AI frenzy means that debt can be interest free
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Investor fervor for the AI boom is so strong that companies are able to borrow billions of dollars right now essentially for free.
Why it matters: The record surge in zero-coupon convertible bonds — which don't pay regular interest — is surprising given that we're in a higher rate environment.
- Typically, that would mean companies would pay higher borrowing costs.
State of play: The overall market for these "converts" is booming. As of Sept. 1, companies issued $186.8 billion globally in convertible bonds across 362 deals — that's already more than last year, per data that Dealogic shared with Axios.
- 60% of these bonds are related to the AI boom: hyperscalers, neoclouds, semiconductors and energy companies benefiting from data center construction among them, says Venu Krishna, head of U.S. equity strategy at Barclays.
- Zero-coupon issuance made up about 43% of the overall total, close to $80 billion — that is the largest amount of any full year going back to 1995, per Dealogic.
The latest: Just this week, Nvidia invested $3.5 billion in a $3.9 billion zero-coupon bond issued by MediaTek, a Taiwan-based chipmaker. Google parent Alphabet also participated.
How it works: A convertible is something of a bond-stock hybrid.
- Say a company wants to borrow $100 and does so by issuing a bond that gives investors the right to convert the debt at a later date into its stock at an agreed-upon higher price.
- If the stock doesn't go up by that much, investors have the option of simply getting paid back the $100.
- Right now these are getting priced aggressively. Stocks would have to move up a lot for converts to pay off — typically around 40%, analysts say. If they do, investors get a tidy payout over a longer time frame than you can get just buying options.
The intrigue: Typically, even with a zero-coupon convert, there may be some yield baked into the agreement — a company might sell a $100 face value bond for $90, which repays $100 at maturity.
- But what's unusual now, says Barclays' Krishna, is that many of the zero-coupon converts are being issued at face value — no baked-in yield.
The big picture: The demand for exposure to the AI buildout is so strong that investors are willing to look past rising rates to bet on rising stock prices.
- It's a very favorable environment for companies issuing debt, and they're "taking advantage of it," says Michael Youngworth, head of global convertibles and preferred strategy at Bank of America Securities.
- "I don't necessarily think just because we see a lot of convertibles, it's a bubble indicator," he says. "But I do think it suggests that there is some froth."
Flashback: In 2021, when certain tech stocks were surging as everyone was forced to stay at home, Peloton's stock was at all-time highs.
- The company issued a zero-coupon convert, and eventually the stock fell by more than 95%.
- "That's an instance where investors overpaid," Krishna says.
Zoom in: Another part of the convert's appeal has to do with what Matt wrote about last month — single-stock volatility is high, while the overall S&P 500 index is relatively calm.
- That volatility is drawing in huge interest in convertibles from arbitrageurs who buy the convertible bond and short the stock underlying it, Youngworth notes.
- Arbitrageurs account for roughly two-thirds of the market for convertibles. The more volatile the market, the more they make.
What to watch: If volatility dries up, the risk is that these investors pull back from the market, Krishna says, emphasizing that this isn't his current base case.
- "These shops may pack up and move on to something else, and that leaves us with a market that is loaded with paper, and not enough investors to sop it up."
