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Raining Debt


There is a relatively large amount of debt being issued by corporations in the form of convertible bonds, a derivative security that is part bond and part call option on the company's stock. The company sells the call option, which can create future dilution in the company's stock, to further cheapen the cost of borrowing.

The convertible bond market as a percentage of the total corporate debt market is still relatively small, but growing rapidly. The market capitalization of convertible bonds in the U.S. is now around $250 billion notional, up 30% from last year, but still only about 5% to 10% of the total corporate debt market. Corporations over the last three years have accessed this market more frequently, taking advantage of the phenomenal growth of hedge funds. Convertible bond hedge funds essentially buy the convertible bonds and sell stock short against the imbedded call option of the bond. This creates a long convexity (gamma) position that is a mainstay strategy of these funds.

The difference between this year and past years is in the quality of companies issuing the paper and in the size of the issues relative to their market capitalization. We are now seeing credit quality of the lowest sorts (almost every airline has issued convertible bonds in the last few months), so low that many of these companies probably would not be able to borrow from banks. We are also seeing companies issue bonds in amounts as high as 40% of their entire equity capitalization. And this leads to the disturbing point. Markets function efficiently over long periods of time because they correctly evaluate risk versus reward: They charge enough return for the risk assumed. When they don't charge enough for the risk, eventually the market at least suffers a major correction to wipe out the excesses. Hedge funds are awash in so much liquidity that they are gobbling up this paper at prices much better for the issuers than the market should bear. So where banks aren't lending, hedge funds are. This can go on for some time, but eventually the markets by definition correct excesses.

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