Convertible debentures mix bond, equity advantages

Tired of low rates on fixed income investments like GICs and Government bonds?  There has been a considerable demand for higher yield, fixed income investments, in a low interest rate environment.

Convertible debentures meet the demand for investors willing to assume more risk.   They have features of both fixed-income and equity investments and are typically classified as fixed income.  But some advisors say that they are closer to equities.

The same debate exists for preferred shares, some would state they are equities.  Some say they are equities.  Others feel they have attributes of fixed income.

Similar to bonds, convertibles offer regular interest income (stated coupon rate) through semi-annual or annual coupon payments.  They also provide a degree of downside protection not found in direct equities.

Convertibles have all the standard features of a bond such as maturity date, coupon, and face value. At maturity, the face value of the convertible is redeemed by the issuer. The convertible’s denomination is the currency and minimum amount in which the bonds are traded.

Similar to equities, convertibles typically offer upside potential for capital growth.  A convertible comes with the option to convert into the issuer’s equity.  At the time of issuance, the conversion ratio is set and is usually based on the number of shares/units per 100.  The time period during which an investor may convert their debentures to stock is usually open to the maturity date.

Since convertibles are more complicated fixed income investments, it is important to read the prospectus fully to understand each issues features and conditions.   Prospectuses are available through www.sedar.com

The debt feature of a convertible debenture is derived from its stated coupon, and claim to principal.  Most Canadian convertibles are unsecured against the issuer’s assets and are not rated by credit rating agencies.  Investors should weigh the lower credit quality, against the current yield and potential to convert into equity (and benefit from capital appreciation).

The conversion feature brings with it additional characteristics and associated terminology.

For an illustration, consider common stock, ABC Oil & Gas.  ABC has issued a convertible debenture with a coupon of 6.5 per cent and a final maturity date of December 31, 2016.  ABC’s share price is currently at $9.20.  The conversion price set at issuance is $11.00.  The conversion ratio is 9.0909 shares (determined by dividing the par value of 100 by the conversion price of $11.00).  This conversion ratio and conversion price is known from the date of issuance and does not change over the lifetime of the bond.  The above convertible represents a loan to ABC, which is paid back at maturity.

Convertibles gain or lose value along with the underlying stock.  When the price of the underlying shares of ABC rises, the price of the convertible will increase as well if the share price is already above the conversion price.  Even if the shares are not above the conversion price, an increase in the common share or trust values should also benefit the debenture provided there is a greater likelihood of conversion before the maturity date.

When the share price of ABC declines, the debenture typically declines only so far before its bond-like attributes establish an effective bond-floor (even if the stock/unit price continues to decline).  Investors will continue to receive the interest income and principal repayment just like a bond and will be protected as long as the company remains a going concern.

When the stock price exceeds the conversion price, the convertible is said to be “in the money.”  At this point, it is more sensitive to changes in stock price than interest rates and trades in-line with the stock/unit price.  When the underlying stock is close to the conversion price, the convertible is said to be “at the money.”  At this point, the price is influenced by both the stock/unit price and interest rates. It will likely capture two thirds of the stocks/units upside movement with only one third of the downside.  When the stock/unit price is less than the conversion price, the convertible is said to be “out of the money.”   When a convertible is out of the money its price is less sensitive to changes in price of the underlying stock/unit and is instead dominated by interest rates and credit factors.

Convertibles perform well in rising equity markets while mitigating downside risk during market declines. They provide a more conservative approach to equities because of defensive bond like attributes. While convertibles can benefit from increases in the underlying stock price they are cushioned against stock price declines by the downside protection provided by consistent income characteristics of fixed income investments. Convertibles offer investors a higher participation in upward movements as opposed to downward movements of the underlying equity.

Convertibles may offer diversification benefits as their performance does not directly correlate to either that of equities or bonds.  Adding convertibles to a portfolio should reduce overall portfolio volatility.  Convertible debentures are typically lower investment grade (most are not provided a credit rating by Moody’s, DBRS, or S&P) and are more appropriate as part of a diversified portfolio.  We feel investors should have at a minimum a moderate risk tolerance.  Not all convertibles are equal, and some would be better classified as higher risk.

Unlike most bonds, convertibles trade on stock exchanges where the bid and ask prices are visible to all market participants. This is an advantage for most investors as it provides greater transparency and efficiency in pricing.   This also provides the ability for investors to put limit orders in to purchase or sell at a pre-determined price.

Credit risk is a concern as with any fixed income investment.  As noted above, most Canadian convertibles are not rated by the credit rating agencies. One way to gauge credit risk is to consider the creditworthiness of the issuer and examine the possibility of default.  Interest rate risk also affects convertibles just like all other fixed income securities.