Fund Investing

A hybrid between stocks and conventional bonds
By June Yee | 22/12/11

Persistently low interest rates and unpredictable stock-market returns are helping to generate interest in convertible bonds. These securities are a lesser known asset class that may appeal to investors who are in search of safety but also want some exposure to a potential stock-market upturn.

About the Author
June Yee is a researcher, writer and editor who covers investment funds. She is a co-author of the managed funds sections of the Canadian Securities Course, and has authored or co-authored articles for numerous media and research organizations. She is a founding member of the Canadian Investment Funds Standards Committee.

As with any investment, the key to making convertible bonds an effective part of your portfolio lies in understanding the opportunities and limitations. Like conventional bonds, convertibles pay to bondholders the fixed current income of the bond's coupon, which is the stated rate of interest when it's issued. With convertibles, as with other types of bonds, investors have the security of knowing the issuer has an obligation to repay the principal in full at maturity.

After drying up during the credit crunch of 2008, the number of convertible bonds issued by Canadian companies has been on the upswing. In 2010, Canadian issuers put forth 52 new issues worth $4.5 billion. This year, the convertibles market is on track to post similar numbers.

The typical coupon on convertibles in Canada lately has ranged between 5% and 8% with an average yield of 6.6%. One reason for their recent popularity is that these yields compare very favourably with the much lower yields on Government of Canada bonds.

"You also have the opportunity to benefit if the underlying stock does well," says Lee Goldman, senior vice-president and portfolio manager with First Asset Investment Management Inc. in Toronto. "The real benefit is that, if the stock goes up, you have the ability to participate in that." Goldman leads the team that is responsible for $550 million in convertible-bond assets, including the $85-million Criterion Canadian Convertible Bond.

The returns from convertible bonds generally have a higher correlation to stocks than to bonds. Moreover, at times of rising interest rates, convertibles tend to be less sensitive to those changes than are straight bonds.

Here's how the conversion mechanism works to provide upside potential: Typically, at any time from issue to maturity, a holder has a right to convert the bond at a specified price into the underlying equity of the issuer.

When the price of the underlying stock reaches and exceeds the conversion price, the convertible bond trades like the equity, following the price of the underlying stock upward with, theoretically, no limit on the potential profit. "Obviously, you should convert only if the stock goes through the conversion price," says First Asset's Goldman.

On the other hand, if the stock price falls below the conversion price, a convertible bond will trade just like a straight bond, with prices largely affected by the interest rates and yield to maturity. In this case, however, the bond holder still benefits from the downside protection provided by the bond's interest payments, which effectively serve to support the price of the bond.

The energy and financial (especially real estate) sectors have always been heavily represented in the Canadian convertible-bond market. The issuers are generally unrated companies that are aiming to borrow cash at reasonable rates by giving bond-buyers the upside potential of their shares.

Even with a growing number of bonds being issued, says First Asset's Goldman, an individual investor may have trouble accessing popular convertible-bond issues. His or her retail broker may be under-allocated or not have access to the issue at all. "On the institutional side, we get excellent fills. It's a fairly big advantage we have," says Goldman.

In June, his company launched Canada's first exchange-traded fund with a focus on convertibles. The debut of XTF Capital's Canadian Convertible Liquid Universe CXF, which combines a rules-based methodology with active management, was followed closely by Claymore Investments Inc.'s introduction of Claymore Advantaged Convertible Bond ETF CVD, which tracks the DEX Convertible Bond Index. That equal-weighted benchmark of the Canadian convertible-bond market is itself new this year, having been launched on May 31.

Notwithstanding the diversification and other advantages of a managed portfolio of convertibles, you should be aware that investing directly in convertibles can give you access to certain strategies that are not permitted in investment funds.

A popular tactic, for example, is a hedge that sees the bondholder short-sell the underlying stock. This effectively uses the conversion mechanism as a covered-call option. In other words, the bond holder would be able to cover the short stock position, if necessary. Of course, there are important intricacies to this strategy, such as the fact that the short position is responsible for any scheduled income payouts.

As with any bond, a convertible-bond holder stands ahead of common and preferred shareholders in terms of claims on company earnings and assets. According to First Asset's Goldman, convertible bonds lie somewhere between corporate bonds and dividend-paying stocks in terms of risk and return. From a credit perspective, he adds, convertibles are comparable to high-yield bonds.

But not only can features differ significantly among individual convertible issues, the combination of a bond and a stock component can make convertibles difficult to price properly. "You really have to have a view on the fixed-income component (being credit spreads and government bond yields), and also a view of equity markets generally, then move to name-specific (opinions)," says Goldman. "But there are lots of moving pieces, so you want to watch closely."

How convertibles work

CouponBond
Price
Share per $100 of
bond on coversion
Price of
common stock
XYZ Convertible Bond6.00%$12010$12.50

In this simplified, hypothetical example, the convertible bond is trading at $120 (per $100 face value). The conversion terms give the holder 10 shares for every $100 of the par value of the bond she holds.

So, on conversion she would get 100 shares per $1,000 par value of the bond. With the shares currently trading at $12.50, the holder would receive common stock with a market value of $1,250 ($12.50 x 100).

Theoretically, the bond price should follow the price of the stock upwards. In this example, however, the bond (at $1,200) is trading below what it should be worth, given the price of the stock. This represents an opportunity for investors in the convertible bond to profit from conversion. The profit, in this example, would be $50. ($1,250 minus $1,200).

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