Of the nearly 500 deals that have been executed in the U.S. convertible market since 2021, about 47% have included call spread overlays. These derivatives raise the effective conversion premium from the 25 – 50% that is most typical in the convertible bond market to higher levels — often more aligned with an issuer’s view of its stock price trajectory.
Conventional wisdom among market participants has been that call spreads are only efficient up to the 100% premium level. Transaction history is consistent with that story, with the majority of call spreads having an up 100% upper strike, and three-quarters of deals clustering at the 75% or 100% levels.
However, as seen in the accelerated share repurchase market, there is also a tendency for capital markets to cluster around precedent behavior, irrespective of a specific issuer’s objectives.
Recent transactions show the market’s ability to digest a range of structures:
- DoorDash (May): up 150%
- Cloudflare (June): up 175%
- ZScaler (June): up 150%
While these call spreads cost more than an up 100% would have (costing ~11 to ~14% of the principal amount), there was no sudden drop in inefficiency above the up 100% level.
In another transaction on which we advised, Etsy opted not to use a call spread overlay. The company, which had previously executed convertible notes offerings with capped calls, instead opted for a concurrent share repurchase as a tool to offset dilution.
The convertible and equity derivative market is remarkable in its flexibility. Each issuer’s balance sheet and capital structure needs are different. Solutions can be designed thoughtfully and analytically to align with management goals without being bound to particular structures for precedent reasons.
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