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Tech companies are taking out record amounts of convertible debt. Here’s why.

When tech companies need to raise money, they typically issue stock — either in the public or private markets — or borrow money through debt. But this year, they’ve increasingly opted for a middle ground: Convertible bonds. These let companies raise cash at lower interest rates without immediately issuing stock and diluting their shareholders. And they let the lenders — institutional investors like mutual funds or asset managers — choose to get paid back in cash or stock, depending on how things go.

Already in 2018, the U.S. tech industry — including Twitter, Square and Etsy — has issued $13.4 billion in these bonds, according to financial markets platform Dealogic. That’s the most through June 12 of any year — even at the height of the dot-com bubble — putting 2018 on track to be a record year for technology convertible bonds, which are surging more broadly.

Why now? For the tech companies, they’re still able to borrow money at super cheap rates — 1 percent interest on average, or about one fifth of what it was in 2000, according to Dealogic. Again, that’s without having to issue new shares right away.

“It spreads the pain over the course of years and doesn’t antagonize shareholders in the short term,” Pimco’s global head of credit research Christian Stracke explained.

Lenders, meanwhile, get exposure to the tech market — which has beat the overall market by more than 40 percentage points over the past two years — with less risk. If things go well, when the loan matures they can convert their loan into the borrower’s stock at today’s agreed-upon rate — and have already made a potentially handsome profit. If the company’s stock declines over the length of the loan, or if we’re in a market slump, the lender is still due its cash with interest.

“Between here and maturity, these bonds will probably have a couple of market spills,” Advent Capital Management Chief Investment Strategist Odell Lambroza said. “Convertible bonds allow users to get their money back and also have equity upside.”

One thing worth noting: These huge spikes in the convertible bond market don’t tend to last for more than a year at a time (see chart above). And the top two years for convertible bonds in the internet era — 2000 and 2007 — were both quickly followed by market collapses. On its own, that doesn’t mean we’re due for a major correction next year. But it’s something to pay attention to.

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