Smaller companies are feeling good about their prospects. Now, many are rushing to issue low-cost debt that lets investors bet their stocks will climb.
So far this year, U.S.-listed companies have issued $48.6 billion worth of bonds that could convert into stock if their shares rise to a certain price. That is the highest issuance of convertible bonds since 2021, when near-zero interest rates during the pandemic fueled a boom, according to Dealogic.
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With shares of smaller companies springing to life in recent weeks, issuance of convertible debt is expected to keep growing. A surprisingly cool inflation report earlier this month all but convinced investors the Federal Reserve will begin cutting rates in September. That sparked a rush into shares of beaten-down companies likely to benefit more from lower borrowing costs.
“In the last couple of weeks, small-caps have really been outperforming large-caps. And that has pulled convertible bonds right along with them,” said Michael Miller, chief executive of Wellesley Asset Management, which specializes in convertible-bond investing.
Excitement over artificial intelligence and rate-cut expectations have helped send the S&P 500 up 14% for the year, despite a recent selloff triggered by the rotation out of tech giants. The broad market rally has lifted all sorts of assets, from blue-chip stocks to riskier junk bonds and leveraged loans.
Many nevertheless expect that the days of ultralow rates are likely in the rearview mirror. That has encouraged companies to return to the convertible-debt market, where borrowing costs are lower than in other corners of the corporate-bond market.
The savings can be substantial. The average coupon on convertible bonds issued this year is 2.6%, according to Barclays data. That compares with an average yield of about 8% for junk-rated bonds.
In February, ride-sharing company Lyft issued $460 million of convertible bonds due in 2029 that pay 0.625% a year. They could convert into stock if Lyft’s share price hits $21.08. Shares closed at $12.23 Friday.
Social-media company Snap in May issued $750 million of convertible bonds due in 2030 that pay 0.5% a year. Shareholders could turn those bonds into stock if Snap’s share price hits $22.18. The stock ended this past week at $13.33.
“In a higher-for-longer rates environment, companies can get significant coupon savings via convertible bonds than straight debt,” said Venu Krishna, head of U.S. equity strategy and global equity-linked strategies at Barclays.
With rate cuts in sight and small-caps outperforming major indexes, everyday investors are warming back up to convertible bonds, too. They have added $367 million to mutual and exchange-traded funds focused on convertible debt this year. In 2022 and 2023, they had yanked a combined $11 billion from such funds, according to LSEG data.
Convertible bonds give investors a way to get in on big potential returns, while protecting their principal. In many cases, investors get their cash back if the debt matures without shares hitting the price target. An ICE BofA index of convertible bonds returned 3.2% this year, outpacing investment-grade bonds and broader fixed income.
Another way companies raise money is by selling additional shares, which is typically unpopular with investors because it dilutes their stakes. With a convertible bond, shareholders often aren’t as bothered by potential dilution since the stock price would need to climb substantially.
The benefits have attracted more investment-grade-rated companies, analysts say. That is giving investors more assurance since convertible bonds are typically favored by companies that have lower credit ratings.
Tech giants Alibaba and other Chinese stocks listed in the U.S. have also been big issuers of convertible debt in recent months. They are tapping the market to fund share buybacks and add U.S. dollars to their balance sheet, which they can then use for overseas expansion and investments, said Michael Youngworth, head of global convertibles strategy at BofA Securities.
Still, there are risks. The recent rally in small-cap stocks could lose steam, and the Fed might not cut rates as soon, or as often, as expected. Over time, elevated rates could also hurt the profitability of smaller companies, making it harder for them to pay their debt while weighing on their share prices.
Convertible bonds also tend to be more vulnerable than traditional bonds to stock-market downturns. And many investors are worried about a spike in volatility around the presidential election in November.
“Our dialogue has been more to try to get an issuance out in advance of elevated volatility around the election cycle,” said Bryan Goldstein, who runs the convertible practice at the advisory firm Matthews South.
Write to Vicky Ge Huang at vicky.huang@wsj.com