By Kate Duguid and Imani Moise

U.S. issuance of convertible bonds in May hit a record high of $20.7 billion, according to Bank of America data, as companies struggling with the impact of the coronavirus pandemic ventured into the one-time niche market seeking cheaper and easier ways to borrow cash.

Convertible bonds, typically popular in tech and healthcare, saw the likes of Southwest Airlines and cruise line Carnival come to market with the second and third biggest deals of the year, according to Dealogic data. This wave of issuance has been met with increased demand from traditional debt and equity investors with less experience in the market, on top of typical inflows, convertible bond specialists said.

"We have seen a pickup in demand from non-traditional convert investors," said Michael Youngworth, head of convertible bond strategy at Bank of America. "I've received lots of calls from either traditional credit investors or some traditional equity investors who are looking to get into converts now."

The unique structure of the debt allows investors to bet that the price of the stock will rise significantly, usually within five years. That has attracted investors looking to position themselves for an eventual economic recovery.

"To the extent there is a downturn again, you're safer being in the convertible tranche than the equity tranche," said Santosh Sreenivasan, head of equity-linked capital markets for the Americas at JPMorgan.

About $20.7 billion in new U.S. convertible debt was issued in May, according to Bank of America, the highest monthly volume on record. The previous high was $19.2 billion in May 2001.

Beyond its appeal as a recovery trade, investors have been drawn to the market's valuations and return. The price of the iShares Convertible Bond ETF is up 6.49% this year, while the S&P 500 has fallen 5.24%.

The convert market has also been a refuge for equity investors, said Joe Wysocki, who manages the long-only convertible fund at Calamos Investments.

"You're seeing companies cut dividends. As an equity investor, convertibles allow you to stay invested, to keep the equity upside," said Wysocki.

Convertible debt is a hybrid security, offering a regular fixed payout like a bond, while giving bondholders the right to trade their debt for equity if shares rise over a certain price.

While the possibility of an equity payout is drawing new investors in, bankers selling issuers on this structure are highlighting the slim chances of a conversion, according to banking sources who declined to be named because they were not authorized to speak to the media.

Banks began pitching convertible deals early the pandemic, after plummeting stock values ground equity issuance to a halt. Since then the product has become the biggest source of fee growth for equity bankers, according to Refinitiv data. Convertibles have made up 34% of U.S. equity deals so far this year, up from 19% last year. The deals were seen as a solution for companies who needed cash but did not want to sell shares at lower valuations, bank sources said.

The ability to issue debt in a zero interest rate environment, and the slim chance the debt would be converted into equity was attractive to companies, those bankers said. Convertible deals are typically structured so the stock would need to rise 75% to 100% before investors could convert, a bank source said.

Desperation for cash, however, has led issuers to make some concessions. Conversion premiums - the amount the conversion price exceeds the current share price - have been falling, according to Wysocki.

"That's good for investors like ourselves because you're paying less of a premium so the chances of that getting in the money are higher," Wysocki said.

(Reporting by Kate Duguid and Imani Moise. Additional reporting by Joshua Franklin. Editing by Megan Davies and David Gregorio)