As tariff uncertainty pressures the U.S. economy and equity markets, investors have looked to mitigate downside risk while participating in the potential upside. Given that landscape and the resurgence of convertible bond issuance by high credit names, convertible bonds are in vogue again as investment vehicles for both sophisticated hedge fund strategies and as a yield enhancement for traditional investors and portfolios.
Convertible bonds as investment tools have been popular for decades, but mostly on the speculative side—usually tech or healthcare companies in early growth stages. However, the market growth in 2025 has been staggering across the board, with 17 issuances over $1 billion from well-established companies including Nissan, Coinbase, and Alibaba.
The reason non-traditional convertible issuers are entering the market is clear: The average coupon of convertible bonds in 2025 was 3.29% as opposed to 6%-7% for traditional corporate debt in the same period. In fact, Alibaba and Coinbase issued zero-coupon convertible bonds this year. The average deal size in 2025 was well above historical norms at $773 million, and the total amount of convertible bonds outstanding surpassed $300 billion for the first time since COVID.
As uncertainty dominates the global economy, companies face significant issues with procurement of materials and manufacturing of their products. Supply chains and traditional manufacturing centers must be rethought, sometimes requiring significant capital investment. The cheaper alternative of convertible bonds becomes very attractive in this environment. Of course, this cheaper on-balance-sheet funding must be weighed with the dilutive effect of convertible bonds. Although there are tools to mitigate this effect—capped calls and stock repurchases, for instance—that Alibaba employed in their May 2024 issuance.
On the investor side, the traditional characteristics of convertible bonds are still present: the participation in the upside of the equity with a limited downside risk of the bond floor. This setting is particularly interesting amid international tariffs and the uncertainties for the U.S. economy. Further, given the high creditworthiness of the issuers in 2025, the bond floor is even more robust; if their stock fell precipitously, the bonds would not be in danger of default.
In a more sophisticated setting, hedge funds can speculate on the long-term volatility of the underlying stock by hedging out the equity exposure, especially in situations where they believe the volatility is underpriced. In other words, they believe the future realized volatility will be greater than the volatility implied in the current market price. This strategy has seen a resurgence since 2023, as the proceeds of the short sale of the equity to create the delta-neutral position can be reinvested at higher interest rates.
However, there’s an even more pertinent and prosaic reason investors are using convertible bonds. YTD historical returns through November 10 have outperformed both equity and bond indices.
Investors eyeing convertible bonds as investment vehicles should keep in mind the risk factors: the interest rate and equity affect prices, and credit and equity volatility are key performance drivers.
There are four distinct regimes that characterize convertible bonds, depending on how the current equity price affects the conversion ratio and the number of underlying stock positions available upon conversion of the bond into equities (in options trading, the scaled delta conveys the same information). Each regime has distinct risks.
- Distressed. In this period the equity is quite low, and the risks are more exogenous rather than market-driven (e.g., how much of the bond will be recovered in the event of a default). The implied recovery rate is the most important element, and of course this is not a market-observable activity. Rather, it is determined by lengthy legal proceedings and must be estimated from historical averages. If nothing is known, the long-term historical average of 40% is almost always used (although that tends to be trending higher since the initial study).
- Fixed-income-like. The risks are more centered on interest rates, and duration is the analytic to heed.
- Hybrid. The instrument acts akin to a total return swap, with exposure to both equity and interest rates. In this regime equity volatility is the most important factor. The reason is that at-the-money equity options have the most sensitivity to volatility. The value of the option above the intrinsic value is given by the likelihood that the option expires in-the-money. As volatility increases, this likelihood increases and so does the value of the option. Options with extreme moneyness are not as sensitive to volatility (and therefore the value is dominated by the intrinsic value), as extremely in-the-money options will almost surely pay out, and extremely out-of-the-money will almost surely not. Changing volatility will only slightly impact the outcome.
- Equity-like. When the underlying equity is high, the economic value of the bond is dominated by the movements in equity, and therefore the bond is better categorized as an equity investment.
