Convertible bonds: growth darlings of 2021 smartly raised cash through hybrid securities

Peloton may be better at predicting demand for convertible bonds than it is for exercise bikes.

In 2021, Peloton took advantage of two factors to shore up its balance sheet. First, its stock price was soaring amid the pandemic with the company’s market cap once approaching $50bn. Second, institutional investors were desperate to hold paper that even had a marginal chance of going up in value. The company in February of last year sold debt — a five-year bond that did not pay coupon but could be swapped into shares if Peloton’s stock price jumped 65 per cent to $239.

Today, Peloton’s stock price is just $13 a share with that embedded call option attached to the bond essentially worthless. The bond itself is trading at just 70 cents on the dollar with the company facing a liquidity challenge.

Convertibles are a type of bond that can turn into equity. These hybrid securities typically have a set interest payment until the conversion date. But like Peloton, several other high-growth tech darlings such as Spotify, Beyond Meat and Affirm issued convertible bonds without coupons. They now have stock prices that have fallen far from their peaks. It may be of some comfort then that these companies were canny enough to at least raise cash off of those inflated valuations before Wall Street fully appreciated how tenuous their business models were.

A typical convertible bond pays a modest coupon of 1 or 2 per cent. A typical zero-coupon bond would be issued at a deep discount — say 50 cents or 60 cents on the dollar — and then “accrete” upwards to a 100 cent payout at maturity. As it were, the convertibles from Peloton and the others were sold as “zero-coupons” at or near par with no accretion feature.

The implication then was that buyers were really just interested in the call option on the underlying company’s equity. That option had value as long as the company’s stock price was both elevated and volatile, the latter a key variable in options pricing models.

Ironically, these convertible bonds are now trading at steep discounts, well below 80 cents on the dollar, implying that the respective companies are, at least on the surface, financially distressed. That makes raising money today much trickier as Peloton just found out when it recently took out a $750mn loan with a near 10 per cent interest rate.