Tesla Fuels $166 Billion Bonanza in a Risky Corner of Finance

Tesla Inc.’s entry to the S&P 500 may be stoking relentless controversy, but in a specialized market for risk assets the electric-car maker is eliciting cheers all round.

Fueled by the Tesla effect, convertible bonds -- which start life as low-interest debt but can turn into shares if stock prices get high enough -- are poised for one of their best-ever years.

A Bloomberg index of the securities is at an all-time high while U.S. exchange-traded funds that track the assets hold a record $8.2 billion.

Elon Musk’s company is one of the biggest and most-famous issuers of the debt, making up more than 7.5% of the Bloomberg Barclays U.S. Convertible Total Return Index. The eightfold surge in Tesla’s shares this year building up to Monday’s disruptive debut in the S&P 500 has supercharged the value of its outstanding notes.

That has helped to thrust convertibles into the limelight as a lucrative way for investors to allocate to growing businesses in a volatile climate. A market rotation in favor of cyclicals, new energy and healthcare triggered by the coronavirus vaccine has only added to momentum for the asset class amid the biggest borrowing binge in at least a decade.

Tesla Fuels $166 Billion Bonanza in a Risky Corner of Finance

“It’s become interesting to all types of issuers: Cyclicals, alt-energy and health care are well-represented in the convertibles universe,” said Jim Doolin, senior portfolio manager at Insight Investment Management in New York. “It’s not just the tech names you remember from the dot-com era.”

Just last week ski station operator Vail Resorts Inc. was able to raise about $500 million at 0% for six years in the convertible market. That’s even as S&P Global said it could downgrade the company’s bonds if the virus keeps skiers away during the high season or forces it to shut its resorts.

Fresh issuance and rising investor interest mean the value of outstanding convertible debt in the U.S. is up $166 billion in 2020 to $400 billion, according to data compiled by Bloomberg. The total return index gained 49.44% in the year through Friday, just over a percentage point short of its record return of 50.72% posted in 2009.

Investors at private wealth managers and institutions that may have once dismissed the securities as too arcane are suddenly making inquiries, according to Doolin and co-manager Frank Campana, who ran a convertible-arbitrage hedge fund in Greenwich, Connecticut, before moving to Insight.

Tesla Fuels $166 Billion Bonanza in a Risky Corner of Finance

Convertible bonds are designed to offer investors like these many of the features of a bond but also the possibility of owning the underlying shares of a company -- if it reaches a certain level of success. For the borrower, who usually has discretion over whether to convert, they are a route to cheaper funding.

For example, Tesla’s first convertible was a $600 million issue in May 2013 with a conversion price of $124.52. Shares at the time were trading at about $92.50. The company was unprofitable, not rated by any of the major ratings companies and using a chunk of the cash to repay a loan, but it successfully boosted the size of the deal and borrowed at 1.5%.

Reopening Trade

The risk for both borrower and lender is that corporate growth can be sporadic and stock moves volatile, and some companies never achieve the share price needed to convert. That means securities remain debt on the balance sheet of a business with stalled growth and thin resources to repay investors.

For now, the prospect of the global economy re-opening at some point in 2021 has been diminishing those kinds of risks and has acted as a tailwind for convertible bonds across the board.

At Insight, Campana and Doolin have the biggest long exposure to convertible bonds in their fund since before March’s meltdown, even though they’re braced for setbacks in the race to vaccinate the world.

“In spite of hiccups the vaccine is coming and the reopening trades will work,” said Doolin.

©2020 Bloomberg L.P.

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