage and he actually looked like Albert Einstein!)

Throughout the decades, convertibles have gone through various periods of popularity and they are once more enjoying a renaissance as firms seek out any which way they can to raise much needed cash to see them through the current recession, which may well turn into a depression. According to data from Refinitiv, global convertible bond issuance is at its highest level since 2007, with $89 billion issued this year already, compared with $63 billion for the whole of 2019.

From a sentiment point of view, this is interesting on two counts. Firstly, the desperation for corporates to raise cash is evident. But secondly, the fact that there is demand for convertibles, and the chance to own equity, tells us that investors still believe in the bull market. It could be another classic sign of the end of a corrective second wave bear market rally.