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Convertible Bonds’ Time Has Come

For an investor who wants to park some money off the farm and into an investment that’s fairly secure, convertible bonds are worth a look. They are bonds that can be switched into shares. With this option, rising interest rates driven by improving business conditions help the investment. Without that convertibility into stock, rising interest rates would tend to drive down the price of the bond as new bonds with higher interest rates hit the market.

“This is a good time buy convertibles,” says John Calamos, president of Calamos Asset Management Inc. of Chicago. The company manages $6 billion in convertibles. “In an inflationary environment, governments will raise interest rates. Conventional bonds will lose value, but the equity component of convertibles will tend to sustain their prices.”

Recently, issuance of convertibles has increased. Many Canadian income trusts have issued convertibles to provide funding for their reversion to corporations in 2011. Like conventional bonds, convertibles pay interest twice a year, have a maturity date and are usually callable. Around the world, there has also been a surge in issuance.

HOW THEY WORK

Convertibles have a specific option to switch the bonds into a defined number of the issuer’s common shares at a given price. Most of the time, the underlying stock price sets the market value of the convertible. As the subordinated debt of small companies, interest rate changes are less important.

If a $1,000 bond is convertible into 10 shares of stock, the parity stock price is $100. If the stock price rises to $150, for the stock and the bond to be in parity, the bond has to rise to $1,500. Thus the bond trades on its merits as corporate debt as long as the stock price is below $100. Once it rises above $100, the bond will take off, much like a stock option, which it, in fact, has become. If the convertible’s gain lags the stock price’s rise, it will show what amounts to a charge for downside insurance embedded in the bond’s price.

If the stock price rises to or above the conversion price, some investors will convert. As well, the issuer can force conversion by calling the bond. Either way, debt is reduced but the company’s equity is diluted and each shareholder’s piece of corporate earnings is cut.

Today, many convertibles have risen above their conversion prices and are selling at a premium over the value of the bond. But should one pay that premium?

Nigel Roberts, a chartered financial analyst who heads Bluenose Investment Management Inc. in Oyama, B. C., says “look at the value of the payback based on the yield to maturity of the bond versus the yield on the underlying security. I want the yield-to-maturity of the bond to be higher than the running yield on the stock.”

Roberts likes convertibles issued by H&R REIT. The most recent issue, HR. DB. C, has a 6.0 per cent coupon with a maturity date of June 30, 2017 and a conversion price of $19. Recently, the common units of the REIT have traded at $16, which means that when they hit $19, the bond, with a recent price of $100, should shoot up. If the stock hits $25, the bond would be $131, Roberts estimates. In other words, a 56 per cent increase in the current $16.50 common share price would turn into at least a 32 per cent bond price gain. It looks like a bad deal, but as Roberts says, “with the bond, you have the security of a fixed redemption date and interest that ranks ahead of interest due on the common. For now, the stock must rise 19 per cent to hit the conversion price, he adds.

Roberts also likes the Russell Metals Inc. 7.75 per cent issue of Sept. 30, 2016. “It’s a good play on a formerly high flying stock,” he notes. As well, he likes grain handling equipment maker AG Growth International Inc.’s 7.0 per cent issue due Dec. 31, 2014. Each has a good yield and plays on an underlying stock with prospects for strong appreciation.

DOWNSIDES

The downside of convertibles is that, in exchange for the potential equity gain, the client must take a rate of interest on the bond that is lower than the general risk level of the bond would justify. Today, the average yield on convertibles is five to six per cent, though for speculative securities, the rate could well be higher.

Should one pay for the embedded stock option packaged in the convertible? The analysis is complex: Compare rates of return, adjust for the different risks of bonds and stocks, check call dates and the effects of conversion on stock dilution, evaluate the different levels of volatility of the two asset classes, and examine liquidity of the assets in their underlying markets.

If that’s too much, then consider closed-end convertible funds. The offerings are slim in Canada, but do include the Lazard Global Convertible Bond (CBF. UN on the TSX), a closed end fund that had its initial public offering on Dec. 9, 2009. As well, Toronto-based Middlefield Group has a closed-end fund called the Pathfinder Convertible Debenture Fund (PCD. UN on the TSX). Closed-end funds are essentially corporations with fixed baskets of securities. They do not buy or sell securities to meet investor purchases or redemptions.

In the U. S., there are just 11 closed end funds devoted to convertibles. All U. S. closed end funds are available to Canadian investors and their advisors. The U. S. list includes the Calamos Convertible Opportunity Income Fund (CHI on the NYSE) and the Calamos Strategic Total Return Fund (CSQ on the NYSE).

BOTTOM LINE

Should one invest in a convertible bond? Chris Kresic, senior vice president at Toronto’s Mackenzie Financial Corporation and manger of the company’s vast range of bond and fixed income funds, says “if you expect the story to be flat for a long time, a convertible bond is a good way to get paid for waiting.”

Andrew Allentuck’s book, When Can I Retire? Planning Your Financial Life After Work, was published last year by Viking Canada

About the author

Columnist

Andrew Allentuck’s book, “Cherished Fortune: Build Your Portfolio Like Your Own Business,” written with co-author Benoit Poliquin, was recently published by Dundurn Press.

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